Dilemmas of an Economic Theorist Presented by Amr S Algarhi Hendrik Buhrs M.Sc. Seminar 29th November 2006

Ariel Rubinstein Born in 1951 Educated at the Hebrew University of Jerusalem in both mathematics and economics. Main field of interest: Game Theory. Currently a Professor of Economics at Tel Aviv University and New York University. Published “Perfect Equilibrium in a Bargaining Model (1982)”, an important contribution to the Theory of Bargaining. Served as President of the American Economic Association in 2004. Received several prizes (e.g. Nemmers Prize, 2004) Photo © Gabriel Baharlia

What are economic theorists trying to accomplish? The Dilemma of absurd conclusions. The Dilemma of responding to reality. The Dilemma of modelless regularities. The Dilemma of relevance.

1. The Dilemma of absurd conclusions Models and conclusions. Sound assumptions and absurd conclusions. Should we be concerned about/abandon these models? Example: Adam in the Garden of Eden.

Adam in the Garden of Eden Framework and Assumptions: Stream of apples. Rational. relation. 2 apples a day Impatient. (1,0) (0,2) (2,0) (1,1) 120 years. ( , )

Adam in the Garden of Eden Adam should be willing to exchange his endowment for a single apple right away! Why is that? (=First Traumatic Experience) Adam enters the Garden. After day 17: One apple per day (= 43,813)

Adam in the Garden of Eden 21 days after day 1: (0,1,1) (0,2,0) (1,0,0) 22 days after day 2: (0,0,1,1,1,1) (0,0,2,0,2,0) (0,1,0,1,0,0) (0,1,1,0,0,0) (0,2,0,0,0,0) (1,0,0,0,0,0) 217 days after day 17: (0,0,0,..,0,1,1,1,….,1,1) (1,0,0,0,……,0)

Adam in the Garden of Eden Recovering from the first traumatic experience The consequences are independent of time: Consumption on day 27 is the same. The consequences are not independent of time: Split his personality Consumption on day 27 differs. t+27 t+26 t+1 t

Adam in the Garden of Eden Framework and Assumptions: Stream of apples. Rational. relation. Less appetite. 1 apple a day (0,1) (1,0) 120 years.

Adam in the Garden of Eden Second Traumatic Experience “Why don’t you give me the apple and get one tomorrow?”, Eve said. (1,0) (0,1) → (0,0,0,0,0,………,∞)

Adam in the Garden of Eden Recovering from the Second Traumatic Experience “Be consistent with sophisticated behaviour”, The snake said. (1,0,1,0,……,1,0,1,0) (0,1,0,1,……,0,1,0,1)

Adam in the Garden of Eden The Third Traumatic Experience Adam can pick one apple every day (1,1,1,….,1,1). “You should pick an apple only after an odd number of days which you have not done”, the snake said. (0,0,0,0) (0,0,0,1) → (0,1,0,1,……,0,1,0,1)

1. The Dilemma of absurd conclusions If we followed this methodology, we would reject a theory if it reaches an absurd conclusion. How should we respond to absurd conclusion?!

2. The Dilemma of Response to Evidence Models and the real world. Experiments. Should we modify a model if one of its assumptions is experimentally rejected? Example: The case for hyperbolic discounting.

2. The Dilemma of Response to Evidence The case for hyperbolic preferences: t+27 t+26 Traditional vs. Hyperbolic discounting formula. Experiments show that people follow the hyperbolic discounting What if we design an experiment to reject the alternative theory? t+1 t

2. The Dilemma of Responding to Reality Problem (1) Imagine you have finished a job and have to choose between two payment schemes: (A) Receiving £1,000 in 8 months. (B) Receiving £500 in 6 months and £500 in 10 months. Problem (2) Imagine you have bought a computer and have to choose between two payment schemes: (A) Paying £1,000 in 8 months. (B) Paying £500 in 6 months and £500 in 10 months. 54% chose A and 46% chose B. 354 participants (rejecting hyperbolic discounting) 39% chose A and 61% chose B. 382 participants 37% chose A and 63% chose B. 113 participants (supporting hyperbolic discounting) 53% chose A and 47% chose B. 118 participants t=6 t=8 t=10 £ 500 £ 500 £ 500 £ 500 ≈ 502 ≈ 499

2. The Dilemma of Response to Evidence Should we dismiss the hyperbolic discounting model? How do we respond to experimental evidence given that it is so easy to challenge (nearly) any given assumptions with it?

3. The Dilemma of Modelless Regularities Models and Regularities. Do we really need economic theory to find these regularities? Or should we rather examine the real world? Example: The Traveler’s Dilemma.

3. The Dilemma of Modelless Regularities Miro Hendrik 300 299 298 297 … 180 Hendrik and Miro visiting Panos. £ 180 - £ 300. £ 5. What is the choice? Nash Equilibrium Basu (1994)

3. The Dilemma of Modelless Regularities A regularity in distribution: 180 181-294 295 296-298 299 300 13% 15% 5% 3% 9% 56% 96 sec. 87 sec. 72 sec. 70 sec.

3. The Dilemma of Modelless Regularities Do we really need complicated theoretical models when we want to find interesting regularities?

4. The Dilemma of Relevance Is the advice economists give of any relevance to the world? How does the formal way economics is taught (models, theorems and assumptions) influence our “message”?

4. The Dilemma of Relevance Assume you are a vice president of a company. The company employs hundreds of workers among them, 196 temporary low-skilled workers. Until recently, the company was making large profits. However as a result of a recession, there has been a significant drop in profits. You will be attending a meeting of the management in which a decision will be made regarding the layoff of some of the temporary workers. Complete the following: I recommend continuing to employ ____________ of the 196 workers presently employed by the company.

4. The Dilemma of Relevance Econ1 Econ2 MBA Law Maths Phil n= 94 130 172 216 64 88 100 49% 45% 33% 27% 16% 13% 144 31% 29% 36% 19% 170 7% 9% 23% 18% 25% 196 6% 12% 11% Other 4% 2% 3% Average 127 133 142 151 165

4. The Dilemma of Relevance Sobe: U. Exeter Psychology: U. Exeter n= 98 74 100 67% 31% 144  19%  27% 170 7%  20%  196 4%  19%  Other 3%  Average 115   143

4. The Dilemma of Relevance The Jungle Model “Social Darwinism”: Only the stronger agent is interested in transactions. Power vector instead of initial endowment vector. The stronger are also the richer (in equilibrium). Purpose: make students reflect/reconsider traditional competitive market model.

4. The Dilemma of Relevance Economic theorists have very little to say about the real world (very few models can be used to provide serious advice) But they influence student’s minds. x* max Photo ©: Volme-Galerie, Ido Rosenthal

Concluding words A good model in economic theory, like a good fable: A situation between fantasy and reality. Has a moral message. Unrealistic and simplistic. Something significant remains.

Concluding remarks How should we respond to absurd conclusion?! The model may still be interesting! How do we respond to experimental evidence given that it is so easy to challenge (nearly) any given assumptions with it? Models are not meant to be testable! Do we really need complicated theoretical models when we want to find interesting regularities? Models have limited scope! Can economists give valid comments on the real world? Yes, although they don’t give advice/predict directly, but influence “culture”!

Thank you Any Questions?!