Importance of model building in economics

 

In the natural sciences, a laboratory experiment can isolate various elements and their movements. There is no equivalent in the discipline of economics. The employment of model building is an attempt to produce a laboratory where controlled experiments can be conducted.

 

The idea of having such a laboratory is very appealing to economists and politicians. Once the model is built and endorsed as a good replica of the economy, politicians can evaluate the outcomes of various policies.

 

This, it is argued, enhances the efficiency of government policies and thus leads to a better and more prosperous economy.

 

It is also suggested that the model can serve as a referee in assessing the validity of various economic ideas. The other purpose of a model is to provide an indication regarding the future.

 

By means of mathematical and statistical methods, a model builder establishes relationships between various economic variables.

 

For example, personal consumer outlays are related to personal disposable income and interest rates, while fixed capital spending is explained by the past stock of capital, interest rates, and economic activity. A collection of such various estimated relations—i.e., equations—constitutes an econometric model.

 

A comparison of the goodness of fit of the dynamic simulation versus the actual data is an important criterion in assessing the reliability of a model. (In a static simulation, the equations of the model are solved using actual lagged variables. In a dynamic simulation, the equations are solved by employing calculated from the model-lagged variables).

 

The final test of the model is its response to a policy variable change, such as an increase in taxes or a rise in government outlays. By means of a qualitative assessment, a model builder decides whether the response is reasonable or not. Once the model is successfully constructed, it is ready to be used.

 

 

Is the mathematical method valid in economics?

 

By applying mathematics, mainstream economics is attempting to follow in the footsteps of natural sciences. In the natural sciences, the employment of mathematics enables scientists to formulate the essential nature of objects. By means of a mathematical formula, the response of objects to a particular stimulus in a given condition is captured. Consequently, within these given conditions, the same response will be obtained time and again.

 

The same approach, however, is not valid in economics. For economics is supposed to deal with human beings and not objects. According to Mises,

 

The experience with which the sciences of human action have to deal is always an experience of complex phenomena. No laboratory experiments can be performed with regard to human action[1].

 

The main characteristic or nature of human beings is that they are rational animals. They use their minds to sustain their lives and well-being. The usage of the mind, however, is not set to follow some kind of automatic procedure, but rather every individual employs his mind in accordance with his own circumstances. This makes it impossible to capture human nature by means of mathematical formulae, as is done in the natural sciences.

 

To pursue quantitative analysis implies the possibility of the assignment of numbers, which can be subjected to all of the operations of arithmetic. To accomplish this, it is necessary to define an objective fixed unit. Such an objective unit, however, does not exist in the realm of human valuations. On this Mises wrote, “There are, in the field of economics, no constant relations, and consequently no measurement is possible[2].” There are no constant standards for measuring the minds, the values, and the ideas of men.

 

People have the freedom of choice to change their minds and pursue actions that are contrary to what was observed in the past. Because of the unique nature of human beings, analyses in economics can only be qualitative.

Individual goals or ends set the standard for valuing the facts of reality. For instance, if the goal of an individual is to improve his health, then he would establish which goods will benefit his health and which will not. Among those that will benefit him, some will be more effective than others. There is no way, however, to quantify this effectiveness. All that one could do is rank these goods in accordance with perceived effectiveness.

 

The use of mathematics in economics poses another serious problem. The employment of mathematical functions implies that human actions are set in motion by various factors. For instance, contrary to the mathematical way of thinking, individual outlays on goods are not “caused” by real income as such. In his own context, every individual decides how much of a given amount of income will be used for consumption and how much for savings. While it is true that people respond to changes in their incomes, the response is not automatic, and it cannot be captured by a mathematical formula.

 

An increase in an individual’s income does not automatically imply that his consumption expenditure will follow suit. Every individual assesses the increase in income against the goals he wants to achieve. Thus, he might decide that it is more beneficial for him to raise his savings rather than raise his consumption.

 

Given that human beings are governed by freedom of choice, various policy analyses by means of models, known as “what if” or multiplier analyses, are likely to generate questionable results. After all, to assume that a change in government policy would leave the structure of equations intact would mean that individuals in the economy ceased to be alive and were, in fact, frozen.

 

Another major problem with most large scale econometric models is that they are designed along the lines of Keynesian economic thinking. Thus, the main variable in these models is gross domestic product, which is explained within the model framework by the interactions between various lumped data known as aggregates.

 

The interaction between various aggregates in the model framework gives the impression that the economy is about gross domestic product, or about balance of payments, but not about human beings and human life. Obviously, this runs contrary to the fact that everything in the human world is caused by man’s purposeful conduct.

 

Various relatively modern addition to model building tools such as the introduction of the so called ARMA methods suffer from the same methodological problems.

 

[1] Ludwig von Mises, Human Action, (1963), p.31.

[2] Human Action, p.55.

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