BFI News•Dec 02, 2015

# The Path Ahead for Economic Theory

A critical framework for understanding a broad range of problems

###### FEATURED MEDIA

## Panel on the Role of Economic Theory

Panel on the Role of Economic Theory

Economic theory stands at an interesting existential crossroads, based on a recent panel discussion at an October conference celebrating Hugo Sonnenschein. Mathematical formalism, the convergence of computer engineering and sociology in the age of massive datasets, and the integration of psychology and biology into the discipline all represent seismic shifts in economic theory, said moderator Nancy Stokey. What will move the next generation of theorists in a new direction?

Alvin Roth argued that for economic theory, Hugo Sonnenschein has been a catalyst for encouraging his students and colleagues to push economic theory into exciting new frontiers, responding to the rising influence of game theory and encouraging young economists to integrate its principles to solve new economic puzzles.

The next step in that spirit of economic theory? Economic engineering—also known as market or mechanism design—which uses model building to tackle real-world problems head-on. Roth called out the complexity of a matching market for kidney donors, patients, and doctors as an example of a problem in need of some “market engineering” toward an optimal solution. Market design involves new challenges for economic theorists, the largest of which may be communication with the people in need of solutions—doctors, lawmakers, consumers, and anyone else who could benefit from a well-designed systemic approach to a problem that affects them. “We’re going to have to learn to talk to non-economists about what they want to do,” said Roth.

Real-world problems also mean that perfect theory can’t afford to be the enemy of “good enough” solutions. “We have to think about how theory and practice are going to interact,” said Roth. “We’re not trying for timeless solutions.”

Roger Myerson presented a slightly different view—good theory

*should*strive to “be timeless.” Rather than fixating on the messier details, perhaps economic theorists can extend their work by moving into new domains, he suggested. He pointed to game theory itself as a classic example—it’s actually just rational choice theory extended into new domains like negotiation. Liberating rational choice theory beyond the supply and demand curves represents a bold way forward for economic theory, breaking new ground for theoretical work in the tradition of Gary Becker and his economic empiricism on the UChicago campus and beyond.That Platonic ideal of economic theory remains vital, argued Myerson, because of the way it can help us evaluate and reform institutions for the better. The role of economic theory is to help us understand government, trust between individuals and firms and “greater economics,” he said.

Ariel Rubinstein took a decidedly poetic view of the tools that economic theory offers us. “What is a good model? A good model for me is a good story about the interaction of human beings. I would rather call a collection of models ‘a collection of economic fables’.”

The crux of his point was that no model has exclusive, perfect predictive power; models simply offer a framework for explaining various ways that forces in the economy interact, clash, or harmonize. He advocated for a future of economic theory more focused on questioning what we don’t know within an economic model, rather than what we assume it can predict. “If anything in a model is to be tested, it is the assumptions, rather than the conclusions.”

While Rubinstein was a bit dismissive of the value of formalizing theory through robust mathematical modeling, Lars Peter Hansen argued that mathematics offers the very interrogation of underlying assumptions that he seeks, just via a different mechanism. Formalism, laid out clearly, makes criticism of theory easier, not harder, he argued. Math opens the door to quantitative calculation and model assessment impossible in traditional theory.

“Models are way too often reduced to a black box,” Hansen said. “The challenge is to make those models more open and transparent.”

However, Hansen cautioned theory cannot be out and out replaced by computation—rather than simply counting on the data to “speak for itself,” he maintained that stylized models offer a necessary framework for computationally ambitious models to assess, test, and refine.

The session concluded with the panel considering the public perception of economic theory—specifically, whether the public is impatient with academia because of the way theory operates.

Myerson pointed out that all sorts of sectors of the economy have integrated economic theory into their work for the better. Stokey pointed out that Wall Street and the banking system had done that, with mixed results. “Most of the time this makes the world worse. But that just means we’re missing pieces of the picture,” she said. Theory put into practice breeds innovation in finance, banking, and elsewhere, but if the theory is bad, we need good ways to evaluate and strengthen it. And that’s a fine role for future economic theorists to play, stocking the shelf with ways to assess the theory that will guide Wall Street tomorrow.

*—Mark Riechers*