Chocolate and Gold Coins

Friday, September 30, 2005

Micro vs. Macro

Café Hayek has an essay on the difference between microeconomics and macroeconomics. Don Boudreaux writes:

Microeconomics focuses on the actions of individuals; it examines how individuals respond to incentives, as well as studies the various incentives that individuals in different circumstances confront. Gary Becker is a living example of a premier microeconomist.

Macroeconomics involves tracing out the unintended consequences of various actions and sets of individual actions. It studies the logic of the spontaneous, unintended order (or disorder, as the case may be) that emerges when each of many individuals respond to the incentives identified and classified by microeconomics. On this definition, Hayek is certainly one of history's greatest macroeconomists.

This definition is, I believe, unnecessarily complex. The distinction between micro and macro is that micro looks at one market in isolation and macro looks at all markets collectively. You might intuitively think that the sum of all the micro models is a macro model. Indeed that is a good description of general equilibrium. And you would be right if you assumed that a good macro model is a whole lot more complex than a good micro model.

So a micro model might look at supply and demand for some market, for example pencils, and try to estimate the supply curve and the demand curve. This is entirely possible because it is easy to look at this market in isolation. One need not consider the possibility that a shift in the demand for pencils might affect other markets like automobiles and airlines.

Now consider an increase in the price of oil. This price increase will reverberate throughout the entire economy. It will affect the automobile industry, the airline industry, and any other industry that uses oil. But it doesn’t stop there. When the price of oil rises, the demand for other types of fuel shifts as well because there might be some partial substitutability between different types of fuel. Electricity might become more expensive, natural gas might become more expensive, and so on. A model of the petroleum market might be really complex.

Actually, the distinction between micro and macro is more fundamental. In practice, micro modelers are econometricians, and these people are experts in statistics. They have marketable skills that allow them to decide between academia and business. Econometricians rule economics.

And almost all econometrics is bunk. This is because it is notoriously difficult to sort out cause and effect by just looking at data. Usually, both cause and effect are mixed in. Let me give a simple example. Econometricians have been trying for years to estimate what factors improve scholastic performance. They wonder if a better student/teacher ratio helps. But you will never observe schools with the whole range from 5 to 50 children per class. If you observe one school with a lower student/teacher ratio, you will have to wonder: is it that they just decided to lower the student/teacher ratio or were they compelled to do so by declining test scores. A low student/teacher ratio could mean a willingness to pay for academic excellence or a desperate attempt to compensate for a failing education system. You might not be able to figure this out just by observing data. This is why most econometrics is extremely suspicious.

In the 1970’s and 1980’s, macroeconomics was revolutionized by a radical idea: general equilibrium. It had the ambitious goal of modeling the entire economy as a closed model. Everything would be included in the model. Prices in all markets would be simultaneously computed. But the models were just too complex to compute. Modern computers are much more capable, but generations of macroeconomists forced to endure the hard mathematics of general equilibrium are now pushing back. General equilibrium isn’t dead but many economists are openly contemptuous of the field.

The problems with general equilibrium come on many levels. The complexity of the modeling requires a collaboration of many people and economist tend to work in very small groups. The models are technically very complex, and most economists didn’t study economics to be some kind of a software engineer. There is also fear that modeling the economy is the first step in government controlling the economy. But another subtle issue is the idea the economy is just too vast and unpredictable to ever allow itself to be modeled. Economic order is created out of the process of the marketplace and is not something predictable.

General equilibrium could allow one to at least attempt to answer a question like, “What would happen if we switched from income tax to consumption tax?” No model could accurately predict all of the subtle effects. But a big model could greatly improve our intuition about what might happen over time. A model is simply an analogy. Instead of saying, “Well, Luxemstan switched to a consumption tax and see what happened to them,” we could say, “In the model, the only thing we changed was the tax policy and see what happened in the model economy.” It gives us something to work with.

I studied general equilibrium in graduate school and understood it very well. I would have hoped that there would be a market for someone with my skills but I am not using those skills at all today. Basically, the market for general equilibrium is underdeveloped. It seems a pity. But there is plenty of work for all types of economists, so I cannot complain.

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