Assessment of economic models

Science is generally concerned with two central semantic features of theories: truth of theoretical hypotheses and reliability of observational predictions. Truth involves a correspondence between hypothesis and the world; while predictions involve statements about the future behavior of a real system. Science is also concerned with epistemic values: warrant and justification. The warrant of a hypothesis is a measure of the degree to which available evidence permits us to conclude that the hypothesis is approximately true. A hypothesis may be true but unwarranted (that is, we may not have adequate evidence available to permit confidence in the truth of the hypothesis). Likewise, however, a hypothesis may be false but warranted (that is, available evidence may make the hypothesis highly credible, while it is in fact false). And every science possesses a set of standards of hypothesis evaluation on the basis of which practitioners assess the credibility of their theories–for example, testability, success in prediction, inter-theoretical support, simplicity, and the like.

This suggests that there are several questions that fall within the domain of epistemology in the context of assessment of economic models. First, we can ask whether the model is a good approximation of the underlying economic reality–that is, the approximate truth of the model. Likewise, we can ask whether the model gives rise to true predictions about the future behavior of the underlying economic reality (subject to the time frame of the analysis). Each of these questions falls on the side of the truth value of the model. Another set of questions concerns the warrant of the model: the strength of the evidence and theoretical grounds available to us on the basis of which we assign a degree of credibility to the model: does available evidence give us reason to believe that the model is approximately true, and does available evidence give us reason to expect that the model’s predictions are likely to be true? These questions are centrally epistemic; answers to them constitute the basis of our scientific confidence in the truth of the model and its predictions.

It is important to note that the question of the approximate truth of the model is separate from that of the approximate truth of its predictions. It is possible that the model is approximately true but its predictions are not. This might be the case because the ceteris paribus conditions are not satisfied, or because low precision of estimates for exogenous variables and parameters leads to indeterminate predictive consequences. Therefore it is possible that the warrant attaching to the approximate truth of the model and the reliability of its predictions may be different. It may be that we have good reason to believe that the model is a good approximation of the underlying economic reality, while at the same time we have little reason to rely on its predictions about the future behavior of the system. The warrant of the model is high on this account, while the warrant of its predictions is low.

Let us look more closely at the semantic properties of economic models: the relation between a model M and the underlying economic reality S. Note, to begin, that the relation between analysis and the economic reality is more complex than it first appears. Models are formulated on the basis of economic theory. The theory itself bears a referential relation to the world. That is, it is appropriate to ask whether general equilibrium theory is a true characterization of the workings of competitive market systems. And it is appropriate to assess the degree of warrant that we can attach to the general theory. So truth and warrant pertain to the general theory. Next we have the model of a particular economy. The model is designed to correspond to the underlying economic reality of the particular economy. Likewise, it is designed to implement the general theory, in application to the particular case. So in the case of the model we have several questions to ask–first, with respect to its adequacy as an implementation of the theory, and second, with respect to its correspondence to the underlying economic reality. Again, there are several distinct epistemic possibilities. We may attach high warrant to both the theory and the model; or we may have confidence in the theory but not the model. (The third possibility–confidence in the model but not the underlying theory–is the instrumentalist’s position. But for reasons spelled out below, I find this implausible.)

Whatever position we arrive at concerning the possible truth or falsity of a given economic model, it is plain that this cannot be understood as literal descriptive truth.[3] Economic models are not offered as full and detailed representations of the underlying economic reality. For a model unavoidably involves abstraction, in at least two ways. First, the model deliberately ignores some empirical characteristics and causal processes of the underlying economic reality. Just as a Newtonian model of the ballistics of projectiles ignores air resistance in order to focus on gravitational forces and the initial momentum of the projectile, so an economic model ignores differences in consumption behavior among members of functional defined income groups. Likewise, a model may abstract from regional or sectional differences in prices or wage rates within a national economy.

The second form of abstraction is more distinctive of economic analysis. General equilibrium theory represents the general hypothesis underlying CGE models. But the application of the theory to a particular economy or policy problem is not straightforward. There is no canonical mode of representing the central economic quantities and processes. Thus utility functions can be represented in a variety of ways, and likewise with consumption and production functions. (The linear expenditure system is commonly used in CGE models to represent consumer demand, in large part because this is a highly tractable formulation. But there are alternative non-equivalent formulations available.) So a given model represents one out of many different possible ways of implementing the general theory; and in order to arrive at an overall judgment of the credibility of the model we need to assess the adequacy of its particular implementation of supply, demand, savings behavior, and the like.

It follows from this observation that the specifics of a given model are not deductively entailed by the economic theory that underlies it. Different model-builders can have equal commitment to the general theory, while providing very different formulations of the central economic processes (e.g., utility functions, production functions, and demand functions). And the resulting models may have significantly different properties, giving rise to different predictions about the behavior of the economic system in question.

Another epistemically significant feature of economic models is the difficulty of isolating causal factors in real social or economic systems. Models (and economic theories as well, for that matter) are generally subject to ceteris paribus conditions. Predictions and counterfactual assertions are advanced conditioned by the assumption that no other exogenous causal factors intervene; that is, the assertive content of the model is that the economic processes under analysis will unfold in the described manner absent intervening causal factors. But if there are intervening causal factors, then the overall behavior of the system may be indeterminate. In some cases it is possible to specify particularly salient interfering causal factors (e.g. political instability). But it is often necessary to incorporate open-ended ceteris paribus conditions as well.

Finally, economic theories and models unavoidably make simplifying or idealizing assumptions about the populations, properties, and processes that they describe. Consumers are represented as possessing consistent and complete preference rankings; firms are represented as making optimizing choices of products and technologies; product markets are assumed to function perfectly; and so on. Suppose that our CGE model makes the assumption that the coefficients of production are constant. This implies that producers do not alter production technologies in the face of different price schedules for inputs. This assumption abstracts from producers’ substitution behavior. But the model-builder may argue that this is a reasonable approximation in a static model; whatever substitutions occur from one period to the next will be small and will have little effect on aggregate input-output relations.

Given, then, that models abstract from reality, in what sense does it make sense to ask whether a model is true? We must distinguish between truth and completeness, to start with. To say that a description of a system is true is not to say that it is a complete description. (A complete description provides a specification of the value of all state variables for the system–that is, all variables that have a causal role in the functioning of the system.) The fact that models are abstractive demonstrates only that they are incomplete, not that they are false. A description of a hockey puck’s trajectory on the ice that assumes a frictionless surface is a true account of some of the causal factors at work: the Newtonian mechanics of the system. The assumption that the surface of the ice is frictionless is false; but in this particular system the overall behavior of the system (with friction) is sufficiently close to the abstract model (because frictional forces are small relative to other forces affecting the puck). In this case, then, we can say two things: first, the Newtonian model is exactly true as a description of the forces it directly represents, and second, it is approximately true as a description of the system as a whole (because the forces it ignores are small).

Consider, then, this account of the truth conditions of theories and models. An economic theory is true if and only if:

1. the causal processes the theory identifies are actually at work in the real system, and
2. the real processes have approximately the causal properties postulated by the theory.

A model is said to be approximately true if and only if:

3. its characterization of the central economic processes is approximately true, and
4. the causal processes it ignores have little effect within the scope of analysis of the model.

This account takes a strongly realist position on economic theory, in that it characterizes truth in terms of correspondence to unobservable entities, processes, or properties.[4] The presumption here is that social systems generally–and economic systems in particular–have objective unobservable characteristics which it is the task of social science theory to identify. The realist position is commonly challenged by some economists, however. Milton Friedman’s famous argument for an instrumentalist interpretation of economic theory (Friedman, 1953) is highly unconvincing in this context.[5] The instrumentalist position maintains that it is a mistake to understand theories as referring to real unobservable entities. Instead, theories are simply ways of systematizing observable characteristics of the phenomena under study; the only purpose of scientific theory is to serve as an instrument for prediction. Along these lines, Friedman argues that the realism of economic premises is irrelevant to the warrant of an economic theory; all that matters is the overall predictive success of the theory. But when we consider general equilibrium models, it is clear that a central part of the overall warrant of the models is the confidence that we have in the approximate truth of general equilibrium theory. If we were to doubt this theory, then we would have no reason whatsoever to rely on CGE models. The instrumentalist approach to the interpretation of economic theory, then, is highly unpersuasive as an interpretation of the epistemic standing of economic models. Instead, the realist position appears to be inescapable: we are forced to treat general equilibrium theory as a substantive empirical hypothesis about the real workings of competitive market systems, and our confidence in general equilibrium models is limited by our confidence in the approximate truth of the general equilibrium theory.

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