Microeconomic models

The use and limitation of Microeconomic theory. Economic methodology

In simple words scientific method means that we have to occupy next stages:

I. observe a phenomenon,

II. make simplifying assumptions and formulate a hypothesis,

III. generate predictions, and

IV. test the hypothesis.

Modern microeconomics focuses on the use of abstract models as a means of pursuing the inner truth of key issues. What are they for? What makes a good model?

Purpose. Apart from claims to intrinsic intellectual beauty (and some models do have an inherent attractiveness all of their own) the quality of a model depends upon such things as its power to explain the reasons underlying observed economic phenomena, to make precise the insights born of common sense. It is almost meaningless to describe a microeconomic model as “good”or “bad” without further qualification. Whether or not a particular model is good depends on the purpose for which it is designed – unless the model is actually so bad that it violates some fundamental economic principle (the equivalent, say, of assuming that water can flow uphill).

So, to assess the worth of an economic model we need a specific context in which to place its abstract components and mechanisms. Different circumstances – but apparently the same economic problem – may demand a different type of model. This does not mean that microeconomics is inconsistent or ambiguous, just that we have to be careful to pause and rethink the objectives of the model, the context in which it is set and the way the model components are to be implemented. The essential components of a microeconomic model can be summarised under the following headings:

– The economic actors. At the heart of the model is the economic actor or agent – someone or something that is taking economic decisions. It is common practice to speak as though this entity is just an isolated person. Often the same principles apply whether this actor is considered to be an isolated consumer, a worker, arepresentative member of a group or the embodiment of a corporation.

– Motivation .. Cynics may say that economics is about greed. In a sense cynics are right: most microeconomic models assume that somewhere deep in the mechanism is the driving force of self-interest. Are there useful alternatives? Certainly it is impossible to imagine many cases where self-interest is not well defined because the “self” may be a difficult concept. It is also possible to consider cases where individuals care about others’ consumption or others’ welfare. But in a sense even this can be seen as an extension of the standard paradigm of selfishness. Individuals select the choices that make them happiest, given the information available at the time of a decision.

Where the topic of motivation runs into diffculty is in characterising the content and structure of these selfish aspirations. In the matter of specifying agents’ preferences the model-builder usually has to fall back on assertion based on extrapolation from one’s own preferences and principles or, sometimes, on mathematical convenience. A special example of this is difficulty lies in the representation of people’s preferences under uncertainty: here strong far-reaching results can be obtained on the basis of a few elementary assumptions about preference structure, but it is not at all clear that they are in fact a suitable way of encapsulating individuals.motivation when faced with choicesunder uncertainty.

– The economic environment. The economic environment may take a variety of forms. The principal form relevant to our discussion is some sort of market. The market itself could be represented in a number of ways: obviously it consists of a collection of other economic actors, but in order to complete its description as the economic environment we need to specify the “rules of the game”.The rules of the game could refer literally to a game but, even in models where game theory makes no formal appearance, the assumptions about the forms of action and interaction that are admissible in the model are crucial in specifying clearly how a model is supposed to work and what it can tell us about human behaviour.

This can be illustrated even without using a formal model. We could imagine three levels of interaction of an individual economic agent with the environment, in ascending order of complexity:

1) Agents may just accept the economic environment like we accept the weather. Just as you cannot change the weather so no agent is large or in.uential enough to manipulate the economic environment, so the argument goes.

2) Maybe agents do not have to accept the economic environment as a given. Just as some human activities may indeed be big enough to affect the weather – so some agents’ economic activities may big enough to influence the market price of a product. However, interaction with the environment is limited: even if you can change the weather it doesn.t try to anticipate your actions

3) A third view is that the environment in which agents operate is not like the weather at all. Everyone has to take into consideration the explicit interaction with everyone else. This interaction will include possible anticipation by one agent of what another agent may do.

Which view of the environment is appropriate clearly depends on the type of microeconomic model and its purpose.

– Assumptions and axioms. Some of the basic ideas about the elements of a model.the nature of preferences, the structure of organisations, the physical nature of production possibilities – have to be modelled from scratch. The free hand enjoyed by the model-builder should be used in a way that well represents the modeller’s craft. The principal way that this craft is exercised in scratch modelling is known as the axiomatic method.

Axioms are just formally stated assumptions. They cannot be right or wrong, although they could be woefully inappropriate, judged by the purpose of the economic model.

What is the purpose of this formalisation? Axioms can help us:

ü carefully develop the flow of an argument;

ü concentrate on the individual components of key results;

ü debug a wonky theory.

But they can never substitute for clear thinking about the purpose and essential functioning of the parent model and about the role of the specific model components for which axioms are to be introduced.

“Testing” a model. What is the criterion of “relevance” of an economic model? Clearly it is advantageous if the predictions of the model do not immediately fall over when confronted with facts. However, this does not mean that all features of a model should be or could be subjected to rigorous empirical test. The standard methods of quantitative investigation can reveal a lot about the detail of agents’ behavioural responses to the market environment and yet miss the central point of a model. In some cases, what may be more promising is to turn this connection between theory and empirics around; if the theory predicts a certain pattern of behaviour by economic agents then use the theoretical predictions as restrictions on relevant econometric models in order to provide more useful estimates.

Testing a the quality of a theoretical model is a more subtle process than just confronting it with empirical testing. The model’s quality also depends on such factors as simplicity of form, clarity of prediction and the absence of.blind-alley. assumptions (those that leave you with nowhere to go when you try to relax them).

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