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Of Poetry, Fallacies and Micro-foundations

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Often one sees communities or organizations being treated as individuals in many scopes of economic analysis. It is like this mostly in macroeconomic analyses (such as those of international trade or intertemporal consumption) but also at the micro level (for instance, in the study of intergovernmental grants); this post focuses on the former.

Such treatment can be inserted in the appeal for the macroeconomic models to have micro-foundations (as it was first advocated by Chicago scholars to criticize the at-the-time dominant Keynesian model), which should include mainly the features of optimizing behavior that characterizes the actions of rational agents. In my opinion, while such approach can sometimes yield important insights, it has gained exaggerated dimensions when it started to be used carelessly in public interventions by leading economists. The most well-known example are the shouts of moral hazard that arise each time one speaks about a sovereign bail-out.

Many prominent authors have studied the extent to which one can frame communities as individuals. The most seminal example is the one by Kenneth Arrow who, in his Impossibility Theorem, proved that dictatorship is the only social decision mechanism capable of presenting the three following properties: i) complete, reflexive and transitive preferences; ii) ability to translate a unanimous ranking of two alternatives correctly; iii) immunity to rank-order voting. Provided we take democracy as being here to stay (i.e., that we don’t allow all social rankings to be those of a single individual), there is no perfect way to aggregate individual preferences into one absolute social preference.

A contrasting result is the median-voter theorem, which states that community preferences can be represented by those of the median voter. However, this is contingent on single-dimensional decisions and on the assumption that voters always prefer alternatives closer to their most preferred outcome. If this is not the case, and most notably if people are called to decide on “bundles” of issues simultaneously, the outcome of a sequential voting process will depend on the order by which proposals are voted. This is the Condorcet Paradox and goes back to the third – and less essential – property of social preferences abovementioned.

“Democracy”, as Winston Churchill once put it, “is the worst form of government, except for everything else that has been tried.” The intransitivity of the process of aggregation of individuals’ (transitive) preferences is just one of its major drawbacks. Ironically enough, in the overwhelming majority of the times people are called to decide upon something, it is precisely a multidimensional choice, as between electoral programs. Voters, even if “microeconomically rational”, are (at least for now) unavoidably vulnerable to whoever has the power to set the political agenda. One field of Microeconomics, Industrial Organization, has a say on this: voters face very large search costs upon deciding their vote and may lead politicians to charge the “monopoly price” (i.e., governing in the most inefficient way), as Peter Diamond once predicted.

If one adds to this the obvious incapability that the standard citizen has to supervise his/her rulers (and here we have, in fact, hidden action) and very often even to assess their potential as political leaders from electoral campaigns (both because of hidden knowledge and of pure demagogy by the candidates), there are more than enough reasons why one shouldn’t apply microeconomic concepts at the macro level so laxly. Again, Industrial Organization has an answer: Harold Hotelling, in his seminal paper on product differentiation, actually discussed political differentiation to conclude the same as with firms: the optimal decision by politicians is to be as similar as possible. Later, when d’Aspremont showed that if firms were too close, they would always try to undercut each other and this would make an equilibrium impossible, he also provided a fascinating metaphor to what we see in politics each and every day.

Micro-foundations have done a lot for macroeconomics since they first were requested. Nevertheless, and like it can happen with any powerful toolset, it has also been used, notably over this sovereign debt crisis, to support fallacies in the political debate and to employ nice-looking metaphors with medical treatments and patients or with teachers and good and bad students. Eloquence should be promoted without lyrics. An economy is not just the sum of its markets, much like a country is not just the sum of its politics.

(I’m running out of words to discuss the topic, although I would still like to discuss whether elections are an aggregation of preferences or a delegation of decisions. I will outsource this to this guy, who suggests that democracy is too much of a burden for many electors who would rather just delegate the decision power to someone else).

João Garcia, #618


Sources: Lee S. Friedman, “The Microeconomics of Public Policy Analysis”

Hal Varian, “Intermediate Microeconomics”


Author: studentnovasbe

Master student in Nova Sbe

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