21 st 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 partial rule of thumb

7. Why does the rational model (partially) work? (1) • Britain’s 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 don’t 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. 40 30 20 10 0 0 10 20 30 40 50 Configuration after only 2 moves per agent 50