Why do we need Micro-foundations….because with out them we blow up the economy!
Filed Under Economics, Economy, Jeremy
Recently Big Dog pointed out to me a recent post by Matthew Yglesias asking the question why Macroeconomic models, to be even be considered in the profession, must be based on Microeconomic Foundations. Matt comments that no other science (social or physical) requires that its theories be based on the foundations of the lower levels that make up that science (i.e. Chemistry based on theories of atoms or Psychology based on neurological theories). *
A macroeconomic model seeks to predict how the larger economy will react to some given stimulus or shock. The reasons the macro models must be based in micro foundations is because the macro economy is, by construction, a collection of individual (or micro economies) that each act independently. Consider dropping a rock into a pond. As is pointed out in Matt’s blog, one does not need not know sub-atomic physics to know that the rock will sink and there will be produced concentric rings on the surface of the pond centered on the point where the rock fell. All we need to know is how each water molecule will react to the rock, not how the two hydrogen and one oxygen atoms will individually act. This is because when bound together in the correct way, the two hydrogen and one oxygen atoms become a different “thing” called water. There is no way for them to act as separate agents. In an economy, however, the individual objects (i.e. people), while still forming a different “thing” called a society, CAN act independently of each other in ways detrimental to the group. If you drop a one trillion dollar stimulus package into the economy, we have to know how each individual agent within the economy is going to act in response to this. If they all (or even some) save their share (i.e. Japan) then the stimulus does nothing. If, on the other hand, each agent uses it to go out a buy a new car, the money gives a shock to the auto industry which, in turns, buys more auto parts from suppliers, who then go and hire more workers (i.e. Obama’s hope).
Another way to look at this is that when we mix two chemicals together and they go BOOM, we just learned something . Just like, for those with little knowledge of electronics, their theory of TV operation is limited to “push button, watch show.” For the most part, this works. If I want to watch a show or make something go BOOM, I have all the knowledge I need to know. The problem, however, arrives when I push the button on the TV and nothing happens! Unless I have a knowledge of the “micro” aspects of television (electricity, transistors, etc), I am faced with the decision of missing my show or buying a new TV. The same can be said about economics. When the macro economy is working just fine, then there is little need for micro foundations. It is only when the macro economy suddenly stops that we need to know something about the make-up of that economy (i.e. individual decision makers) in order to fix it because we can not, unfortunately, go buy another.
To see what happens when we try to fix a broken economy without this consideration, see the Great Depression. In response to the poor economy we raised taxes (governments were going broke), we increased tariffs (had to keep Americans working) and we failed to stop the run on banks. While few economists will agree as to what ended the Great Depression, most will agree that those policies likely made it worse than it otherwise would have been. Why? Because higher taxes means less money for people to spend so they stop buying stuff and thus firms stop making stuff and then lay off workers (a basic idea from microeconomics). Tariffs raise the prices, even domestically, on goods being protected because they are no longer subject to competition from the outside (a basic idea from microeconomics). This means that those industries that use these products as inputs see higher prices so they cut costs by laying off workers. When some banks are no longer able to give people their money back when demanded, all individuals decide not be the one left with no money when the bank goes under so no money is deposited into banks (a basic idea from microeconomics) meaning banks have no money to lend meaning that people stop buying large ticket items on credit so less stuff is made and firms lay people off. Notice the common thread here. Those responses to the Great Depression, however, were the accepted responses to the macro problems of the times…responses NOT based on micro foundations.
So you see, it is not that breakthroughs in macroeconomics only occur when built from micro foundations, but when we are trying to predict how a collection of individuals will react to a given stimulus or shock (i.e. form a model of the macro economy), it helps to know how each individual is going to react to that stimulus or shock. Otherwise we may prescribe the exactly wrong solution to the problem.
-J
*Let me offer full disclosure; I am a micro-eLet me offer full disclosure; I am a micro-economist so my answer to this question just might be somewhat skewed (as a matter of fact, I really dis-liked my macro theory classes).
