Sunday, May 31, 2009

Reflections on a Loaf of Bread, or, alternatively titled: Why History Matters for Economic Theory

Once, passing by my room at home, my sister noticed a drawing of a loaf of bread on my notebook. She's always looking for a way to make fun of her brother (it's all in good spirits, though) so she asked me what a picture of a loaf of bread was doing on my notebook.

I was thinking about a loaf of bread when considering how to explain the notion of time in economic analysis. First, it is important to realize that standard supply and demand analysis is just one "slice" of the loaf, of the story of an economy or economic analysis: it is a snapshot in a movie. This is not, a priori, a weakness of economic theory. In fact, in some ways it is extremely helpful to first think about something in a static state and then try to generalize behavior of that equilibrium over time. However, many economists take this idea too far: they think that supply and demand formalized in this way provides a powerful framework for explaining the state of an economy far into the future; even "dynamic" models in neoclassical economics are essentially a collection of static states "meshed" together: what I mean is, take time period 1, 2, 3, 4, 5. There is some change between 1 and 5, but think of the change in this fashion:

You're describing how a ball moves through the air. The picture at time period 1 has a person (person A) on the far left of the frame, holding a baseball. At the far right, is another person (person B), currently empty-handed. Time period 2 (the next "frame") shows person A with their arm extended and the ball halfway up. Time period 3 shows the ball at its apex, now, neither person is holding a ball. Time period 4 shows the ball halfway down, and the person on the right is now opening their hands. Time period 5 shows the ball in the other person's hand.

Why is this so significant to neoclassical economics and time? Consider what was changing over the course of the 5 frames: the people changed position: person A started out with a ball in their hand and was seen throwing it. Person B started out with nothing but was seen catching it by the last time period. The ball's position changed as well. But what (more importantly) was not changing, what was assumed constant throughout the picture frames? Several very important factors: gravity, windspeed, sun glare!, etc. Of course, these variables may seem trivial if our goal is to project a path of a ball. The projection also has limited social implications if we end up being wrong. For economies, the situation is much more important. Gravity, sun glare-- all these things are analogous to institutional and behavioral characteristics of an actual economy and its agents, which change quite often -- due to external and internal impulses on the individual and individuals interacting with the institutions. We cannot assume these things to stay constant over time. Our analysis is fundamentally weakened if we cannot incorporate time dependency and institutional change.

My main thesis is that time should not be treated simply as another dimension in economic analysis, such as by discounting each successive state by some fraction of the previous state. Incorporating time alters the structure on which the theory is based.

My sister quickly left the room about halfway through my above arguments to go hide in her room. Let's hope my students don't do the same if I decide to give a lecture on history and economic dynamics!

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