21st Century Economics

1
21st Century Economics
Paul Ormerod Volterra Consulting Ltd February
2006
2
The history of economic thought (1)

• From 1870 to 1970, the main concern was to
  develop and formalise the theory of the optimal
  allocation of a given set of resources
• Agents (firms, people) maximise, and all have
  access to complete information
• Preferences are fixed
• This is still the basis of much of the theory
  which is taught
•  

3
The history of economic thought (2)

• The programme of research on general equilibrium
  was finalised by the mid-1970s
• The theory contains no testable propositions
• There is no implication in general equilibrium
  theory that market demand curves slope downwards
  Sonnenschein-Debreu-Mantel
• There is no implication in general equilibrium
  theory that factors of production are paid their
  marginal products Bliss

4
The history of economic thought (3)

• In the 1970s, some smart American economists
  realised the game was up with complete
  information models
• Bounded rationality
• Agents still maximise, but not all, perhaps none,
  have access to full information
• Preferences are still fixed
• Pioneers like Akerlof and Stiglitz now have the
  Nobel prize

5
The future of economic theory

• Agents no longer maximise, because of limits on
  their cognitive ability to do so
• They use behavioural rules of thumb with
  incomplete information
• Preferences might be altered by what other agents
  do
• The 2002 Nobel winners have produced a lot of
  empirical evidence to support this position
  (Kahneman, Smith, AER, June and Dec. 2003)

6
Type of theory Ability of agents Ability of
agent to gather information to process
information   Rational full maximise   Bounded
rational partial maximise   Behavioural parti
al rule of thumb  
7
Why does the rational model (partially) work? (1)

• Britains prisons are full to bursting
• The prison population has doubled over 10 years
• Crime has fallen approx. 40 per cent over 10
  years
• Non-economists are puzzled why are so many
  people in prison when crime is falling so rapidly?

8
Why does the rational model (partially) work? (2)

• For economists, it is because prison numbers have
  risen that crime has fallen
• Same for US Steven Levitt J Ec Perspectives,
  winter 2004
• Incentives matter the only general law in the
  social sciences
• Does not mean agents act rationally in the face
  of incentives
• Rationality sees through a glass darkly

9
The frontiers of economics are about behavioural,
partial and rule of thumb

•  
• Akerlof (Nobel prize 2001) in this new style
  of economics, the economic model is customized
  to describe the salient features of reality that
  describe the special problem under consideration.
  For instance, Perfect competition is only one
  model among many, although itself an interesting
  special case
•  
• Kahneman (Nobel prize 2002) The central
  characteristic of agents is not that they reason
  poorly, but that they often act intuitively. And
  the behavior of these agents is not guided by
  what they are able to compute, but by what they
  happen to see at a given moment

10
Common features of these models

• Simple behavioural rules for agents are chosen so
  that the macro properties of the system emerge
  from their interactions
• The rules are custom-made for each application
• But the behavioural rules of agents imply they
  act as if they have low or even zero cognitive
  ability

11
Examples

• Financial markets why are they so volatile
• New technologies why the best dont always
  succeed in the marketplace
• Why we observe racially segregated cities
• Why the business cycle exists
• Why markets work as they do
• Why we observe a particular distribution of
  crimes committed per criminal

12
Challenges

• To develop more realistic models grounded in
  agent behaviour which out-perform conventional
  approaches
• Out-perform
• decide key stylised facts of the system of
  interest
• The properties of the model emerge from the
  interaction of heterogenous agents
• We are not doing econometrics and trying to
  curve-fit
• This is a much more scientific methodology

13
Schelling model of segregation

• We observe a high level of residential
  segregation on racial lines
• Not just in the US similar issues in the UK
• Does this mean that people are prejudiced?

14
Schelling model (1)

• The model contains N agents
• There are equal numbers of two types of agent
• The agents are placed at random on squares on a
  torus
• There is a small percentage of empty squares

15
Schelling model (2)

• The 'neighbourhood' of an agent is defined e.g.
  all 8 squares which surround any given square
• An agent is called at random and decides whether
  or not to move
• If an agent moves, it moves at random to an empty
  square

16
Schelling model (3)

• The agent moves if more than a specified
  percentage of all agents in its neighbourhood are
  of a different kind to itself
• The model proceeds to the next step, and an agent
  is again called at random to decide whether or
  not to move
• What happens if an agent moves if and only if
  more than 50 per cent of its neighbours are
  different i.e will tolerate a 51/49 split?

17
Initial random configuration of agents
50
40
30
20
10
0
0
10
20
30
40
50
18
Configuration after only 2 moves per agent
50