I should also say that I'm very open to work that questions rationality

Question: How can you create a falsifiable test for it?

Yeah, I know, much of economics doesn't do that traditionally...

I have to say I am puzzled by your choice of the Enron California example. Anyone who was familiar with the history of the electric utility industry from 1920-1935 knew exactly what was happening in California that summer without any reference to economic theory. That is why electric utilities ended up as regulated monopolies (emphasis on the "regulated") at the end of the 1930s: the structure of the industry [1] was and is such that manipulation of that type is always a danger. And the regulators historically audited interchange contracts very thoroughly and carefully to prevent the type of fraud that did occur in California.

Yet from 1995-2000 the electric utility industry was restructured according to the advice of those who claimed that more "competition" would automatically unleash great benefits to the consumer and to society as a whole, using exactly the sort of simplistic perfect competition models that economists posting in these threads have said are not really at the core of modern economics. Yet these models were used as a public policy club to effect very large changes in law and regulation - changes that have not resulted in any great improvement to society and quite a bit of disbenefit to consumers and employees. And this under a nominally Democratic Administration.

So I am confused. On the one hand, the professional economists here claim that the profession has embraced changed and moved on from naive models. On the other hand, when push came to shove in the political area economists testified before Congress with great conviction using the naive models on a topic of huge real-world importance.

sPh

[1] Among others, strong increasing returns to scale and efficiency maximization based on exclusive geographic service territory.

Even in a perfectly honest market however there are different amounts of information available to different participants and a cost to obtaining more. There are also differing consequences to the parties for choosing to participate/not participate in a transaction (e.g. the marginal change in output of adding another employee for the employer vs. starving to death for the employee).

sPh

I should also say that I'm very open to work that questions rationality - but I don't think we've yet reached the point where rational-man models have outlived their usefulness.

What I don't understand, Professor, is why it is so difficult to persuade either a heterodox or an orthodox economist to review a defense of the progressive income tax that uses this same kind of argument to explain why the rich do not actually suffer any loss of purchasing power when they pay even steeply progressive income taxes. Because they are all taxed in a way that preserves their relative positions within the hierarchy of all disposable incomes, each of them is spared the reduction in purchasing power that they would have experienced if only they had been the ones forced to pay the tax.

(Similarly, a firm that wants to give its employees an extra week of paid vacation puts itself at a competitive disadvantage if it acts alone, but if all firms are required to be equally generous, none of them actually loses out, competitively speaking.)

Whether or not an individual's perception of gain or loss is rational depends on whether the gain/loss is experienced exceptionally, or if it is experienced commonly, wouldn't you agree? If you do agree, then perhaps you would also agree that it would be rational to read through and give thoughtful consideration to a defense of the Progressive Income Tax that emphasizes this very point?

I think Democrat economists would do well to pick up on this theme and use it a lot when they are criticizing Republican economic mythology...

Adequate, correct, and non-manipulated information is necessary for rational behavior, but it's not sufficient.

It's arguably possible for people to be more rational than they generally are, but even if that were so, it's easier to profit by taking advantage of -- if not actively encouraging -- irrationality.

The two other major drawbacks of simple models based on rationality is that -- as far as this layman knows -- there is little or no effort to take either long time scales or emergent results into account. What could be seen as rational behavior by one person, in a near- or medium-term time-frame, often turns out to be irrational when considered over a longer period, and/or when millions of people engage in the same seemingly rational behavior. But by the time that overall irrationality becomes clear, there's a huge social/political/economic momentum that makes changing course incredibly difficult.

Similarly, a firm that wants to give its employees an extra week of paid vacation puts itself at a competitive disadvantage if it acts alone ...

Good stuff, but I just wanted to pick a nit with this. An extra week of paid vacation doesn't necessarily put a company at a competitive disadvantage. While it might seem so in a simple construct -- 50 person/weeks per year means higher productivity than 49 person/weeks per year at the same salary -- it's not quite that straightforward. As some companies have discovered, people who get more vacation (up to some point) are sufficiently more productive during their working hours to more than make up for the additional week off.

Indeed, some companies set minimums for time off -- each employee must take off at least X weeks of their alloted vacation during each calendar year. They know an exhausted employee is an unproductive one, no matter how many hours they put in.

You have to remember that the object of competition is to eliminate your competition, by and large. Once you have done that, as the oil companies and the so-called "defense" or aerospace industries have done, you then own the entire market and can do whatever you want in terms of prices and quality of your offering. That's what often happens when so-called "competition" takes place. This is especially true when there is no elasticity in demand, and people have to buy weapons or gasoline with no viable alternatives in sight.

It seems to me that economics - as a guide to policy - should be like engineering rules, not like ideology. Like engineering (say civil engineering rules for building bridges and buildings, or circuit design rules for integrate circuits), economics can inform us what is possible and how to achieve it. But what we as a society ought to aim for - economics cannot tell us that.

But economics discussions all seem to be of the sort - "every bridge must be a suspension bridge, because that is what is good". Neither "free markets" nor "bridges" are ends in of themselves.

To my mind, the problem is not with assuming rationality, but with assuming that markets are disembodied from the social and political contexts in which they operate.  I tend to assume in my own work that individuals act rationally, but as someone who studies political economy with a big P and little E, the assumption that political elites will use markets for political gain is a no-brainer. That observation is frequently missing from neoclassical models, and it seems to be a big part in all these posts and comments of the collective concern with neoclassical economics in general.  The "noise" generated by politics, society, etc. that finds its way into orthodox neoclassicism is often not random at all but systematic and therefore in need of serious explanation, theorization, modeling, and so forth.  And, I'd add, in need of better treatment than it gets in works such as the acclaim-grabbing Economic Origins of Dictatorship and Democracy.

Professor Krugman's posts are my favorite of the thread thus far, as they're so concrete and concise, and as it sounds reasonable to say that we've plenty of opportunity to analyze the effects of regulation or market manipulation, not just ideal free markets. Yet I'm not altogether convinced, for something of the same reason as sPh.

The Enron example is teling for me, as it helps set up an instance in which we can see things that don't fit the model. That sets up an excessive dichotomy, of the crooked cases that don't fit and everything else. That alone seems an obvious way of sidelining issues of how power or law create the entities and choices in markets.

For example, this week the paper reported on miserable conditions for flyers. Airlines keep cutting costs, including the cost of open seats, by overbooking, downsizing, etc., etc. Is that an efficient outcome, especially if pretty much everyone is unhappy? Presumably not, so one has to ask about barriers to entry (including costs, but also everything from limited airport space to monopolization and buyouts distorting markets). One also has to ask about whether all consumers are equal. One solution, the article argued, would be to put conditions on refundable tickets, but businesses might balk as individuals and vacationers might not (and they may not get to go to Jet Blue on the assumption that it bucks that rule for long).

Similarly, an interview with a self-aggrandizing trader in New York magazine lets him make the ponit that one reason people lose money in the market is that they collectively cannot move money at the rate institutional investors can. In each case, we're talking about various inequalities arising from concentration of ownership of wealth. And we're not even going near things further outside the economic mainstream, such as manufactured desires, the limits on rationality versus emotion, externalities, balances of liberty and equality, community goals, whatever.

Marx's predictions about concentration arising naturally is the one thing I got from his economics (although some of the philosophy of human needs and materialism interested me). He was wrong to think it'd lead to united labor (at least in America for long), and his quantification of the costs to workers in terms of surplus value didn't mean much to me, but it seems like he got at least one thing right that Neo-classical economics has trouble coping with.

John

http://www.haberarts.com/

I used to work in a regulatory agency, and some of us looked at power markets, how the market inefficiencies arise, and if what we saw could inform our own regulatory approach.

I guess in hindsight we took it as given that firms are profit-maximizers - indeed it's hard to think of firms behaving otherwise. Instead, we approached the issue by asking the question - if you wanted to maximize profits in the power markets, how would you do it?

The issue that kept on coming up as the critical characteristic of electricity was that it cannot be stored. And this in turn gives power producers a degree of clout that no other primary industry, to my mind, appears to have. (It's certainly unique in the financial services space.) It's scarily easy to create an artificial supply shortage.

When you overlay the fact that a company like Enron not only had the capacity to supply power, but also traded it in all its various forms, it could extract profit all through the supply chain. And the circumstances of the California crisis were the perfect storm for Enron.

Their generating business could sell power, if memory serves, around 200-250x the production cost.

Their spot trading business, from where the salacious tapes originated, made silly money from trading around what they call in the business the "spark spread".

Their derivative trading business - which basically ran long vega positions while still betting on rising wholesale prices over time - was way in the money as the rolling blackouts caused a large volatility spike.

So whilst I guess from a pure economics standpoint, focusing on profit-maximization did help "cut through the mess" and served to counter market fundamentalist baloney, I am not sure it fully explained how the market manipulation occurred.

For me, when you can get a basic grasp of the power industry, then it's possible to understand how the manipulation can occur. The truth about Enron and the California crisis is that you had a bunch of capital markets hicks who cooked their golden goose. It's more subtle these days, the firms are long-term greedy (i.e. with a longer horizon for profit-maximization) but to my mind not that much has happened to rebalance the power market back towards consumers.

We were doing a different type of regulation, which didn't involve utilities, natural monopolies, capping profits etc.

So I think we worked off reasonable assumptions when looking at Enron - which was only partially a utility co, and definitely was not having its profits capped by the FERC.

It is very disappointing that David Card did not have the courage of his convictions to stick to his guns, continue with his research, and live with the attacks. After all, they were not PHYSICAL attacks.

Contrast that with George Akerloff, who in his Presidential address to the American Economic Association argues the very heretical position that economic theory could do a better job explaining observed behavior by including social norms in the utility functions of economic decision makers.

If a lesser economist had made such an assertion when New Classical Economics surge was at its peak, this act of heresey could have gotten him burned at the stake (metaphorically).

There is no question about the fact that there is too much laissez faire dogma in mainstream economics and too little serious science. Hopefully most economists who want to do science and not engage in harmonie lehre will have the courage to stand of to the upholders of dogma.

Incidentally anyone with a reasonable good background in macroeconomics, intermediate undergraduate macro will do and even a good macro principles course will probably do should read Akerloff's presidential address "The Missing Motivation in Macroeconomics." It is in the March 2007 issue of the American Economic Review.

The problem is that the economy is an ecosystem and a functioning society is an organism. Neoclassical economic assumes society is simply predator and prey within the ecosystem of the economy. Keynesian economics treats the economy as the ecosystem within the belly of the social organism. As with everything, there are two sides of the coin and no one wants to admit the other side exists.

Krugman himself is an excellent example of the problem of the sociology of the economics profession. In his newspaper articles he sometimes admits that recent trade agreements have had negative impacts: "Fears that low-wage competition is driving down U.S. wages have a real basis in both theory and fact" (May 10, 2007). Yet in his best selling international economics textbook he generally dismisses such concerns (see pp.37-39 especially.) In fact he and Obstfeld say so many different things that confusion is the general result. But the overall rhetorical trick is clear: They state and then simply dismiss moral philosophical questions (p.184), recognize the distributional consequences from trade but say this is not a reason for protection, demonstrate the logic of the factor price equalization theorem and then dismiss it as not relevant most of the time, and then acknowledge the existence of “intellectually respectable” market failure arguments for a tariff but say now that in the “real world” it won’t work.

Similarly, with exchange rate instability Krugman has written clearly about the importance of destabilizing speculation (http://www.econlib.org/library/ENC/ExchangeRates.html) yet the textbook explanation is the Dornbusch overshooting model, one of the truly most hilarious attempts to maintain a rational choice equilibrium explanation for something that doesn't need one.

Claim scientific openness but return to the good old orthodox religion when pushed: that's the recipe. (It's how the American ruling class works too, but that's another story.) And remember folks, Krugman is about as good as it gets. The vast majority of orthodox economists just really don't care about ANYTHING except advancing their own careers.

Or we need to accept -- based on the overwhelming predominance of an oligopolistic economic real world -- that everyone will not play fair, and then regulate the resultant oligopolies intelligently.

To "make sure everyone plays fair" should not be the purpose of government. Instead, governments should regulate the economy in order to produce the best economic outcomes based on the values expressed by the people who elect those governments.

For example, economic security is often associated with economies that are predominantly oligopolies/oligopsonies well-regulated to ameliorate some of the counter-productive features of such economic arrangements. If economic security is a high priority for the citizenry, and I think it is, then economic policy should favor less competitively 'cut-throat' economic arrangements in favor of smartly regulated oligopolies/oligopsonies.