Tuesday, January 27, 2015

Formulating a Framework for Economic Analysis (with Agent-based Modeling in Mind)

What is economics? In his Principles of Economics, Carl Menger tells us that his goal is to “reduce the complex phenomena of human economic activity to the simplest elements that can still be subjected to accurate observation, to apply to these elements the measure corresponding to their nature, and constantly adhering to this measure, to investigate the manner in which the more complex economic phenomena evolve from their elements according to definite principles (46-7).” Economics is about the relationships that arise between elements, and those new elements that come into existence within the market order. These cannot be studied with Cartesian causation, with what Menger referred to as “a natural-scientific orientation,” if the goal of the study is to understand the economic processes and complex relationships of diverse economic elements. Emphasis must be on structure and process as opposed to simple input-outputs processes defined by parameters. This requires greater emphasis on the elements of economic analysis than is embodied by the modern paradigm.

What are the objects of study in economics? Before, we considered the example of a husband pleasing his wife within a general economic framework, but we did not identify systematically the objects of interest to the study of economics. These include:
  1. Agents
  2. Preferences
  3. Goods
  4. Capital Structure
  5. Money
  6. Property Rights
  7. Prices
  8. Expectations
  9. Entrepreneurship
I will review these one at a time.

1.  Agents

The economy is comprised of real life human beings. These agents are ecologically rational, meaning they do not reason only by means of internal objects. They relate their thought processes to the webs of objects that comprise their reality (Gigerenzer 2008). While agents can adopt technically advanced methods of decision making, most decisions are made using heuristics – rules of thumb. Those that reduce decision making down to the attributes of one or a few elements in their environment have been shown to be efficient (Gigerenzer and Goldstein 1996). The common practice in economics has been to assume that agents have perfect information. This assumes away the process that economics, at its core, seeks to analyze.

Marshall referred to supply and demand as a pair of scissors. One blade requires the other for successful analysis. Herbert Simon and Gerd Gigerenzer suggest that a new pair of scissors to motivate analysis:

The structure of natural environments, however, is ecological rather than logical. In Simon’s words: “Human rational behavior is shaped by a scissors whose two blades are the structure of task environments and the computational capabilities of the actor [emphasis mine]” (Simon, 1990: 7). Just as one cannot understand how scissors cut by looking only at one blade, one will not understand human behavior by studying either cognition or the environment alone. (Gigerenzer 2008, 7)

Agents offload computational work by using objects that they have identified from the environment. This is why doctors don’t understand how to apply Bayesian statistics when information is couched in statistical jargon and formalization, but can apply simple math to the structures they already use to interpret reality, and thereby arrive at a more accurate survey of the data. The information that agents access is typically not purely abstract. The habit of academia is to assume that all reasoning must take place in formless models. This has been true in economics as a consequence of the growth of rational expectations as the dominant mode of analysis.

The problem here discussed is well represented by analysis of the real world. Gerd Gigerenzer notes:

When physicians try to draw a conclusion from conditional probabilities, their minds tend to cloud over (chap. 9). What can be done to correct this? From an internalist perspective, one might recommend training physicians how to insert the probabilities into Bayes’s rule. Yet this proposal is doomed to failure. When we taught students statistics in this way, their performance dropped by 50 percent just one week after they successfully passed the exam and continued to fade away week by week (Sedlmeier & Gigerenzer, 2001). Moreover, the chance of convincing physicians to take a statistics course in the first place is almost nil; most have no time, little motivation, or believe they are incurably innumerate. Are innumerate physicians inevitable? No. In the ecological view, thinking does not happen simply in the mind, but in interaction between the mind and its environment. This opens up a second more efficient way to solve the problem: to change the environment. The relevant part of the environment is the representation of the information, because the representation does part of the Bayesian computation [emphasis mine].”(17)

This efficient form of computation – let’s call it ecological Bayesian computation – has no analog in typical models. Luckily, an agent-based computational framework allows for this sort of representation and decision making. This paradigm of analysis has an obvious medium for modeling!

2. Preferences

In our model of the economy, preferences are the ultimate given. I (implicitly) spent enough time last post describing preferences. Preferences are observed directly from the actions of agents. If an agent chooses to take a particular action, it is because she believes the results of the action, given its expected cost, to be better than the other options she can imagine. Traditional models abstract away from decision-making processes and make decisions dependent upon expected utility. This measure is typically treated like a cardinal value, which might be useful for conveying the nature of economic action. From the perspective of “pure” theory, preferences are ranked ordinally, not cardinally. We can only observe what an agent does. If in a model, an agent’s preferences are assigned utility values, the states that arise from the interaction of the agent with her environment are the objects of interest to the study of preferences. Any sort of optimization of utility derived from calculus is a convenient tool for arriving at ordered preferences. Cardinal utility has no bearing on these real life processes.

3. Goods

Carl Menger clearly defines a good in his Principles. He writes:

Things that can be placed in a causal connection with the satisfaction of human needs we term useful things. If, however, we both recognize this causal connection, and have the power actually to direct the useful things to the satisfaction of our needs we call them goods (52).

A thing is a good if the following prerequisites are met:

1.     A human need
2.     Such properties as render the thing capable of being brought into a causal connection with the satisfaction of this need.
3.     Human knowledge of this causal connection.
4.     Command of the thing sufficient to direct it to the satisfaction of the need. (52)

Not only must these prerequisite be met, but they must also appear to be achievable by the agent in question (Note criteria from #2).

A thing ­­loses its good character if:

1.     Owing to a change in human needs, the particular needs disappear that the thing is capable of satisfying
2.     Whenever the capacity of the thing to be placed in a causal connection with the satisfaction of human needs is lost as the result of a change in its own properties
3.     If knowledge of the causal connection between the thing and the satisfaction of human needs disappears
4.     If men lose command of it so completely that they can no longer apply it directly to the satisfaction of their needs and have no means of reestablishing their power to do so. (52-53)

But a good that loses its goods character may still be treated like a good:

1.     When attributes, and therefore capacities, are erroneously ascribed to things that do not really possess them
2.     When non-existent human needs are mistakenly assumed existent. (53)

Last time, I described a good with a simple story about a husband seeking to please his wife. While a story is a nice way to remember a concept, it is important for the sake of study this more general definition. Remember that a good can only exist if some agent expects that attainment of the good will improve his position. Thus, the definition and type of good requires context.

4. Capital Structure
a.       Orders

Capital structure is a formal description of the arrangement of economic goods. A good can be described by its order: its position in the process of production. If a good is employed to produce a higher order good (say machinery), the good is itself a higher order good. But if that same good is consumed with expectation that consumption will improve the welfare of the agent consuming it, then the good is a first order good. Thus, there is nothing intrinsic about the order of a good. It is a description relative position in the structure of production.

5. Money

Money serves several roles. It is:

 1. A medium of exchange.
 2. A store of value.
 3. A common unit of account.
a.       A standard of deferred payment.

Historically, money has arisen when agents in a community begin to accept one a small number of commodities as a medium of exchange. Consider the first oat farmer who realized that he was not only growing food, but money! Under such a standard, exchanges are measured in terms of volume of wheat. Oats have a finite lifespan, which does not serve well for functioning as a store of value. Eventually, a money that is durable and easily divisible will be commonly accepted.

6.  Property Rights

Assumed in our analysis is an organization of ownership described as private property. Menger describes property rights as:
The entire sum of goods at an economizing individual’s command for the satisfaction of his needs, we call his property. His property is not, however, an arbitrarily combined quantity of goods, but a direct reflection of his needs, an integrated whole, no essential part of which can be diminished or increased without affecting realization of the end it serves.” (76)

In our model of the economy, as well as in real life, agents are empowered by their ownership of goods. When an agent owns a good, that good is under his control. Thus, property ownership provides a social space for a property owner to experiment with the allocation of goods at his disposal. When property rights are considered alongside the existence of money and money prices, the scheme serves to account for all of society’s available resources, assuming that property rights are secure.

Property rights, however, are not perennial. While ownership may be a natural habit of humankind, formal property rights, guarded by the legitimated use of violence – historically from the state – must be developed. Security of property rights has fluctuated overtime, and has seen its greatest development since the Glorious Revolution with the ascension of a government that served a broader array of interests than those of the aristocracy (North, Wallace, and Weingast 2012). This is not to suggest that property rights did not exist elsewhere, or that they were perfected at that time. Rather, this era marks a turning point in the representation of group interests in the edifice of government. It is no coincidence that since that time, society has flourished in a manner never before observed in history. It is also no coincidence that this move toward well-defined property rights has tended, even if imperfectly, to shift responsibility of ownership to those who are best able to maintain valued resources.

Thus, we have explored a large part of the general economic framework. In future posts, I will spend more time investigating prices, expectations, and entrepreneurship as each of these elements merit thorough description.

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