Model economics: Encyclopedia II - Model economics - Pitfalls

Model economics - Pitfalls

Model economics - Restrictive unrealistic assumptions

Economic models can be such powerful tools in understanding some economic relationships, that it is easy to ignore their limitations. For example, perfect-competition equilibrium market models. These models are based on perfect information, an identical product, and inability of individual agents to significantly affect total output or demand. When these assumptions are met, the resulting static equilibrium conditions will be Pareto-optimal. One can interpret optimality as an ideal situation in which each agent can do no better. When these assumptions fail, for instance under imperfect information or product differentiation, the model cannot be used to draw these conclusions (nor can the propositions be shown false; alternative methods, such as experimental economics are required).

An economic model that has been established to have validity in explaining a relationship under one set of assumptions, is useless if the assumptions are not valid. Model assumptions include not only those can be expressed as predicates on model parameters but others with more qualitative or asymptotic form. This basic concept is however surprisingly often ignored. A common example is the application of Keynesian economics to government fiscal policy. The simple Keynesian model postulates (among other things) that output is a function of aggregate demand. Government spending is one component of aggregate demand, so Keynes' model is often applied to conclude that increasing government spending will have the same positive effect on output as private investment (see the article by Paul Samuelson, Simple Mathematics of Income Determination). This application of the model is correct in the short run, but the model does not take into account the results of this policy change, which may affect business cycles, interest and tax rates, private investment, and other factors which could in the long run either reduce or increase output as a result of the change in fiscal policy. This example highlights one of the difficulties of applying economic models, which is correctly inferring short term and long term effects of economic policy.

Model economics - Omitted details

A great danger inherent in the simplification required to fit the entire economy into a model is omitting critical elements. Some economists believe that making the model as simple as possible is an art form, but the details left out are often contentious. For instance:

• Market models often exclude externalities such as unpunished pollution. Such models are the basis for many environmentalist attacks on mainstream economists, for including the price of everything but the value of nothing in their models. It is said that if the social costs of externalities were included in the models their conclusions would be very different, and models are often accused of leaving out these terms because of economist's pro-free market bias.
• In turn, environmental economics has been accused of omitting key financial considerations from its models. For example the returns to solar power investments are sometimes modelled without a discount factor, so that the present utility of solar energy delivered in a century's time is precisely equal to gas-power station energy today.
• Financial models can be oversimplified by relying on historically unprecedented arbitrage-free markets, probably underestimating the chance of crises, and under-pricing or under-planning for risk.
• Models of consumption either assume that humans are immortal or that teenagers plan their life around an optimal retirement supported by the next generation. (These conclusions are probably harmless, except possibly to the credibility of the modelling profession.)

Model economics - Are economic models falsifiable?

The sharp distinction between falsifiable economic models and those that are not is by no means a universally accepted one. Indeed one can argue that the ceteris paribus (all else being equal) qualification that accompanies any claim in economics is nothing more than an all-purpose escape clause. See the N. de Marchi and M. Blaug collection for a philosophical discussion of these issues. The all else being equal claim allows holding all variables constant except the few that the model is attempting to reason about. This allows the separation and clarification of the specific relationship. However, in reality all else is never equal, so economic models are guaranteed to not be perfect. The goal of the model is that the isolated and simplified relationship has some predictive power that can be tested. Ignoring the fact that the ceteris paribus assumption is being made is another big failure often made when a model is applied. At the minimum an attempt must be made to look at the various factors that may not be equal and take those into account.

Adapted from the Wikipedia article "Pitfalls", under the G.N U Free Docmentation License. Please also see http://en.wikipedia.org/wiki