Biases in Economic Theory

Jon Steinsson prepared some short remarks for a panel on the future of macroeconomics. As someone who dabbles in macro, I found the whole thing interesting, but as a full-time theorist, I found this line worth mulling over:

[Macroeconomics] was very exposed to another problem: models in which markets work well are (usually) easier to solve than models in which market work poorly. This simple fact has huge consequences because it imparts a bias on economic theory towards models in which markets work well. Since models in which markets work well are easier to solve, researchers tend to work with such models. The default assumption about a market is typically that it is perfectly competitive. (emphasis added)

To explain Steinsson’s point. In a competitive model of supply and demand, the modeler needs to solve for price and quantity. In a model with market power, the modeler needs to solve for price, quantity, and the market power/mark-up number. The competitive model has to be easier to solve since it has fewer variables.

“Simplicity bias” is absolutely something to worry about with economic theory. We need to be aware of it.

Within simplicity bias, there are two aspects worth separating out. First, it leads to models that “miss” part of reality because we can actually solve the model. This really isn’t a problem since every model misses part of reality. Every thought a person has misses many parts. That’s life. There is no more lame critique of a model than that the model ignores X.

Steinsson is addressing a second, more legitimate issue: the ability to solve the model systematically biases economic theory in a particular direction. Steinsson says the bias is “towards models in which markets work well.” It’s the drunk searching under the lamp post.

In economics, especially within macroeconomics, Steinsson explains the standard approach:

[The] researcher will often introduce a carefully constructed friction in a critical place in their model and focus their analysis on the implications of this friction. But all other markets in the model are typically modeled as being perfectly competitive for simplicity.

There are legitimate reasons for this approach since it allows the model to be focused (which is the point of a model). Still, as Steinsson stresses, this approach can introduce biases into our analysis and we should be aware.

On the discussion of biases in economic theory, I’d like to add two more for people to consider.

Look How Clever I Am Bias

Theorists are rewarded professionally for solving models. If you can’t solve the model, you don’t get the publication. So theorists simplify, as Steinsson notes.

But all else equal, economists get rewarded more for solving harder models. Solving a hard model shows your colleagues in the profession that you’re smart and that will be rewarded.

It’s always a delicate balance and art to differentiate which complications will be successful in terms of getting published and which complications will just lead to an incoherent kitchen-sink model with a random collection of complications that don’t make any sense.

Models are like fashion. Economic models, I mean. Break a rule or two creatively and you’re an innovator. Break all the rules and you’re a gaudy monstrosity.

If you’re successful at solving complicated models that are classy, not the kitchen sink, you can write your ticket to anywhere in the profession.

But every theory paper must include a complication that makes it so the markets don’t work well. In today’s world, models of perfect competition do not publish well, all else equal.

While the models have gotten more complex over time and you’re more likely to get dismissed for using a simple model, especially within macro, the “look how clever I am” bias isn’t a new thing.

Warning: casual history of economic thought ahead….

I’d put a lot of the 1960s “market failure” research into this camp. Markets indeed have “failures" and we should study them. But when I look back at a lot of the second-tier papers in this field, I see a lot of “look how clever I am to find this problem and a solution to it” papers.

No one is considered clever for saying “actually things work well and I don’t know how to improve it. Maybe we should leave things alone?” We want a profession of expert plumbers to fix things!

Second Singer Bias

Economists are always asking: “compared to what?” To say that there is a bias that “markets work well” one implicitly is saying there is something else that works better.

Here, I’m not so sure that’s true.

There’s a common parable within economics where a king was holding a singing competition. After hearing the first singer, the king announced the second singer as the winner, since there was no way in the king’s mind that the second singer could be worse than the first.

In economics, the market is the first singer. After pointing out a market failure (remember how clever I am?) the obvious solution to many economists is for the government to fix things.

This is an instance of Steinsson’s point. Outside of explicit political economy research, in most economic models, the focus is not on the government’s behavior. As Steinsson points out, when an aspect is not the focus, it is assumed to work well for simplicity.

Implicitly in many economic models is a well-functioning policy in the background. Models of market power in industrial organization implicitly assume the market power is not because of government favors.

This isn’t always true; often frictions in trade models are attributed to tariffs. But that’s the exception, the friction isn’t because of policy. Otherwise, the policy works fine and is quietly in the background.

Since most economists study markets and not governments, there is a bias in economics against markets and in favor of governments.

That’s the opposite of what most people think. Most people think economists are pro-market zealots. But if Steinsson’s point about the focus of research is right (which it is), then that implies there is a bias against markets in economics.

None of these biases are knockdown arguments about how economics should be done. Just like biases in behavioral economics, it isn’t hard to identify biases. It is more valuable to study how they interact and how social forces provide feedback that corrects or amplifies biases.