allen, beth - the future of micro economic theory (2000)

8/4/2019 Allen, Beth - The Future of Micro Economic Theory (2000)

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The Future of Microeconomic Theory

Beth Allen

The Journal of Economic Perspectives, Vol. 14, No. 1. (Winter, 2000), pp. 143-150.

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Beth Allen

hile I wish to avoid attempting to define econonlic theory-perhaps it'slike pornography, in that you know it when you see it-iievertheless itseems appropriate to begin ~ n ydisc~ ssionby considering what rnakes

good theo~y. will then present some lower-risk predictable predictions about thefuture development of a number of research areas in rnicroeconon~ictheo~y,longwith one higher-risk prediction.

Good theory starts from a good question arid does not cheat by adding enoughcollditiolls so as to assume the answel.. I~nportantresearch questions, even in"highbrow" theo~y,can alniost always be explained in wo~.clsto a well-trainedresearch economist who is not a theorist and call usually also be explained to agood undergraduate major, a scholar fro111a different discipline, a busiliess personor lawyer, or the educated public. A good question should instalitly i~ilpressone asbeing sigllificallt or fascinating and it should exhibit a strong likelihood of leadingto additional important discoveries. Perhaps the litlnus test is whether one's instinctis to blurt out: "Why didn't I think of that?" In this sense, theory does not differfroni other fields of economics. Good theory is derived fro111sensible long-tern1research goals and strives to take at least a slnall step toward some vision. It is acreative endeavor where innovation is desirable, even if the ~ icwdeas and nletliodsrnay cause initial discomfort. Surprising co~iclusionscan be w o~ id er f~ ~ l .inally,successf~~lheo~yfl-equently leads to explanatiolis that validate one 's C ~ ~ I I ~ I I ~ I Isense, at least in retrospect. I t sonletirnes leads to a beautif~lland elegant nod el;when this happens, research is very satisQing indeed.

Moreover, research projects in which the risks and potential rewartls are both


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high teilcl to conti.ibute the most toward importailt new advances in economictheory (o r ally scientific field ). This is not to devalue the worth of the huge volunieof inore pedestrian research, especially if it is carefully performed and useful, but1'111 convinced that major sigilificailt and exciting strides are associated with highrisk research. Funding agencies should be more cognizant of the benefits thataccrue from riskier projects because such work is less likely to find sufficient privatesuppoi,t, but inore likely to provide a genuine public good.

In the area of methodology, I choose not to rehash the positive/normativedistiliction or the debate about testability in economics. In my opinion, these issuesare discussed in economics classes more thail they deserve to be at this stage in thedevelopillent of economics, altllough the emphasis might have been warrantedmany decades ago-that is, before I was a student. Frequently an article or researchproject integrates both positive and normative aspects; on e must first understaildhow things work before being able to suggest ilnprovements. Moreover, I think thatthe old criterion of making a prediction and then testing it empirically has beenoverrated as a scientific standard. In econornics it's even less relevant, because onecan't always set up a properly controlled experiment or obtain the requisite data.Even if these obstacles can be overcome, empirical studies ill econornics seldomprovide clean tests of a specific hypothesis, but rather tend to intermix the phe-nomena of interest with the specifics of the model and its mailltailled assumptions.Much outs tanding theory is inherently ui~testable, ut it call frequently be validatedthrough mathematics, as discussed below.

On a sirrlilai- note, 1ain pleased that the seemingly endless disputes on the roleof nlathematics in economics have largely ceased. Perhaps my circle of contacts islimited, but illy impression is that a consensus has developed in the economicsprofession that one is justified in using whatever mathematics (o r statistics or otherformal tools) is necessa~yo formulate and solve a worthwhile problem effectively.Needed techiliques cannot be criticized as "too much," although unnecessarilyfancy and complicated methodologies which serve more to show off the author'sskills than to advance understanding of a genuine economic problem shouldcontinue to be discouraged by the norins in our discipline.

Despite the hard-won silence 011 appropriateness of inathen~atics, fear thatillany theorists are now backtracking from rigor in their work. The guilty ones arefrequently young lnenlbers of our profession. Perhaps this alarming trend reflectsthe heightened p~lblish r perish pressures faced by new entrants to the academicjob market during the last decade, but surely sloppiness is a strategy that isi~lconsistentwith solid scientific accomplishinent. (I hesitate to insert an exceptioilfor true geniuses, since most people think they're better than average and econo-mists-or researchers in general-are probably more arrogant than most people.)In fields of ecoiloinics other than microeconomic theory, I perceive ongoingtension between a group that demands rigor and a group that finds rigor to be


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Beth Allen 145

prevents one froin making both obvious and subtle mistakes in the analysis,mistakes that might not be caught by one's intuition and that could generatefurther faulty research. Without rigor, the author and the reader simply cannotevaluate whether a result is right or wrong.

Yet another disturbing trend in econoinic theory is that many researchers arechoosing to step back from genuine theory. When they have a good idea or aninteresting example that illust~,ates new phen omeno n, they fail to push it reason-ably to its logical conclusion. The result is a cute article that contains some niceideas pointing out something that's potentially exciting and important, but thereader has no clue about the possible generality or lirrlits of the analysis becauseonly an example or a highly-specific closed-form parametric model has beenpresented. This issue is distinct from my complaint above about the absence ofrigor; a little exarnple call be carefully analyzed so that all claims about it are true,but this is less valuable when the analysis is incomplete, albeit correct. My formercolleague Dave Cass is fond of arguing that there 's no clear distinction between anexample and a nod el or theorem because the latter category also depends oncertain assumptions, including the nlaintained hypotheses such as constrainedoptimization. While this point is well taken, I'm suggesting here that economicswould be better served if theorists would more often deliberately move in thedirection of abstraction and generality, which is where theory can most effectivelycontribute to economic science.

It's hard to discuss research trends without considering interdisciplinary work.However, I confess that until recently, I had not found interactions with most othersocial scientists to be particularly fruitf~~l,ith the exception of those who arealready themselves interdiscipl ina~y r engaged in formal theoretical research (forexample, in political science, law, or accounting) . My opin ion has shifted, however,as certain interdisciplinary connections have developed. The "new" political econ-omy has emerged as a prornising field. Finance has had a huge influence ineconornic theory, stiinulating rnuch of our large and important literature oneconomies with uncertainty and asyminetric infor~nation,r~cluding he subtopicsof rational expectations and contract theory. A newer trend is the influence ofresults from operations research and computer science on topics in economictheory such as complexity, parallel processing of information, stochastic versusdeterministic systems, and con~puta tional echniques.

I predict that biology and engineering will be the interdisciplinary influencesof the f~lture. or biology-or, more precisely, cognitive neuroscience-the link isthe relation between biological bases of behavior and rational choice (Dickhaut etal., 1999; Grether, 1999). The potential new connections fro111 engineering toeconomics, ~vhichwill be discussed in more detail later in this paper, operatethrough the importance of technology. Finally, a list of interdiscipl ina~ynfluenceswould be incomplete without rnention of experirnental economics (which is


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A nlore local ve~,sion f interdisciplinary work is emerging withirl economics:the traditional distiilction between ~nicroecono~nicheoly and inacroeconorriictheory is disappearing. The line has been blurred by the view that illacroeconoinicsshould be based on niicroeconoinic fou~ldatiorls nd genela1 equilibrium theory. Ianticipate that this positive trend will accelerate. Dynamic eco~lo lnic heory is ablend of microeconomics and macroeconomics, which offers an interestiilg andi~npor tantarea for future research.

Some Predictable Predictions

Rather than presenting a laundry list of research topics for the coming years oran exhaustive description of current research that has important ui~finished xten-sions, I shall focus in this section on t~vomain topics: game theoly and information,not ~lecessarily n o rder of iinportance.

The introductioli of game theoly into ecoilo~iiicshas a long and bumpyhis to^?;, starting (iinplicitly) with Cournot (1838) in the 19th century. A large andso~netiinesechnical literature developed in the 1960s and 1970s, centering on thesearch for strategic foundations for competitive equilibriuln. This work was based011 cooperative games, defined to be those in which groups of players (o r coali-tions) call conlnlullicate and forril binding agreelnents with each other. Thiscontrasts with noncooperative games, in which the only thing an individual playercan do is to pick a strategy based 011 what he or she knows about the gaine.(Comn~unication iay be part of a strategy, but agreements are not enforceable ifplayers decide to deviate, except possibly through the device of punishlnent strat-egies. Note that cooperation can arise in equilibriu~ll n certain noncooperati\7egames.)

By the 1980s, the focus had shifted to llollcooperative game theoret ic ~nod el sof strategic behavior, which were then advocated as the only part of game theorythat could be valuable in economics. The argullle~lt as based on the claim (11101-erecently showll to be incor1.ect) that only iloncooperative games could featureasy~n~lietricnforination, the observation that cooperative ga ~n es o not captureactual strategies very well as they're defined in ternis of feasible payoffs to variouscoalitions, and the fact that ~loncooperativegalnes could seemingly use Nashequilibriunl exclusively as their sole solution concept, whereas the list of solutionconcepts in cooperative galne theory was long and growing. The third supposedadvantage of the ion cooperative ir~odelwas quickly el i~ r~ inateds the 1-ealizationthat one frequently faced a plethora of Nash equilibria displaying widely varyingqualitative features (tha t is, efficient and inefficient equilibria, equilibria in pureand inixed strategies, and nontrivial equilibria in games in ~vhich very player doingnothing persisted as an equilibrium) gave rise to well over a hu~idred istinct


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tional problem that these noncooperative equilibria are fragile; they are extremelysensitive to slight variations in the assumptions. I interpret the seminal work ofKohlberg and Mertens (1986) on strategic stability to indicate that a satisfactoryrefinement is impossible and to imply that the elucidation of specific refinements,even if defined axiomatically, for particular economic problems cannot progressbeyond the status of being a long list of examples from which no systematic generalconclusions can be drawn.

While some recent research on computational and empirical aspects of Nashequilibrium is interesting, my impression is that attempts to validate Nash equilib-rium have generally failed due to the robustness problem mentioned above. Thistells me that the future implications of noncooperative game theoly are limited,even though such strategic considerations have had a fundamental, pervasive, andlargely positive impact on the way we d o economic theoly and, in fact, on the wayeconomists think. Note that game theory is increasingly included in the undergrad-uate curriculum for nonmajors as well as majors in economics.

My personal picks for interesting research areas in game theoly that are likelyto be important for future economic theory include network games and games thatare both cooperative and noncooperative. Network games or games on graphsprovide models of strategic local interactions. Such games exhibit different possi-bilities for strategic behavior and different equilibria or solutions than gameswithout the network feature. Indeed, in cooperative theory, a player in a networkgame may communicate or belong to a coalition (and hence make binding agree-ments) with only those players to whom the given player is connected according tothe graph. For the noncooperative version of network games, the key idea is that aplayer's payoff depends only on the actions of nearby players. These networks canreflect social relationships, locations, communication patterns, and so forth.' Aninstance of burgeoning importance concerns the Internet , which is rapidly becom-ing a significant part of U.S. eco~lomic ctivity, as e-mail, Internet-based commerce,Internet-based business services, and global enterprises expand. Mixtures of bothcooperative and noncooperative game theory are relevant for the iloncooperativefoundations of cooperative game theory, including the possibilities for noncoop-erative implementation of various cooperative solution concepts. As introduced byZhao (1992), hybrid games are games which contain both cooperative and nonco-operative stages; they can be used to model, for example, simultaileous cooperationwithin firms and competition among firms or, more generally, a strategic version of"island economies" as the term is used in macroeconomic t h e ~ r y . ~inally, I includecoalition formation within this category as an important contiiluing area of inves-tigation. To date, game theory has been unable, in general, to explain or predictwhich coalitions will emerge when a game is played. This surprising gap needs tobe closed, because the concept of a coalition provides a general way to model


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various economic institutions such as firms, countries, cities, customs unions, andSO on .My second predictable prediction concerns the economics of information.Many open questions remain about both individual behavior and equilibrium inthe presence of asymmetric information. Some of these questions focus on incen-tives, but I refuse to reduce the economics of information and uncertainty to thestudy of incentive compatibility constraints. One of my pet open questions in thisarea concerns the exploration of why markets are incomplete, which in turn canlead to endogenous explanations of market structure. A bigger question is toincorporate information in a fully endogenous way into microeconomic theory andgame theory. While progress has been made during the last four decades (compareChapter 7 of Debreu (1959) and Radner (1968) to Allen (19 90) ),we are unfortu-nately still very far from a sat isfacto~y eneral model.

An Unpredictable PredictionI believe that eco~lomic heory will and should devote more attention to

technology issues in the coming decades. One motivation for pointing to this areacomes from the importance of technology in explaining economic growth.3 Asecond reason is that this area of economic theory has been neglected, at least sincethe era of research on satisficing and the behavioral theory of the firm. Anexception is the area of intellectual property rights, where a recent burst ofenthusiasm has followed earlier fads such as patent races and research jointventures.

It's useful to divide the ecoilomic theory of the firm into six interrelatedthemes: 1 ) the definition of the firm and technology itself; 2) product and processinnovation and R&D policy; 3) the evolution of individual firms as economicinstitutions (for example, Holmes and Schinitz, 1995; Lucas, 1978); 4) financialaspects of individual firm behavior and of asset markets in equilibrium; 5) mana-gerial control, contracting, and incentives; and 6) strategic behavior. Researchtopics such as firm for~rlation,networks, and product portfolios deserve moreattention from researchers trained in economic theory. Further work should ex-plore the allocation of R&D effort among various projects; Allen (1991) offers on eattempt in this direction.

However, the most glaring gap is in the economic treatment of technologyitself, where little change has occurred in eco~ lomic heory during the last half-centuly . The basic standard treatment still follo~vs he outline set forth by Debreu(1959), in which a firm's technological possibilities are specified by a productionset. With the exception of consideratioil of economies of scope, contestability, andsustainability, econoinists haven't made progress in ascertaining which assumptioils


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Be th A l l en 1 4 9

are appropriate for production sets. For example, microeconomic theoly doesn'teven recognize Henry Ford's assembly line, beyond stories about economies anddiseconomies of scale leading to suitable shapes for cost functions. Yet the manu-facturing sectors of modern economies have been changing rapidly. The businesspress has publicized the importance of mass customization, kilo~vledgeworkers,computerization and net~vorks n the workplace, just-in-time inventoiy controls,product life cycles, environmental concerns such as recycling and re-manufacture,and much more. New materials have appeared and new processes for both batchand continuous production have been developed. Computer-aided design andcomputer-assisted manufacturing have become coininon throughout most indus-tries in developed countries. Perhaps our concept of technology needs to beredefined to go beyond standard production sets, or perhaps stronger assumptionsare needed. Either way, economic theory must reflect these real-world advances.

In addressing this topic, I see vast potential for economists to learn fromengineers. On the other side of many campuses, engineers are studying productselection and technology choice in a unified fashion, termed "product develop-ment" based on "design for manufacture" considerations. In our universities,unfortunately very little "technology transfer" has occurred in either direction.

More generally, the growing numbers of management of technology pro-grams, which teach how to manage high technology enterprises, provide a primeexample of new interdisciplinary connections. These programs usually lead to acertificate at the M.S./M.B.A. level for a case-study and project-based curriculumoriented toward individuals with interests and backgrounds ill both business andengineering, computer science, or physical science. I'm acquainted with suchprograms at MIT, Cornell, Minnesota, Berkeley, and Stanford, but I'm sure thereare others. Based on the influence that economists and econoinic research haveearned in traditional areas of management science such as finance, I would expecteconomics to play a larger role in this growing area. This offers exciting opportu-nities for cross-fertilization between research and teaching during the coiningdecades.m P ) ~ p a m t z o nof tlzzs nzrcnusctzfit Tuns sz~fi fiortp d y the LVc~tzon nl c le n c ~Fou ndatz on tllrougllgrants SBR97-53139 and DAII98-16144, the Cur-tzs Cnrlson Chnzr zn Erononzzrs at theUnzverszty of AIznn eso ta, the Of$ce of the Thee Pressdent for ofe se n~c h t t he U ~zzv e rs~ tyiVLznnesota, a n d the Federal Reserv e Ba n k of iVLz~znec/polzs. lze vze-ius exfnessecl herezn are thoseof the auttlo) and not neressarzly those of the Fedelal Reser71e Bank of Mznnec/polzs or theFederal Reseroe Systenz.


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150 Jou rn al of Eco)lontir Petspectives

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Allen, Beth. 1990. "Information as an Eco-ilomic Commodity." A ~il r ri cnn Eco7 lo n~ ic R m i ~ ~ u(Papers and Proceedings). 80:2, pp. 268-73.

Allen, Beth. 1991. "Choosing R&D Projecb:hInformational Approach." A11~ericn7?rono~nicRc-v i m (Papers and Proceedings). 81:2, pp. 257-61.

Barro, Robert J. 1980. "A Capital Market in anEquilibrium Business Cycle hfodel." E C O I I O ~ I P Cricn. 48:6, pp. 1393-1417.

Cournot, Augustin. 1838.Rechvrcltes sur les Pri~ z-cijf~es l.I(~thC~izc~tiq~~es1 Ricllc~ses.e T l ~ : o ~ i e e sParis: Hachcttc.Debreu, Gerard. 1959. 7%eo1y of Vnltcc.. NewHaven: Yale University Press.

Dickhaut, John, Kip Smith, Kevin McCabe,and Nicole Peck. 1999. "Inferred Brain Functionin the Formation of Allocatio~ls n an EnglishAuction." Preprint, Department of Acco~ui~ting,Carlson School of Managcmcnt, University ofMinnesota, hlinneapolis.

Forges, Franqoise. 1986. "&I Approach toComm~ui~ications 54:6,quilibria." Eco~to~~trlr iccl .p p 1373-1386.

Grether, David M. 1999. "Physiological Basesfor Econornic Decisions." Presentation atCaltech on hfay 12, 1999 ofjoint work by JohnAllinan, David M.Grethcr, Charles R. Plott, andhfarty Sereno.

Holmes, Thomas J, and James A. Schmitz, Jr.1995. "On the Turnover of Business Firms andBusiiless Managers." J oz ~ r~ zo lf Poliiicnl Eco7ionty.103:5, p p 1005-1038.

Kollberg, Elon and Jean-Fran~ois Mertens.1986. "O n the Stl-ategic Stability of Equilibria."l: 'co~zo~~rri~z'cn.45, pp. 1003-1037.

Lucas, Robert E., Jr. 1972. "Expectations andtllc Neutrality of hfoney."Joz~nlt11 fEcoi1onlic The-alp. 4:1, pp. 103-24.

Lucas, Robert E., Jr. 1978. "On the Size Dis-tribution of Business Firms." Bell Jol~17tcrlo jEco-7101izic~.:2, pp. 508-23.

Mokyr, Joel. 1990. 771e Lever ofKicltrs: lbchno-logic01 Q-entiviij 011d Eeo~zotr~ie New York:I O ~ P S T .Oxford Univel.sity Press.

Myerson, Roger B. 1986. "Multistage Gameswit11 Comrn~ui~ication."co7zo11~etriccc.54:2, pp.323-58.

Phelps, Edmund S. 1970. "Introd~~ction"oi\.lio-oecoilo11ricFou11dntio~lsfE~~lplojnlerztrztl Irzflrc-tion Tlleo~g.New York: Norton.

Prescott, Edward C. 1998. "Needed: A Theor).of Total Factor Productivity." I~rtn-izcztionczlEco-iroi71ic Krwieru. 39:3, pp. 525-51.

Prescott, Edward C. and Jose-Victor Rios-Rull.1992. "Classical Competitive ,4t1;1lysis of Econo-mics with Islands." Journ cil of Eco7to11hic 77~eorg.57:1, pp. 73-98.

Kadner, Roy. 1968. "Competitive Equilibriuln~111dcl-Uncertainty." Ecu~to~nefr icc~.6:1, pp. 31-58.

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Schtunpeter, Joseph. 1950. Copifn l is~n, ocinl-isin, nitd Dr~nocrclcj. 3rd edition. New York:Hal-per and Row.

Zhao, Jingang. 1992. "The Hybrid Solutioils ofan N-Person Game." Ga111c.sn11d Bcono771ic Beltnu-iol-.4:1, pp. 145-60.


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Beth Allen

The Journal of Economic Perspectives, Vol. 14, No. 1. (Winter, 2000), pp. 143-150.

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[Footnotes]

1 An Approach to Communication Equilibria

Francoise Forges

Econometrica, Vol. 54, No. 6. (Nov., 1986), pp. 1375-1385.

Stable URL:http://links.jstor.org/sici?sici=0012-9682%28198611%2954%3A6%3C1375%3AAATCE%3E2.0.CO%3B2-Z

1Multistage Games with Communication

Roger B. Myerson

Econometrica, Vol. 54, No. 2. (Mar., 1986), pp. 323-358.

Stable URL:

http://links.jstor.org/sici?sici=0012-9682%28198603%2954%3A2%3C323%3AMGWC%3E2.0.CO%3B2-P

2 A Capital Market in an Equilibrium Business Cycle Model

Robert J. Barro

Econometrica, Vol. 48, No. 6. (Sep., 1980), pp. 1393-1417.

Stable URL:

http://links.jstor.org/sici?sici=0012-9682%28198009%2948%3A6%3C1393%3AACMIAE%3E2.0.CO%3B2-D

3Endogenous Technological Change

Paul M. Romer

The Journal of Political Economy, Vol. 98, No. 5, Part 2: The Problem of Development: AConference of the Institute for the Study of Free Enterprise Systems. (Oct., 1990), pp. S71-S102.

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3 Lawrence R. Klein Lecture 1997: Needed: A Theory of Total Factor Productivity

Edward C. Prescott

International Economic Review, Vol. 39, No. 3. (Aug., 1998), pp. 525-551.

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References

Information as an Economic Commodity

Beth Allen

The American Economic Review, Vol. 80, No. 2, Papers and Proceedings of the Hundred andSecond Annual Meeting of the American Economic Association. (May, 1990), pp. 268-273.

Stable URL:

http://links.jstor.org/sici?sici=0002-8282%28199005%2980%3A2%3C268%3AIAAEC%3E2.0.CO%3B2-G

Choosing R&D Projects: An Informational Approach

Beth AllenThe American Economic Review, Vol. 81, No. 2, Papers and Proceedings of the Hundred and ThirdAnnual Meeting of the American Economic Association. (May, 1991), pp. 257-261.

Stable URL:

http://links.jstor.org/sici?sici=0002-8282%28199105%2981%3A2%3C257%3ACRPAIA%3E2.0.CO%3B2-2

A Capital Market in an Equilibrium Business Cycle Model

Robert J. Barro

Econometrica, Vol. 48, No. 6. (Sep., 1980), pp. 1393-1417.

Stable URL:

http://links.jstor.org/sici?sici=0012-9682%28198009%2948%3A6%3C1393%3AACMIAE%3E2.0.CO%3B2-D

An Approach to Communication Equilibria

Francoise Forges

Econometrica, Vol. 54, No. 6. (Nov., 1986), pp. 1375-1385.

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12/12

On the Turnover of Business Firms and Business Managers

Thomas J. Holmes; James A. Schmitz, Jr.

The Journal of Political Economy, Vol. 103, No. 5. (Oct., 1995), pp. 1005-1038.

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On the Strategic Stability of Equilibria

Elon Kohlberg; Jean-Francois MertensEconometrica, Vol. 54, No. 5. (Sep., 1986), pp. 1003-1037.

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Multistage Games with Communication

Roger B. Myerson

Econometrica, Vol. 54, No. 2. (Mar., 1986), pp. 323-358.

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Lawrence R. Klein Lecture 1997: Needed: A Theory of Total Factor Productivity

Edward C. Prescott

International Economic Review, Vol. 39, No. 3. (Aug., 1998), pp. 525-551.

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Competitive Equilibrium Under Uncertainty

Roy Radner

Econometrica, Vol. 36, No. 1. (Jan., 1968), pp. 31-58.

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Endogenous Technological Change

Paul M. Romer

The Journal of Political Economy, Vol. 98, No. 5, Part 2: The Problem of Development: AConference of the Institute for the Study of Free Enterprise Systems. (Oct., 1990), pp. S71-S102.

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allen, beth - the future of micro economic theory (2000)

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