On microfoundation

There are two ways we can model the whole macroeconomy. We can model the aggregates directly, like aggregate consumption, price, and so forth. Alternatively, we could build from the bottom up, we start from people's decision making---solving their optimization problem, and then model their interaction, and finally the whole market. The second approach is a multi-layered approach in that in each layer you specify the rule, you study each layer separately, from the bottom up, and using the result you solved for in the previous layer as input. The idea of micro-founded economics is illustrated in the following diagram.

An Illustration of Microfoundation

A digression for the super serious: what the above diagram illustrates is a more hierarchical model where different groups of individuals make decisions sequentially. In reality, and in literature, different groups often make decisions simultaneously, and yet taking into account what other group will be doing (and other group will take into account of what that group is doing as well in an infinite loop) (for those who know game theory, we are looking at Nash Equilibrium). 

So an obvious observation is that the second approach is so complicated. After all, why bother to study from the bottom up if all you are interested is the top level? Indeed, economists have taken the first approach for a long time, until comes along the famous Lucas Critique:

"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models."

What in essence Lucas Critique says is that, when we model the top layer and decide to engineer some policy to bring out better outcomes, we have changed the environment the individuals face---and that change will pass through all those layers into the top layer---which means that our old model of the top layer becomes invalid. The most famous illustration is the Philipps Curve.

So we have turned to the second approach, with lots of added effort. The extra effort does not mean we are golden. Quite the contrary. The problem is when we model each layer, it will be highly imprecise. All those imprecision adds up and amplify each other, and when we get to the top, it is nothing like the the real world---that is how we get highly unrealistic models that very few has faith in. The standard approach in economics is that calibrate our model----find parameters (the very first inputs) to match our data.  Because of the problem I mentioned, to fit the macro data, our estimates of the parameters would be non-sensible in the micro level.  Not surprisingly, micro-level and macro-level data often give us highly different estimates.

Another Digression for the super-serious: Imprecision is a bad word choice as it suggests a mere error term that would be dealt with in statistical analysis. Instead, I mean the deviations of structures from the reality. For example, imposing homothetic utility does not just generate random errors. Another point is that, we can always tweak our models so that it will fit micro-level and macro-level data. But are we just telling stories so that the data will fit, or are we actually making the first several layers more precise? In some sense, the purpose deviates from the true spirit of micro-foundation, to spinning a story that resembles micro-foundation.

An example to illustrate. When I was young, I like to play with ship models. I liked those fancy ones where you build from very tiny parts. Those require very careful work, but I was clumsy. When I put together those little pieces in a less than perfect manner, I could no longer fit that giant chunk into the frame of the ship. I used brute force, squeezing here and there until it fits, more or less. But when I looked back at those little parts, it is so distorted now. Several parts were displaced, some parts fell off, and it was just a mess. I think that is very similar to the mess economists are dealing with.
While my modeling experience could be improved via better craftsmanship, the modeling experience of economists are in some sense hopeless----To mathematically model these layers, things get so complicated. To make things tractable, we have to make numerous simplifying assumptions, not all of which are innocuous. Further more, by imposing those assumptions, we limit the type of questions we could ask as well.

So which approach is better? I do not think there is a definitive answer yet, but I want to contribute my two cents. The critique against the first is that it is not robust to policy changes, but it could be fine in the absence of policy change/paradigm shift. The second approach is aimed to address this inadequacy. But it fails the job---the changes in policy/environment pass through the model highly distorted due to the imprecisions added at each layer.

Admittedly, if we take the first approach, we can be a scientist, but we can never be an engineer---the very attempt of engineering would destroy our model. However, could we ever aspire to be an engineer in those fields? There are always things we do not model, and those things might be irrelevant in the previous world, but matter a lot in an engineered world. If you think you can fine-tune the economy with DSGE, you are guilty of the pretense of knowledge.  As a conclusion, I want to be provocative and say that  mathematical thinking and careful judgements+intuition are not substitutes, and they as a whole make up rigorous thinking (though some arrogant people tend to view mathematical thinking is necessary and sufficient for rigor).


After Note: Micro-foundation is the mainstream in macroeconomics, or any branch of economics these days. I thought about this for a long time, but never wrote much about it. This blog came out of a discussion I had with a friend, and I feel I need to write it down to invite further discussion.

an interesting comment

I saw an especially interesting comment today on facebook. Let me quote it in full.

i wish i could say this only applied to bowdoin:
What does Bowdoin not teach? Intellectual modesty. Self-restraint. Hard work. Virtue. Self-criticism. Moderation. A broad framework of intellectual history. Survey courses.English composition. A course on Edmund Spenser. A course primarily on the American Founders. A course on the American Revolution. The history of Western civilization from classical times to the present. A course on the Christian philosophical tradition. Public speaking. Tolerance towards dissenting views. The predicates of critical thinking. A coherent body of knowledge. How to distinguish importance from triviality. Wisdom. Culture.

btw, here's some of what they do teach: Queer Gardens, Beyond Pocahontas: Native American Stereotypes; Sexual Life of Colonialism; Modern Western Prostitutes.
Explores how the garden in Western literature and art serves as a space for desire. Pays special attention to the link between gardens and transgression. Also considers how gardens become eccentric spaces and call into question distinctions between nature and culture. Examines the work of gay and lesbian gardeners and traces how marginal identities find expression in specific garden spaces. Reconsiders one of the founding myths of Western culture: the idea of a lost Eden. Authors and gardeners may include Marvell, Lanyer, Pope, Seward, Dickinson, Burnett, Carroll, Sackville-West, Nichols, Jarman, and Pollan.

Are we ready for knowledge?

Knowledge is a huge burden. Without it, we act on default. When we know about the consequences of default however, it is impossible to continue act on default without debating over alternative actions, which inevitably involve moral judgement and clashes over value systems.

Let me give a concrete examples. Studies have shown that when girls and boys are educated in the same class for maths and science, girls learn worse than when they are taught separately. However, boys learn better in a co-ed system. The problem is shall we bring them apart? Some would say yes, arguing it is unacceptable that allow boys do well at the expense of girls' suffering. Well, that is one argument, but this argument uses the reference of boys and girls studying separately. However, if our reference is co-ed, and we consider the alternative, we might ask, is it ethical to let boys do worse so as to make girls learn better?
When we know nothing, choice does not carry a moral consequence. Ignorance is amoral, not immoral. However, when we know what each option would entail, it is just tough. Anyone who tries to make an overly simplistic picture for his own agenda, is a demagogue at best, most likely a dangerous man, and a devil at worst.
As a future researcher, I could just focus on positive analysis, and leave normative analysis to others. However, I have to constantly remind myself, that we live in a dangerous world, and positive analysis could easily abused to benefit an ambitious and evil group.

official nonsense

The background is that I went to the Boston RMV to apply for a learner's permit. I had to go through the driver's manual. Unfortunately, there is some statistical non-sense in the manual that annoys me greatly.

In order to convince drivers to wear safetybelt all the time, they say "Most motor vehicle crashes happen within 25 miles of home. In fact eight out of every ten accidents occur when drivers are going 40 mph or less".  The problem of this sentence is that it is irrelevant and misleading. This is what is called a prosecutor's fallacy (http://en.wikipedia.org/wiki/Prosecutor's_fallacy). The idea is the the probability of event A given B could be very different from the probability of event B given A.  Whether we want to wear a seatbelt is dependent on the probability of having an accident conditional on we are only driving within 25 miles of home.  If that is too low to justify the cost of putting on a seatbelt, a rational person might decide not to. However, we are not interested in the probability of being within 25 miles of home given an accident happen. Reductio ad absurdum, Imagine a world where everyone drives within 25 miles of home. Even if the accident rate is negligible (less than the accident rate of air plane), we can still claim that most (actually in this case, all) motor vehicle crashes happen within 25 miles of home.

I completely understand that the intention of RMV is good--to convince people to wear safety belt. But good intention does not justify ignorance/stupidity or outright misleading. (I myself have lots against the compulsory seat belt wearing thing, as I think it makes the road less safe, but that is a topic for another day)

Prosecutor's fallacy is rampant, to my dismay. Let me digress and point out how prevalent it is. The Phi Beta Kappa society, which claims itself to be an elite society, points out that "Since inception, 17 U.S. Presidents, 38 U.S. Supreme Court Justices, and 136 Nobel Laureates have been inducted members." seems likes a high percentage for a lay person? Not really? I have an even better number. All  of US presidents, US Supreme Court Justics, and Nobel Prize winners are human beings!!! So the right thing to consider is what is the probability of doing great things given a PBK membership? Probably pathetically low. My fellow PBKs, I do not think you have any reason to register any pride with this society. 

Back to RMV. When I entered RMV at 11:51. I got a slip saying that the estimated waiting time is 14 min. I thought to myself, great!!! Then I was called when it was past 13:00. I doubt if takes super advanced statistics to get a slightly more accurate estimates. 

Why I hate dogs

I hate dogs.

I like to bike and many times when I bike pass some house, there will be a dog barking fiercely at me, sometimes even chase me, as if I am about to invade their house.

From the intelligence of a human being, I am so unlikely to be an invader, by just biking past a house. But for the intelligence of a dog, what do you expect? Perhaps, I should not hate them, but I am annoyed.

Some politicians like to call this country a threat and that country a threat when those countries are peacefully minding their own business, just like me. Perhaps, even more ridiculous, a dog won't even bark at an ant walking past its house.

paranoid, or?

No pressure, my friend

I like to be pressure-free. Neither do I like to pressure myself, nor do I like to get pressure from others.

Friends. I have always believed in the Chinese saying that the friendship between noble people should be as bland as water 君子之交淡如水。It means that when we make friends, we should not expect anything from friends, and we should not make friends feel pressured to do anything because of us.  I am always hesitant to ask favors from friends, especially close friends---being close friends, I fear they will tend to feel the pressure to agree, and that makes me feel upset. I really hope one day people around me, will always tell me honestly, whenever they feel inconvenient to do something I asked for.

People now like to show "support" for friends. For me, I think it is quite unnecessary. We are friends because we share similar interests, but we do not have identical interests. When I am doing something I am interested in but you are not, why should you feel obliged to show support? Friendship, I feel, should be based on common interests and goals, not on reciprocity. One of my friends told me after my thesis defense that when he arrived, he knew he would not understand anything, and said those things are about friendship. I replied that is exactly the reason why I was reluctant to tell him the time and place of my defense. I feel guilty for creating pressure on you, my friend.  I showed up to your history thesis defense not because you are my friend, but because I am genuinely intrigued by your paper.

Friendship should be simple. No burden. Simple joy.

Why I gave up martial art

I used to be a student of martial art, a fervent one. During my worst days, that was my only companion--it was only during those hours when I practice martial art that I could focus and not distracted by painful thoughts. I seriously thought I would take it as a life-long pursuit.

But I gave it up in college. Williams is not to be blamed. It is true we do not have such a professional martial art club, but I gave it up more because I wanted to.

My first encounter with Martial Art is Tai Chi, an ancient form of Chinese martial art.  The first day we did not learn forms, but about the philosophies. I remember very clearly what the master said: " The purpose of martial art is not violence, but is to stop violence. We learnt that our biggest enemy is never others people, but ourselves, our inner urge toward violence and brutality, and to master martial art, we need to master the art to curb such aggression. （克己） This is not an idealistic romantic tenet of some ancient Chinese philosophers, but a very wise idea---you can be very strong, as strong as you can, but if you cannot curb your urge to violence and aggression, soon it will backfire when you upset enough people and/or strong enough people. We will turn old and weak, and none of us can stay on the top, aggression and violence will turn back toward us if we do not curb them in the first place. Respect (礼）and benevolence (任）are always stressed. As these guide the previous principle, which literally means hold back yourself from you should not do. Even in Japan, the tenet of Bushido includes respect and benevolence, but they over-stressed loyalty and honor, and when being loyal to the wrong thing, and taking honor in the wrong thing, things get bad. What happened in WWII is only a sick and disgusting deviation from the true spirit, not the orthodox martial art philosophy. In the movie Yip Man, Yip Man said rightly: " You Japanese invaders are unworthy of martial art".

That is all good and beautiful. Later I realized however, mastering martial art will not help stop violence. In this age, violence never takes the form of bare-fist fight between individuals, but are staged by countries, organizations, and using deadly weapons that easily out-power the most skillful martial artist. In the movie Yip Man, Yip Man felt the same futility when he saw Japanese invaders did horrible things, and killed people but he could do nothing though he is the best martial artist of the time. What is more, I realized I began to develop knee problems from martial art practice. The purpose of martial art is to protect others from violence, and not only is that impossible, but also, instead of protecting ourselves, we are hurting ourselves. That was the last straw.

In this world, when the media continuously distort the truth, we do not even know what is right and what is wrong, then what is the use of power?