Models and Reality

Linked below is a 95m Video Lecture on the previous post on Simple Model Explains Complex Keynesian Concepts“. In Chapter 2 of General Theory, Keynes has two points against the classical theory of the labor market. He points out that laborers react strongly (with strikes) against wage cuts, but show no similar reaction to inflation. This means that the decision to supply labor does not depend on the real wage — instead it must depend only on the nominal wage. The SECOND point, which he regards as fundamental, is that the bargain between firms and laborers is conducted in terms of nominal wage — this decision does not determine the real wage. The real wage is an emergent property; it comes out of the system as a result of collective decisions of all, and is not controlled by any two parties. One of the KEY contributions of the SIMPLE MODEL discussed in the previous post, and in the video lecture below, is to show how this works — regardless of how the laborers and landlords negotiate and decide on the nominal wage, the real wage does not change. It is amazing that there is no understanding of this — which Keynes calls the “fundamental point” in the literature on labor economics. Current labor textbooks seem to completely ignore Keynes, and I am not aware of an explication of this anywhere else either [Readers: please provide pointers to clear explanations elsewhere if you know of some]. This can be considered as the main contribution of the simple model explained in the video lecture linked below (and the previous post, linked above).

THIS post (below the video lecture on previous post) is actually an assignment to the students to construct variations on the simple model. However, I start by discussing a crucial methodological issue: the relation between models and reality. I explain how this has been radically misunderstood by economists, due to some fundamental mis-steps in Western philosophical tradition. As a result the working concept of an economic model is disastrously different from what it is supposed to be. I provide a very brief summary of the differences between current western concepts and the correct notion of a model, and explain it with some simple examples. An extended discussion of this concept, and a 45m video lecture on it, are also linked below. This is followed by some exercises in model building for students.

95m Video Lecture on: Simple Model Explains Complex Keynesian Concepts

1      Models and Reality

There is a radical difference between how we understand “models” and how these are understood by economists and philosophers of science.  According to the understanding common among economists, the internal structure of a model is COMPLETELY IRRELEVANT.  Friedman argued that the validity of the axioms of a theory was not relevant; all that mattered was the ability to derive true conclusions from them:  “Truly important and significant hypotheses will be found to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions.” (See: Friedman’s Methodology: A Stake Through the Heart of Reason) You can construct any model – regardless of how complex it Is, and regardless of how unrealistic it is – if it produces predictions which match observed realities, it is a good model. Furthermore, the job of checking whether or not the predictions match is left to the applied economists – theoretical economists only produce the models, and do not need to check whether theses models produce predictions which match reality.

In this course, we operate with a VERY DIFFERENT understanding of what models are, and how they are used. The reality is very complex, and very difficult to understand – a huge number of factors are at work, and they interact with each other in a variety of ways to produce the observations that we see. We would like to UNDERSTAND some strange phenomenon that we observe. MODELS are an extremely simplified version of reality within which the phenomenon that we want to study arises. We want to simplify reality to the largest extent possible, and make the simplest possible model which can produce the phenomenon of interest. The simplicity of the model enables us to understand the model, and understanding the model is one step towards understanding a much more complex reality. Note that the emphasis and focus is on creating UNDERSTANDING, which is why we need simple, easy to understand models. In contrast, conventional macro texts introduce hopelessly complex models – instead of helping us understand reality, the models themselves are impossibly difficult to understand, and create a DOUBLE BARRIER to understanding – we cannot understand the model, and we cannot understand how the model relates to reality.

The phenomenon that Keynes was trying to understand was unemployment – according to classical theories, it should not exist. Can we create a simple model in which this phenomenon comes up? That was the goal of the model that was discussed in class on Monday, 17th September 2018 – (See: Simple Model Explains Complex Keynesian Phenomenon). This exercise asks you to explore variants of this model, under different assumptions and conditions. THIS is how one learns to use models.


I have discussed the connections between models and reality very briefly in the class lecture (which has been linked above). The issue is explained in considerable detail on the webpage linked below, devoted to this topic:

  Models Versus Reality  

SURPRISINGLY, there is a HUGE number of misconceptions about the concept of models and how the relate to reality. The webpage linked above provides a brief discussion of the following six subtopics regarding the relationship between models and reality:

S1:   Models SIMPLIFY reality 
S2:   Models map complex reality to simple understandable structures, which allow calculations and other manipulations.
S3:   Models as Metaphors — Identifying two objects which are ENTIRELY different.
S4:   The Necessity of Using Models: Even though models are ALWAYS wrong, we MUST use models to understand reality. There is no option. .
S5:   The Dangers of Models: Models Highlight somethings IGNORE others, and generally DISTORT reality
S6:   Confusing Models with Reality

A video lecture on methodology which is based on the notes above is: AM20 —Advanced Micro, Lecture 20 : Methodology. This lecture is in two parts. AM20a discusses general methodological flaws at heart of modern economic theory. The second part, AM20b, is 45m Video Lecture which explains the relationship between models and reality at length:

3      Exercises in Building Models

RECAP:  An agricultural economy produces only one good, say corn, using a simple fixed proportions production function. One Laborer working on One Acre of Land can produce 10 units of corn. All the land is owned by Landlords, and they do not do any work themselves. Rather they hire laborers to work their land. The economy functions according to the following rules. At the start of the period, Landlords hire laborers and pay them the going market wage rates in money. Then goods are produced and the market for goods opens. The Landlords retain some of the goods for themselves – this is their profit, or equivalently, their rent. The rest of the goods are put up for sale in the market. The laborers are the only consumers and they purchase the goods with the money they have earned in wages. That ends the period.

There are ten landlords, and each of them owns 5 acres of land. Suppose there are 40 laborers. In a symmetric case, all landlords will hire 4 laborers, and end up with 40 units of corn produced. How much everyone gets depends on HOW the markets are arranged. We will do several exercises to illustrate how this can vary. The object of playing around with the model under different assumptions is to create familiarity and understanding among students.

To simplify, we will consider that the wage rate is exogenous and set at Rp 100 by law. This way, there is no bargaining about wages in the model.


  1. In the economy described, suppose that a communist revolution takes place – distinction between landlords and laborers is eliminated, and all work equally and share equally. Show that the outcome is Pareto-superior – that is everybody consumes more. However, this does not take into account discomfort/disutility from labor.
  2. A share-cropping economy: Instead of hiring laborers, landlords can rent land to laborers on the basis of getting a SHARE in the output. Then this can be non-monetary economy – corn is produced and shared. Use Assumption A – maximum possible food consumption is 10 units. What is likely to happen in a one period static CLOSED economy? CLOSED means that food cannot be exported or used in any way other than for domestic consumption. What shares would emerge as equilibrium values? MAKE plausible ASSUMPTIONS about how laborers and landlords negotiate. Take into account the fact that every landlord is making profits and wants to hire more laborers. What is likely to be the result of this competition? Explain whether or not landlords are likely to give up some portion of their maximum consumption in order to be able to hire extra labor in a CLOSED economy?
  3. Share Cropping (cont): Now consider an OPEN economy, where the landlords can EXPORT the corn they get as their share, and earn foreign exchange, which they use to buy imported luxuries. Now there is no longer a limit on maximum consumption for landlords, because they don’t consume the corn at all, they simply export all of it to earn revenue. Suppose we start with a situation where the share is 50% for landlord and 50% for laborer. This is considered fair and just by all — as we have seen, marginal productivity DOES NOT determine wages; actually they are strongly dependent on social norms regarding fairness, and the relative power of the two groups which are negotiating. Suppose ONE of the landlords gets greedy and says that from now on, I will offer only 40% to laborers and keep 60% for myself. (A) What is likely to happen, when there is competition among landlords? (B) In contrast, what may happen when the landlords collude? (C) Alternatively, what happens if the landlords compete, but the laborers form a union. (D) If landlords and laborers BOTH form unions then what will happen? In answering this question – there are no CORRECT answers. Anything can happen. Here is how to GUIDE your thinking about the matter in a SCIENTIFIC way. Science is not concerned with making up good axioms or fancy equations. It is concerned with what happens in the real world. You have played an experimental game in which there were landlords and laborers who negotiated and worked according to the rules given. Suppose we set up an experimental game where there were 10 landlords and 40 laborers – or reduce it to 5 landlords and 20 laborers to make the experiment easier. Now consider a game where there is NO DIRECT COMMUNICATION or DISCUSSION allowed between landlords and also between laborers. Wage Offers and acceptances or rejections are sent via signals, without conversation. What would happen in such a game? This is the question about which you should think and formulate a HYPOTHESIS – note that hypothesis need not be sharp – you might think that any share between 10% and 90% can emerge depending on relative bargaining abilities of the two parties – this is ALSO a prediction. If in repeated experiments only one share emerges, then this prediction would be wrong. So even “ANYTHING CAN HAPPEN” can be a WRONG prediction about the game, if the same thing happens in every game. You should try to predict what will happen in the four cases (A),(B), (C) and (D) above. Then you can CHECK your predictions by running experiments under different conditions.
  4. RENTAL OF LAND: All above cases are NON-MONETARY economies. All dealings are in terms of the real good, corn. Now we consider a MONETARY economy. Landlords RENT their land to the laborers, for some rent R, which we don’t know at this point. Now the production of 10 units of corns belongs completely to the laborers. BUT laborers are no longer earning Wages. They must BORROW money in order to pay rent – assume, to simplify things, that they can borrow money at 0% interest. IDEALLY, each laborer would just CONSUME all ten units that he produces, since that would maximize his utility. However, he must SELL at least some of the goods on the open market, in order to be able to repay the loan he took to pay the rent to the landlord. Consider different hypotheses about how laborers would behave – how much will they put up for sale, and how much they will keep for self-consumption – and calculate the outcomes for all participants under different assumptions. Also consider whether or not the outcome is an EQUILIBRIUM – everyone is satisfied, and there is no built in tendency for people to change their decisions. Note the depending on different assumptions about how laborers behave, in terms of how much corn they put up for sale, different amounts of money would be suitable as equilibrium RENT for land.
  5. Interest based loans: Suppose that, in the original model, the landlords (some or all of them) do not have enough money to pay the wages to the laborers in advance. Then they might BORROW the money at interest. Since the product they sell exactly recaptures the amount they spend on wages, there is no monetary profit — there is REAL profit because they keep surplus corn for themselves, but the money they pay is exactly the maximum they can earn — there is no other money anywhere else in this simple, primitive, closed economy. As a result NO ONE can pay back any interest, and defaults on interest rate repayment for loans are GUARANTEED to happen. A solution to this problem is created by Islamic modes of financing, which do not allow the lender to be absolved of RISKS of doing business. “Loans” are ONLY for social purposes, and cannot be used to business. Business Financing MUST be done on partnership basis, and the one who provides money MUST participate in the risks of doing business. In this case, if the landlord makes a profit, he provides a share to the financier, but if he makes a loss, he repays only what is possible for him, passing on the loss to the financier. In this case everyone will remain solvent, and financiers will not make any profit or loss (on the average) on their loans.

Bring in the solutions to this problem set for discussion in next class. We will also discuss points left over from the previous lecture, and perhaps move on to Chapter 3 of Keynes on Effective Demand.

  1. Sana Younas said:

    Sir, Reality is totally a subjective term so for example for same object different people have different perception then it could be possible that for same object different models exist. My question is which should be declared as true model in that case?

    • Reality is not totally subjective — it is objective, but it is not available to us for viewing, except via our subjective apparatus, so we cannot directly perceive reality. The closest approxiimation we can get is the inter-subjective — something on which there is widespread consensus — a lot of people agree on what is out there.

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