P10: Comments on Varian

Before proceeding with Re-Reading Keynes, I would like to clarify the issue of exogeneity and endogeneity, which he understands, but most of his followers failed to understand.  This is to clarify a segment of a phrase he uses in describing the four ways in which level of employment can increase within the framework of the classical theory of economics. The fourth factor listed by Keynes appears somewhat mysterious in the original text:
(d) an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.
== in the previous post (P9: Theory of Employment) I re-stated this as an exogenous increase in real wage, to clarify what Keynes wanted to say. However, (d) above is what Keynes actually wrote, and I want to explain why Keynes wrote in this way. This involves an excursion into the supply and demand model, and the concepts of exogeneity and endogeneity.
What Keynes is saying here is that if there is an increase in demand for luxury goods consumed by aristocrats, and an associate decrease in demand for necessities purchased by laborors, then the real wage will rise and that will increase employment. Keynes is very careful to create a scenario in which the real wage rises due to EXOGENOUS factors shift in demand by non-wage earners — the aristocrats.  What Keynes understood is something basic which is not understood by modern economists like Varian when they discuss the supply and demand model — ONE CANNOT CONTEMPLATE VARIATIONS IN AN ENDOGNEOUS VARIABLE (because endogenous variables are not free to move; they can only change if some of the exogenous variables which affect them change). This means that asking what consumers will demand if the price changes is a WRONG question — prices are endogenous and they cannot change by themselves. An increase in price cause by shortfall in supply would lead different consequencs from an increase in price caused by an upward shift in the demand. If a consumer is asked what he will do when the price changes, he should ask WHY did the price change, because his response to the price change DEPENDS on cause of the price change. He cannot provide a response to the question without learning about the cause, and whether or not this is a temporary or permanent change.

 

Comments on Varian: Intermediate Microeconomics. Chapter 1, which sets up a simple supply and demand model.

Brief Summary of Post:

These comments are about the first few pages of the chapter. Quotes from Varian are in italics. Criticisms are made in this post about the concepts of models, optimization, equilibrium, and the concept of exogeneity, as dealt with by Varian. Models are used without explicit discussion of the relationships between model and reality, which is essential to understanding how models work. For an extended discussion see my lecture on Models Versus Reality. The post explains why optimization, taken is tautological by Varian, is false as a description of consumer behavior. For an extended discussion of the conflict between axiomatic theory of consumer behavior and actual human behavior, see my one hour video: Behavioral Economics Versus Neoclassical Economic Theory.  Similarly, the decision to study only equilibrium behavior handicaps economists, making them blind to disequilibrium events like the Global Financial Crisis.

Detailed Discussion

Varian starts out by constructing a model for understanding the prices of apartments. We create a model by simplifying the world that we see, to highlight those ASPECTS that WE THINK ARE EXTREMELY IMPORTANT. At the same time, we SUPPRESS elements that we think do not matter. This decision, what we choose to model, and what we choose to ignore, is of extreme importance, but completely hidden from view. For example, suppose we believe (as I do) that human welfare is strongly dependent on communities in which humans live. Then in studying housing, I would keep the impacts of housing choices on communities as a crucial variable which we must model. Then I would be looking at groups of people living together in nearby houses as a community. However, these issues would be completely ignored by people who believe in individualism, where everyone leads isolated  and lonely lives independently of any community. There is a strong element of subjectivity and hidden social norms in the process of modeling, carried out under the pretense of objectivity.

We will think of the apartments as being located in two large rings surrounding the University. The adjacent apartments are in the inner ring, while the rest are located in the outer ring. We will focus exclusively on the market for apartments in the inner ring. The outer ring should be interpreted as where people can go who don’t find one of the closer apartments. We’ll suppose that there are many apartments available in the outer ring, and their price is fixed at some known level. We’ll be concerned solely with the determination of the price of the inner-ring apartments and who gets to live there.

There are two rings – why? The outer ring accommodates those people who cannot find an apartment within the market we will study.  This is a PARTIAL EQUILIBRIUM model – that is we study one aspect in isolation, without worrying about what happens outside this model .

An economist would describe the distinction between the prices of the two kinds of apartments in this model by saying that the price of the outer-ring apartments is an exogenous variable, while the price of the inner-ring apartments is an endogenous variable. This means that the price of the outer-ring apartments is taken as determined by factors not discussed in this particular model, while the price of the inner-ring apartments is determined by forces described in the model.

“the price of outer ring apartments is determined by factors not discussed in this model.” This is an OSTRICH definition of exogeneity. It means that we can make variable exogenous by not discussing them.  An exogenous variable MUST NOT BE INFLUENCED by endogenous variables. This is not mentioned in the definition above, because exogeneity concepts are not well understood by most economists. To ensure that a variable is exogenous, it is necessary to prove that there are no feedback loops; as described in the diagram below. Of course, it is understood that models are only approximations, and weak feedback loops may be ignored. However, completely ignoring the issue leads to widespread misunderstandings; these misunderstandings are embedded within the standard supply and demand model being exposited by Varian. Once we achieve clarity on the issue of exogeneity and endogeneity, we can see clearly that supply and demand cannot function in the way that is described in economic textbooks. This has been hinted at in the opening paragraph above, and will be explained clearly in a later post dedicated to this issue.

Varian’s confusion about exogeneity (that it can be achieved by refusing to discuss a variable) is extremely important in the context of the supply and demand model  under discussion in this chapter– ONE CANNOT CONTEMPLATE VARIATIONS IN AN ENDOGNEOUS VARIABLE (because endogenous variables are not free to move; they can only change if some of the exogenous variables which affect them change). This means that asking what consumers will demand if the price changes is a WRONG question — prices are endogenous and they cannot change by themselves. An increase in price cause by shortfall in supply would lead different consequences from an increase in price caused by an upward shift in the demand. If a consumer is asked what he will do when the price changes, he should ask WHY did the price change, because his response to the price change DEPENDS on cause of the price change. He cannot provide a response to the question without learning about the cause, and whether or not this is a temporary or permanent change

 

exogeneity

But what determines this price? What determines who will live in the inner-ring apartments and who will live farther out? What can be said about the desirability of different economic mechanisms for allocating apartments? What concepts can we use to judge the merit of different assignments of apartments to individuals? These are all questions that we want our model to address

Note that judgement of merit automatically involves NORMATIVE judgments. Also, the mechanisms under discussion are based on social norms which legitimize certain concepts of private property, implicitly, in background, and without discussion. These norms are then taken as objective facts. The questions that the model is used to study is PARTLY a consequence of how we choose to model, and partly determined by the model. This will be seen more clearly later, when we look at alternative ways to model the same economic situation described by Varian. Now Varian introduces what might be called the fundamental methodological commitment made by modern economic theory:

The optimization principle: People try to choose the best patterns of consumption that they can afford.

(This) is almost tautological. If people are free to choose their actions, it is reasonable to assume that they try to choose things they want rather than things they don’t want. Of course there are exceptions to this general principle, but they typically lie outside the domain of economic behavior.

Far from being tautological as Varian states, this is simply not true. It might have been true if consumption was a central or main concern of life. However, if our main interest lies elsewhere, then we would do SATISFICING – that is, consume whatever is sufficient for our needs, instead of MAXIMIZING consumption. By satisficing, we can fulfill our needs and save time and money for pursuit of higher goals of life. If consumption the highest goal of life (and a market economy creates this illusion and orientation) than the above optimization principle MIGHT hold. In real life, behavioral economists and psychologists have tested this theory, and found that it fails – people do not try to choose the best patterns of consumption that they can afford. Advertising OFTEN misleads people into buying products that they do not want, that they cannot afford, and that they do not use. One study in Australia showed that every year people purchase more than a million dollars worth of goods that they never use – even once!. So obviously, it is not true that people optimize their consumption patterns.

The second principle introduced by Varian is also part of the core methodological commitments of modern economic theory:

The equilibrium principle: Prices adjust until the amount that people demand of something is equal to the amount that is supplied.

The second notion is a bit more problematic. It is at least conceivable that at any given time peoples’ demands and supplies are not compatible, and hence something must be changing. These changes may take a long time to work themselves out, and, even worse, they may induce other changes that might “destabilize” the whole system. This kind of thing can happen . . . but it usually doesn’t. In the case of apartments, we typically see a fairly stable rental price from month to month. It is this equilibrium price that we are interested in, not in how the market gets to this equilibrium or how it might change over long periods of time.

This principle is completely wrong. In recesssions, it is a common experience that more than 1000 people applied for a few positions available. Obviously this shows an excess supply of labor, so the price should be adjusted downward.  However, in many historical episodes all over the globe, even though this pattern persisted for more than a decade, there was no downward adjustment in the real wage for labor  – they remained more or less stable and flat. Similarly, in many markets, one observes excess supply and also excess demand, but one does not see any adjustment in prices. That is why STICKY price models have become popular in some parts of economics. Basically it was this observation – that wages did not adjust downwards even though there was excess supply of labor – that led Keynes to the creation of Keynesian economics. The MAIN PURPOSE of Keynesian economics was to explain WHY supply and demand theory does not work in the labor market.

The second part of Varian’s explanation for why we study equilibrium is even worse: “It is this equilibrium price that we are interested in, not in how the market gets to this equilibrium or how it might change over long periods of time” Who decided that this is what we are interested in? In the Global Financial Crisis, we were interested in finding out why the prices of homes collapsed suddenly, in violation of equilibrium theory. Economists who are not interested in this, will never be able to answer this question. That is why the Queen of England went to the London School of Economics to ask “Why did no one see this coming?” In fact, in most markets, equilibrium is never achieved. Even when there are forces which drive to equilibrium, these forces vary in strength due to different, complex circumstances. When these forces are very weak, or non-existent, as Keynes claimed about the labor market, equilibrium might never happen. When these forces are very strong, equilibrium can emerge quickly. In the middle, there forces driving towards equilibrium and other forces which counter them. To understand such markets, it becomes essential to study dis-equilibrium process. The simplest such model which students may have seen is the Cobweb model of price adjustment. Even the simplest such models show that convergence may fail to occur, and equilibria can be UNSTABLE. This means that if you are exactly at equilibrium, you will stay there, but if you are slightly away from it, then market forces will push you further away from it. So to understand real economies, we must go beyond equilibria. Unfortunately, as Varian writes, economists are ONLY interested in the equilibrium price, so they completely fail to understand the real world, and in particular the global financial crisis, where disequilibrium is the rule, rather than the exception.

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