October 13, 2010

A Nobel Lesson: Economics is Getting Messier

When Peter Diamond was a graduate student at MIT in the early 1960s, he spent much of his time studying the elegant new models of perfectly functioning markets that were all the rage in those days. Most important of all was the general equilibrium model assembled in the 1950s by Kenneth Arrow and Gerard Debreu, often referred to as the mathematical proof of the existence of Adam Smith's "invisible hand." Working through the Arrow-Debreu proofs was a major part of the MIT grad student experience. At least, that's what Diamond told me a few years ago. (If I ever find the notes of that conversation, I'll offer up some quotes.)

Diamond certainly learned well. In a long career spent almost entirely at MIT, he became known for work of staggering theoretical sophistication. As economist Steven Levitt put ittoday:

He wrote the kind of papers that I would have to read four or five times to get a handle on what he was doing, and even then, I couldn't understand it all.

But Diamond wasn't out to further prove the perfection of markets. He was trying instead to show how, with the injection of the tiniest bit of reality, the perfect-market models he'd learned so well in grad school began to break down. Today he won a third of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (it's not technically a "Nobel Prize"), mainly for a paper he wrote in 1971 that explored how the injection of friction between buyers and sellers, in the form of what he called "search costs," prices would end up at a level far removed from what a perfect competition model would predict. The two economists who shared the prize with him, Dale Mortensen of Northwestern University and Christopher Pissarides of the London School of Economics, later elaborated on this insight with regard to job markets (as did Diamond).

The exact practical implications of this work can be a little hard to define — although Catherine Rampell makes a valiant and mostly successful effort in The New York Times. What this year's prize does clearly indicate is that the Nobel committee believes economic theory is messy and getting messier (no, I didn't come up with this insight on my own; my colleague Tim Sullivan had to nudge me). The last Nobel awarded for an all-encompassing mathematical theory of how the economic world fits together was to Robert Lucas in 1995 for his work on rational expectations. Since then (with the arguable exceptions of the prizes awarded to Robert Merton and Myron Scholes in 1997 for options-pricing and to Fynn Kydland and Edward Prescott in 2004 for real-business-cycle theory) the Nobel crew has chosen to honor either interesting economic side projects or work that muddies the elegance of those grand postwar theories of rational actors buying and selling under conditions of perfect competition. The 2001 prize for work exploring the impact on markets of asymmetric information, awarded to George Akerlof, Michael Spence and Joseph Stiglitz, was probably most similar to this year's model (and, not coincidentally, Akerlof and Stiglitz were also MIT grad students in the 1960s).

The implications of messier economics are interesting to contemplate. The core insight of mainstream economics — that incentives matter — continues to hold up well. And on the whole, markets appear to do a better job of channeling those incentives to useful ends than any other form of economic organization. But beyond that, the answers one can derive from economic theory — especially answers that address the functioning of the entire economy — are complicated and often contradictory. Meaning that sometimes we non-economists are just going to have to figure things out for ourselves.

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