Economists and the Economy

15 August 2007 at 10:03 am Peter G. Klein Leave a comment

| Peter Klein |

Chris Dillow, channeling yours truly, writes:

Economists are everywhere. Steve Levitt, Tim Harford and Steven Landsburg use newspaper columns and best-selling books to show how economics can account for why drug dealers live with their mums, why you can’t find space to park, why school teachers cheat, why people share umbrellas and why sexually transmitted diseases are so rife. Simple economics, it seems, can explain everything.

Everything, that is, except the economy. Although orthodox economics can do a good job of explaining why people get a divorce or the clap, it does a much worse job of accounting for what people think it should explain.

Dillow’s essay in the Times goes on to focus on the prediction problem. As he writes in an accompanying blog entry:

What I meant to say was that the simpler version of neoclassical economics is entirely wrong. It assumes people are knowledgeable but powerless. This is true in everyday life — hence the success of Harford, Levitt and Landsburg. But it’s exactly wrong for many companies. They are powerful but ignorant.

Put it this way. First-year undergraduates are taught that the job of bosses in competitive firms is to solve a production function, subject to prices and wages that are set beyond their control.

But this is hardly ever true. Production functions aren’t given. They have to be discovered. This is what entrepreneurship is about; the superiority of Austrian over neoclassical economics lies in seeing this fact.

One can also think not of discovering a production function, but discovering (or creating) attributes of assets, a theme discussed here and here. More generally, the standard approach in production theory is hampered by the assumption that all the relevant variables — input and output prices, characteristics of the production function, and the like — are given (or governed by known probability distributions). Absent Knightian uncertainty, there is little for the entrepreneur to do — just solve a few maximization problems that first-year students can handle. Is it any wonder that entrepreneurs find standard economics so frustrating?