Does

Macroeconomics
Need
Microfoundations?
Kevin D. Hoover

Topics to be covered
From Political Economy to Microeconomics
Reductionism: Taking Science to Economics
Methodological Individualism
The Illusion of Aggregation
Representative Agent Models
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From Political Economy to

Microeconomics
Lucass Longing Sound economics vs Bad Economics
Economics: Management of the household
Political Economics: Management of the state

Early (17th & 18th century) Economics

Hierarchy > Individual
Determining and enhancing military capabilities

From Political Economy to

Microeconomics
Seeds of Individualism Adam Smith
Classical Economists with a love for markets
Limited Individualism

19th Century marginalism

Individual highlighted by the French
Individualism vs Super Individual categories

Methodological Individualism

From Political Economy to

Microeconomics
Alfred Marshall
Removed the Political in Political Economy
Representative Firm and agent

Mid 1930s, Keynes and General Theory

Distinguished macro from micro
Heterogeneity of individuals, but
No systematic aggregation technique

1936
Criticism of General Theory and IS-LM Models
Birth of representative agent models

Reductionism: Taking
Science to Economics
Scientific explanation: Parsimony
18th Century gas laws: Boyles-Charles law

Reduced macro-physical gas into microphysical Newtonian mechanics

Restrictive assumptions
Temperature Mean energy
Pressure Mean momentum

Reductionism: Taking
Science to Economics
the only way to reduce biology to chemistry is through death
The philosophical mind/body problem
Mental state (macro) and brain-state (micro)

Supervenience:
No one-to-one mapping between micro and macro phenomena

Methodological
Individualism
Defining Economics
Plutology: Study of wealth
Mill and Marshall Study of wealth + Study of man

Lionel Robbinson The science of choice

Cournot Problem
Heterogeneous individuals with unique tastes and constraints

Reclaiming teleology in economics

Contrast with biology

Methodological
Individualism
Lucass Critique
People are not stupid!

Securing against Lucass Critique

Birth of Methodological Individualism

Methodological or Ontological Individualism?

Methodological
Individualism
Lucass Critique
People are not stupid!

Securing against Lucass Critique

Birth of Methodological Individualism

Ontological Individualism

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Methodological
Individualism
Supervience of Macroeconomics to Microeconomics
Intentionality at micro Cournot Problem
Microeconomics necessarily uses Macroeconomics models as input

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The Illusion of Aggregation

Microeconomics or Macroeconomics?
Same language, technique and mathematics
Economists part ways with physicists

Economics is about heterogeneous things

In search of a common denominator
Coal and Oil
H2O

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The Illusion of Aggregation

Composite Commodity Theorem
Constant Relative prices

Assumptions
Constant tastes and technology (Identical Utility Functions)
Utility function is homothetic
Renders Income distribution unimportant
Same ratio of consumption and relative prices
Composite Commodity theorem holds

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The Illusion of Aggregation

These conditions do not hold
Distributional Variations Aggregate functions are unrestricted
Altering fundamental categories after aggregation

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Representative Agent
Models
Assuming the problem away is not actually a solution!
Aggregates that belong to no one!
Frank Ramseys optimal savings problem and the wise men at Cambridge
Two theorems of welfare economics
Top down rather than Bottom up
Ignores redistribution

He who comes into equity shall come with clean hands

Avoid the category mistake

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Whom or what does

the representative
individual represent?
Alan P. Kirman

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Whom or what does the

representative individual represent?
Theoretical in nature
Published in Journal of Economic Perspectives
By Alan P. Kirman (professor at European Universtiy Institute, Florence, Italy)
The year 1992
Volume no 6
Pg 117-136

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What is the article about?

HOW THE MODEL OF REPRESENTATIVE AGENT IS
NOT NEEDED
CREATES PROBLEMS IN THE ANALYSIS

WHAT SHOULD BE FOLLOWED INSTEAD OF THE REPRESENTATIVE

AGENT MODEL

ALLOW HETROGENIETY

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Apprach of the article

TO TEAR APART THE ARGUMENT OF THE OPPOSING

PARTY(REPRESENTATIVE INDIVIDUAL ARGUMENT) ONE DIMENTION AT A

TIME

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Need for Representative

individual
Due to microfoundations
Why microfoundations are called for?
Because they believe that an adequate model of agent behavior has been found
Because they need unique and stable equilibrium
Need to use comparative statics in order to analyze policy changes.

Need to create appropriate shape of the aggregate demand curve

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Why cant we find conditions

for unique and stable
equilibrium
Need for representative individual might not arise If there conditions can be
found which give a unique and stable equilibrium

There are none

Sonnenschein (1972)
Debreu (1974)

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Restrictuve conitions
Attempting to create unique and stable equilibrium via assumptions: via

applying 3 assumptions

continuity; that the value of total excess demand must equal zero at all positive

prices
the budget constraint for the economy as a whole be satisfied (Walras' law);
Excess demand is homogeneous of degree zero (only relative prices count).
Even this solution suffers from weak axiom of revealed preferences

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How about locally unique

We could use locally unique and stable equilibriums.
This argument is weak because of
Inconsistencies
Not actually used by macroeconomists.

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Typical assumptions on
representative agent (NOT ALL)
Homothetic utility functions
relative income distribution should be fixed and independent of prices.

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Where would the representative

individual be useful
Stoker(1986)

individuals take their decisions only on

the basis of aggregate variables

all individuals have the same marginal
reaction

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Why we cant skip

representative individual
If we do either
Preferences vary
Income distribution would vary.

Prefernce vary
Degrees of freedom would be too high
Multiple equilibria

Income distribution vary

Multiple equilibria

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Representative individual
Representative individual is one "representative" standard utility maximizing

individual whose choices coincide with the aggregate choices of the

heterogeneous individuals

Will discuss the issues that come by one by one.

Where repetitive we would mention the concept again without giving full

details

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1. No coordination
Identical agents dont need to coordinate as there is nothing to coordinate

about.

Such models are particularly ill-suited to studying macroeconomic problems

like unemployment, which should be viewed as coordination failures

Economists show this through models of no trade such as

Rubenstein, 1975;
Hakansson et al., 1982;
Milgrom and Stokey, 1982

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Counter points
Argument for representative agent says that Such models are not intended to

study those problems which involve, in an essential way, questions of

coordination but are designed to examine some central macroeconomic
phenomena.

The failure of the above argument is due to four reasons

Aggregate behavior is not equal to individual behavior

Economy might be rational on the aggregate but it does not mean that
the individual is rational
Using such a model to analyze the consequences of policy

changes may not be valid

Because actions preferred by the representative individual may not be

preferred by the actual individuals

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 The preferences of the representative individual cannot

legitimately be used to decide whether one economic

situation is "better" than another because
it may well be the case that in two situations of which the

representative prefers the first to the second, every individual

prefers the second to the first

Empirical testing of the representative agent might be

falsified because

Individual possessing unnatural characteristics.

if one rejects a particular behavioural hypothesis, it is not clear

whether one is really rejecting the hypothesis in question, or

rejecting the additional hypothesis that there is only one
individual

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2. No trade (counter
argument)
Counter point is that economy is always in equilibrium.
i.e. the representative agent eats what he produces.
Hence the actions of the representative agents are movements around the

equilibrium which show the evolution of the economy.

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No trade counter point

weakness
The argument requires some adjustment mechanism e.g. tatonment.
these adjustment process are found to hold

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3. Representative agent
before and after the policy
If the representative agent that represents the aggregate choice might

represent the aggregate change after the policy change.

His equilibrium and not his choices coincide with the society.

Proven in the papers.

Geweke (1985)
Kupiec and Sharpe (1991)

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4. Problem of preference of
the individual
It is possible that the representative individual prefers situation a to situation

b, whilst all the individuals that are "represented" strictly prefer b to a.

Jerison (1984),

For technical details refer to the paper

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5. Joint hypothesis problem: testing the

change or the compatibility of the change
with the representative individual
Whenever we are testing a behavioral hypothesis we are testing two things:
the behavioral hypothesis itself
if the choices of the aggregate can indeed be described as the choices of a single utility-

maximizing agent.

Summers (1991) says that in Hansen and Singleton (1982, 1983) the rejection of

the asset pricing and consumption relationship was more a rejection of the
relationship between consumption and asset pricing of the representative
individual rather than the asset pricing of the aggregate.

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Another example: excess

consumption smoothing
The very existence of the Deaton paradox might be due to the representative

agent i.e. Clarida (1991) constructed a model that allowed for heterogeneity
but does not contain excess smoothing.

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STUDIES INVOLVING
HETROGENIETY ARE THE ANSWER
Increasing dispersion of income and preferences would be a positive

development because

It would more stable outputs Hildenbrand (1983) and Grandmont (1987, 1991),
erratic individual demand behaviour may give very smooth aggregate demand

behaviour(Cournot)
Individual jumps will occour at diferent prices and hence cause the Demand cuve to
be more continuous. (Trockel, 1984).
if the income distribution is decreasing -that is if each successively higher income
class contains a smaller proportion of agents-then the law of demand holds.
Hildenbrand (1983)

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STUDIES INVOLVING
HETROGENIETY ARE THE ANSWER
Increasing dispersion of income and preferences would be a positive

development because

if agents have very spread out preferences, then aggregate excess demand will have

the well known "gross substitutability" property and equilibria will be unique and
stable. Grandmont (1991)
Dont even require maximization as long as the budget constraints are satisfied.

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INTRODUCTION OF THE
HETROGENIETY IS NOT ENOUGH
Need to change the way economic agents interact with each other
Change from unconscious to direct and conscious, which include
Trading
Passing of information
Reputations
Groups for purposes of bargaing

New tools could be introduced

Game theory

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Game theory
Single agent models are being replaced by multiple agent models
Individuals operate in sub-pockets of economy.
local but interacting activity emerges some sort of self organization which provides

regularity at the macroeconomic level. Lesourne (1991)

Models for interaction of agents and how the changes are propogated throughout
the economy are also investigated.

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Conclusion
We should take the right way out, not the easy way out.

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THANK YOU