Wednesday, November 26, 2014

Microeconomics for All

TOULOUSE – For the last half-century, the world’s leading universities have taught microeconomics through the lens of the Arrow-Debreu model of general competitive equilibrium. The model, formalizing a central insight of Adam Smith’s The Wealth of Nations, embodies the beauty, simplicity, and lack of realism of the two fundamental theorems of competitive equilibrium, in contrast to the messiness and complexity of modifications made by economists in an effort to capture better the way the world actually functions. In other words, while researchers attempt to grasp complex, real-world situations, students are pondering unrealistic hypotheticals.

This educational approach stems largely from the sensible idea that a framework for thinking about economic problems is more useful to students than a ragbag of models. But it has become burdened with another, more pernicious notion: as departures from the Arrow-Debreu model become more realistic, and thus more complex, they become less suitable for the classroom. In other words, “real” microeconomic thinking should be left to the experts.

To be sure, basic models – for example, theories of monopoly and simple oligopoly, the theory of public goods, or simple asymmetric-information theory – have some educational value. But few researchers actually work with them. The bread-and-butter theories for microeconomics research – incomplete contracts, two-sided markets, risk analysis, inter-temporal choice, market signaling, financial-market microstructure, optimal taxation, and mechanism design – are far more complicated, and require exceptional finesse to avoid inelegance. Given this, they are largely excluded from textbooks.

In fact, microeconomics textbooks have remained practically unchanged for at least two decades. As a result, undergraduate students struggle to understand even the abstracts of papers on the complex representations of microeconomic reality that fill research journals. And, in many areas – such as antitrust analysis, auction design, taxation, environmental policy, and industrial and financial regulation – policy applications have come to be considered the domain of specialists.

This does not have to be the case. While it is true that realistic microeconomic models are more complex than their idealized textbook counterparts, grasping them does not necessarily require years of research experience.

A case in point is the economics of two-sided markets, which involve competition between platforms whose principal “product” consists in connecting two categories of users, who then offer each other network benefits. When markets are two-sided, many of the standard assumptions of antitrust analysis no longer hold: market entry can be bad for consumers, exclusive contracts can increase the number of firms in a market, and pricing below cost may not be predatory.

A survey by David Evans and Richard Schmalensee describes numerous situations in which applying old assumptions could lead to mistakes by, say, an anti-trust regulator with only an undergraduate degree. The unmistakable message is, “Don’t try this at home.”

But every behavioral divergence between two-sided and traditional markets can be understood using simple tools of elementary microeconomics, such as the distinction between substitute and complementary products. When producers of substitutes collude, they usually raise prices; producers of complements, by contrast, collaborate to lower them.

So, if two platforms that appear to be performing similar services are complementary – for example, because one platform connects consumers with a set of users that helps them to value another set of users more highly – market entry can be bad for consumers. In fact, two platforms can even be complementary for one set of users and substitutes for another. The different stages of a televised soccer (football) tournament, for example, are complementary for viewers and substitutes for advertisers.

Moreover, exclusive dealing can increase competition by allowing two platforms to occupy distinct market niches, with the alternative being that one drives out the other. In short, with a solid understanding of the difference between complements and substitutes, one can do almost everything the fancy models do – without hiring a single expensive expert.

Undergraduate-level microeconomics should empower students, not alienate them. While the Arrow-Debreu model has its value – namely, it explains why an unplanned economy can produce order – it is discouraging for students to find that what they are deemed capable of comprehending offers little insight into real-life situations.

Restructuring the microeconomics syllabus would send a far more inspiring – and accurate – message: even complex ideas developed by experts can be understood and applied by educated laypeople.

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    1. CommentedTruong Chung

      Agree! The message is try to design the syllabus to capture the complexity of economics, as closer as possible to the nuances of real world; instead of teaching simple, beautiful, mathematical model which based on unreal assumptions.

    2. CommentedJoshua Ioji Konov

      Macroeconomics should evolve from a linear one-dimensional mathematical conceptions into a multidimensional probability theory of adjustable theory to properly apprehend the ongoing complex realities. The economic agents and the invisible hand could only work if probability is taken in its full comprehension!

    3. CommentedPhilip Palij

      Lets start with a definition from Investopedia - Investopedia explains Microeconomics: "The field of economics is broken down into two distinct areas of study: microeconomics and macroeconomics. Microeconomics looks at the smaller picture and focuses more on basic theories of supply and demand and how individual businesses decide how much of something to produce and how much to charge for it. People who have any desire to start their own business or who want to learn the rationale behind the pricing of particular products and services would be more interested in this area.

      Macroeconomics, on the other hand, looks at the big picture (hence "macro"). It focuses on the national economy as a whole and provides a basic knowledge of how things work in the business world. For example, people who study this branch of economics would be able to interpret the latest Gross Domestic Product figures or explain why a 6% rate of unemployment is not necessarily a bad thing. Thus, for an overall perspective of how the entire economy works, you need to have an understanding of economics at both the micro and macro levels."

      If you don't agree on a definition then that is a profound source of trouble. The subject is vast, the nuances overwhelming, the potential for ideological, geopolitical, geographic anomalies and schisms are huge.

      Professor Seabright, if you think you can get a million strong herd of economists all heading in the same direction you are quite frankly P1$$1ng in the wind.

      You are a very brave man doomed to failure.

      You should develop several theories based on empirical analysis for particular markets, countries, regimes and levels of corruption.

      Hope this helps. C'est La Vie

    4. CommentedJohn Nightingale

      I notice that Professor Seabright ignores the relatively simple models of microeconomic change that are used by economics' dis-owned daughter-disciplines of strategy and management. These are the models of market evolution popularly associated with Schumpeter but also, more rigorously, with Richard Nelson & Sidney Winter, and the research programs that have emerged from these literatures. All the complex and messy strands cited by Seabright relate to the discovery of equilibria rather than the process of economic change that drives capitalism from day to day and from decade to decade.
      It is this disjunction rather than that of the complexity of 'real' microeconomics that has driven university economics courses into irrelevance. Managers can achieve an MBA with only a single 12 week introductory microeconomics and macroeconomics. Management and accountancy degrees can require as little as two economics subjects, but a larger number of business strategy, human resource management, finance (where the basics of efficient markets theory has to be taught - thus the 2008 crisis) are required.
      I'd put current microeconomics teaching back to Samuelson's first textbook, early 1950s. I've taught from current textbooks that barely differ from Samuelson's 4th edition that I studied in 1962!
      Is economics driving itself further into irrelevance?

    5. CommentedVinicius Spader

      Your article is basically the description of my microeconomics classes, I felt just like that. But nonetheless, I believe that a most effective change must happen in both professors and students attitude confronting this distance between model and reality.

      Nor did I searched for how to apply those models, nor did my professor showed it.

    6. CommentedProcyon Mukherjee

      Paul Seabright is indeed raising such an excellent point, which could be applied outside of academics as well; in the sphere of management of firms most managers have the more simple Arrow-Debreu model through which they see business problems, while the reality is governed by what the latest research papers are dealing with which they are never exposed to. So think of it, the complex nature of world's problems even in the highest of management echelons never go beyond the basics of micro-economics, while many of the decisions that they take directly or indirectly actually lead to serious consequences. The world is more non-linear than any model and our simplistic view to comprehend world's current problems and the limitations make most of the results appear as random walk. This probabilistic nature of outcomes is something that the world of business has found very difficult to grapple with.

    7. CommentedLeo Arouet

      Tal parece que la realidad no ha llegado a las aulas de los alumnos de economía. Pero puede y se necesita hacer un trabajo vinculante entre universidad y empresa o estado. De manera que los conocimientos que se impartan sólo se adecuen a la realidad, sino que estos propios conocimientos sean adecuados para comprender esa realidad compleja.