Wednesday, 1 January 2014

General equilibrium in contemporary economics

Thanks to Gavin Kennedy over at the Adam Smith's Lost Legacy blog I was alerted to this article by Paul Seabright in The Moscow Times. Seabright opens his piece by saying,
For the last half-century, the world's leading universities have taught microeconomics through the lens of the Arrow-Debreu model of general competitive equilibrium. The model, formalizing a central insight of Adam Smith's "The Wealth of Nations," embodies the beauty, simplicity and lack of realism of the two fundamental theorems of competitive equilibrium, in contrast to the messiness and complexity of modifications made by economists in an effort to capture better the way the world actually functions. In other words, while researchers attempt to grasp complex, real-world situations, students are pondering unrealistic hypotheticals.
(Below GE denotes general equilibrium.)

I would argue that Seabright misrepresents much of contemporary economics and economics teaching here. As I noted in a working paper on The past and present of the theory of the firm: A survey of the development of the mainstream approaches to the firm in economics,
A final point about the models of the firm discussed in this essay is that they highlight a general issue to do with post-1970 microeconomics, that is, the retreat from the use of general equilibrium (GE) models.
In a footnote I add,
When discussing the influence of Gerard Debreu [Debreu is most famous for his work on GE] on economics Duppe (2010: 2-3) nicely sums up the fate of GE as well. "From the point of view of today Debreu's influence on the body of economics could be called zero, in that general equilibrium theory (GET) is the economics of yesterday. While GET had mirrored most analytic advances in economic theory before Debreu, after Debreu most theoretical innovations came as alternatives to GET (from game theory to complexity theory)". Historian of economic thought Roger Backhouse writes that "[i]n the 1940s and 1950s general-equilibrium theory [ ... ] became seen as the central theoretical framework around which economics was based" (Backhouse 2002: 254) and that by the "[  ... ] early 1960s, confidence in general-equilibrium theory, and with it economics as a whole, as at its height, with Debreu's {\em Theory of Value} being widely seen as providing a rigorous, axiomatic framework at the centre of the discipline" (Backhouse 2002: 261), but "[  ...  ] there were problems that could not be tackled within the Arrow-Debreu framework. These include money (attempts were made to develop a general-equilibrium theory of money, but they failed), information, and imperfect competition. In order to tackle such problems, economists were forced to use less general models, often dealing only with a specific part of the economy or with a particular problem. The search for ever more general models of general competitive equilibrium, that culminated in Theory of Value, was over" (Backhouse 2002: 262). One set of particularly problematic results for general equilibrium are the Sonnenschein-Mantel-Debreu (SMD) theorems. "In part because of a conviction that progress could not be made in general equilibrium theory, there was a substantial redirection in economic theory. As the results in SMD theory became well known, for example through Wayne Shafer and Hugo Sonnenschein's survey (1982), economists began to question the centrality of general equilibrium theory and put forward alternatives to it. Thus in the ten years following the Shafer-Sonnenschein survey, we find a number of new directions in economic theory" (Rizvi 2006: 230).
I go on to noted that,
As early as 1955 Milton Friedman was suggesting that to deal with "substantive hypotheses about economic phenomena" a move away from Walrasian [GE] towards Marshallian [partial equilibrium] analysis was required. When reviewing Walras's contribution to GE, as developed in his Elements of Pure Economics, Friedman argued,
"[e]conomics not only requires a framework for organizing our ideas [which Walras provided], it requires also ideas to be organized. We need the right kind of language; we also need something to say. Substantive hypotheses about economic phenomena of the kind that were the goal of Cournot are an essential ingredient of a fruitful and meaningful economic theory. Walras has little to contribute in this direction; for this we must turn to other economists, notably, of course, to Alfred Marshall" (Friedman 1955: 908).
By the mid-1970s microeconomic theorists had largely turned away from Walras and back to Marshall, at least insofar as they returned to using partial equilibrium analysis to investigate economic phenomena such as strategic interaction, asymmetric information and economic institutions.
I illustrate this point with reference to the theory of the firm and contract theory.

All the models discussed in the working paper are partial equilibrium models, but as I note, in this regard the theory of the firm is no different from most of the microeconomic theory developed since the 1970s. Most of modern microeconomics, such as incentive theory incomplete contract theory, game theory, industrial organisation, organisational economics etc, has largely turned its back on GE theory and has worked almost exclusively within a partial equilibrium framework.

One major influence on the development of the theory of the firm has been contract theory. But contract theory is a good example of the contemporary theory's increasing reliance on partial equilibrium modelling. Contract theory grew out of the failures of GE. As Salanie (2005: 2) has argued,
"[t]he theory of contracts has evolved from the failures of general equilibrium theory. In the 1970s several economists settled on a new way to study economic relationships. The idea was to turn away temporarily from general equilibrium models, whose description of the economy is consistent but not realistic enough, and to focus on necessarily partial models that take into account the full complexity of strategic interactions between privately informed agents in well-defined institutional settings".
One of the main features of the teaching of modern microeconomics is the emphasis on issues in economics which GE does not handle well. As an example of this consider the contemporary theory of the firm. The current literature on the theory of the firm can be seen as being divided into two general groups based on which of two of the standard assumptions of GE theory, namely symmetric information and complete contracts, is violated when modelling the firm. In contract theoretic terms the former gives rise to principal-agent type models and the latter to incomplete contract type theories. The necessity of having to violate basic assumptions of GE theory so that we can model the firm, suggests that as it stands GE can not deal easily with firms, or other important economic institutions. Bernard Salanie has noted that,
"[ ... ] the organization of the many institutions that govern economic relationships is entirely absent from these [GE] models. This is particularly striking in the case of firms, which are modeled as a production set. This makes the very existence of firms difficult to justify in the context of general equilibrium models, since all interactions are expected to take place through the price system in these models" (Salanie 2005: 1).
But economics students are taught about the areas of economics were GE theory breaks down. They all learn about game theory, asymmetric information, industrial organisation, incentive theory etc etc and all these areas utilise partial, rather than general, equilibrium theory in an effort to overcome shortcomings in the current approach to GE.

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