BBVA OpenMind: Frontier Research in Economics

Reseach in EconomicsThis enrichment in the description of the working of individuals, firms, government, and society at large, has also had the side effect of significantly increasing the inter-disciplinary nature of current research in economics. We are witnessing a remarkable overlap with political science and sociology, of course, but also with psychology, biology, and neuroscience.

Even with such a severe restriction in scope, I shall have to be more superficial than I would like. Also, my choice has the drawback of leaving completely uncovered important and dynamic areas of economics such as macroeconomics, nance, trade, and development, to mention a few.

The essay proceeds as follows. In the next section I start by giving a summary view of the GE model, undoubtedly the core paradigm in economics. Section 3 describes the major departures from the standard GE model. Then I move into a more in depth analysis of the recent contribution of the behavioral approach to individual decision making. Inspired by research in psychology and largely based on controlled experiments, behavioral research tries to carefully document patterns of individual behavior that deviate from the choices predicted by the classical rational behavior model. Section 4 provides a description of all the ingredients involved in a decision so that we can give a more structured account of the different results and what are the precise ingredients that are questioned. Section 5 gives a synthetic account of the main contributions in behavioral economics. Finally, Section 6 takes stock of the research reported, makes an evaluation of the net contribution and derives implications for future research.

General Equilibrium and Welfare Economics

Modern GE theory started in the 1950s. The 1954 paper by the Nobel laureates K. Arrow and G. Debreu on the existence of a competitive equilibrium and the 1959 book by Debreu Theory of Value can be taken as the beginning of four decades of an extremely fruitful effort to understand the working of competitive markets. The books by Arrow and Hahn (1971) General Competitive Analysis, W. Hildenbrand (1974) Core and Equilibria of a Large Economy, and A. Mas-Colell (1990) The Theory of General Economic Equilibrium: A Differentiable Approach can be considered the most significant landmarks of this endeavor.

GE consists of a very complex but schematic model that tries to capture the coordinating role played by markets in an otherwise atomistic and individualized society. It provides a rigorous proof of the Smithian claim that the invisible hand is sufficient to make mutually compatible the decisions taken by completely uncoordinated individuals and firms (1). In this sense, the elimination of any reason for explicit or tacit coordination as well as of individual concern for others was crucial to the model. With all participants furthering their own interest (narrowly understood) and limiting their interaction just to supply and demand through the markets, the outcome would not turn out to be chaotic but orderly and efficient—in a sense to be made precise below.

Let us recall some of the assumptions needed to derive this mathematical result. The participating agents are an arbitrary number of individuals and firms. All participants can buy and sell commodities (labor, for instance) through the markets at the ruling prices. Most important, all participants are assumed to behave competitively, that is, to take prices as given (2). In addition, individuals own all the shares over existing firms. The distribution of these shares across the population is arbitrary.

Initially, each individual owns a collection of commodities (which may well be only labor) and shares. By selling and buying they can obtain a new set of commodities (for instance, eight hours labor sold and bread and butter purchased). The amounts traded have to be within each individual’s budget, where the monetary value of the budget is determined by the ruling prices. All individuals have preferences over the traded commodities, that is, they can rank any pair of bundles of commodities in terms of their desirability. Besides being complete, this ordering is assumed to be transitive, reflexive and satisfy a weak convexity condition (3). Most important, these preferences depend on personal consumption only, hence eliminating any form of altruism. Then, individuals are assumed to act rationally. That is, among the trades affordable to them (the value of purchases cannot exceed the value of sales) they choose the one they rank highest in terms of desirability. Thus, for any given vector of market prices each individual consumer thus has a well-defined vector of demands and supplies of the traded commodities.

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