The standard (or neo-classical) view of economics makes a lot of assumptions. The main ones are that people have rational preferences, they are self-interested, they are utility maximisers and they have access to all relevant information (including information about the future). The economy is assumed to be in equilibrium, markets are efficient and perfect competition reigns (of course this is a simplification). These assumptions come in for a lot of criticism but they are defended as necessary simplifications. However, the assumptions economists make have a huge effect on the world of economics and therefore world economies.
One response to these assumptions that is popular among non-economists is to deride economists and call for their assumptions to be dumped. A great many people feel that viewing the economy as governed by self-interested utility maximisers as so unrealistic as to be useless. They say we should ditch it all and start afresh. Most of the key pillars of neo-classical economics have been debunked. There are numerous studies showing that people are not rational, preferences are not stable, people do not have perfect information, markets are not efficient and people do not have utility curves. Particularly since the Financial Crisis there has been anger at economists, many of whom are seen as out of touch with reality.
Economists respond to this by either ignoring complaints or arguing that the assumptions must be simple to make their work easier. A common phrase is that “All models are wrong, but some are useful”. Economists claim that the economy is too complex to accurately model, so they must use a simplified model in order to provide insights. They claim they can still learn a lot about the economy from these simplified assumptions. One lecturer I had begun her class on utility functions by saying that none of this was true in the real world, but we had to learn it in order to construct models. Of course no one really believes in perfect competition, she said, but it is too complicated to create an accurate model and a simplified one gets us as near to the mark as possible.
I have two main objections to this. First of all, economists have a tendency to forget they are simplifying. It is common to hear economists criticise minimum wages or unions or taxes based your standard economic textbook explanation, seemingly forgetting about the unrealistic assumptions behind such theories. For example, take a look at this post. I choose Bryan Caplan as he is one of the more respected and well-known economists. Yet his post essentially argues that when history contradicts basic economics (the unrealistic assumptions no economist supposedly takes seriously) he believes that history must be wrong. He assumes that all workers had perfect information and were paid their marginal productivity of labour. When heterodox economists criticise these theories they are sometimes accused of attacking a straw man. (In case you think that was a once off, see here)
Secondly, it is somewhat absurd for a discipline to base itself on foundations generally agreed to be false. If we know people are not rational, should it not make more sense to build theories on how people really do behave? Is it not better to be roughly right than precisely wrong? Think about what unrealistic assumptions do to economics. It pushes away students disappointed that studying economics is of no help in explaining what is happening in the world around them (even Masters in economics are based on unrealistic assumptions, it is only academic economists who come close to describing the real world). It leads to self-selection so that those who don’t mind or even agree with unrealistic assumptions so that those who end up becoming academic economists see no reason to change things.
Finally it leads to stagnation. If we close off large parts of economics and refuse to listen to criticism of the core assumptions, then how is the field of economics supposed to grow? If new ideas or changes to neo-classical economics is dismissed or ignored how can economics advance? Is economics supposed to be forced into more and more obscure areas or more and more complicated (though no more accurate) models? Are neo-classical assumptions to be treated as non-falsifiable truths even when they’re wrong?
Other economists would say that perfect competition etc is only a starting pointing and that distortions and market failures get added on to models. However, your starting point has a strong impact on your end point, just as there is a large difference between assuming innocence until proven otherwise and assuming guilt. If markets are assumed efficient and consumers rational until proven otherwise this leads to an overly rosy view of markets and consumers, giving them powers they do not have. If you don’t believe me, imagine what it would be like if we assumed that the free market was dominated by monopolists. This would be easy to model and no less accurate than assuming perfect competition. But this view of the market would be far more negative with a much greater emphasis on government intervention.
But the crucial point is that unrealistic foundations don’t bring you closer to reality. Not only is a large core of economics (especially microeconomics) unhelpful in describing the real world, but economists are largely looking in the wrong direction. Economists could study how consumers really make decisions in all their irrational glory. It would be imprecise, inexact and not very mathematical, but it would be real. Or they could keep drawing indifference curves and constructing mathematically impressive but functionally useless models. They could look at how economies really function, with their inefficiencies, market failures or they can create perfect economies in the clouds. They can either look in the weeds where the key is or under the streetlamp where the light is better.
I once went to a talk by the lecturer I mentioned above, who admitted that the utility curves she had to teach were not real. She was presenting some game theory research of hers where she examined interactions between inventors and firms in the world of innovation. It was an interesting paper, but there was one glaring hole in it. None of it was real. She didn’t interview any people, study any business or examine any data. All she did was make a lot of assumptions, create an algorithm and get a result (which in this case was that private sector funding of research was more efficient than public sector). I use her as an example not because she was a neo-classical, but because she wasn’t. She voted for a left wing European party and was critical of many economic assumptions. Yet she too created a model with little connection to the real world.
There are many serious problems affecting economies over the world. They have been badly damaged by the Financial Crisis, the policies of austerity and most have still not recovered. If we want to effectively combat these recessions, we need economists who are willing to examine the world as it really is, not as they wish it was. Simplified models with only one consumer in the economy or world where people have perfect information, leads economics in the wrong direction. It brings us away from the real world of bubbles, busts, panics and euphoria’s and instead economists solve problems that do not exist while the real problem of millions of unemployed is ignored. If you take a perfect economy as your starting point, then the idea of systematic failure will never cross your mind. The problem is these crises occur whether we are ready for them or not. It is time economists climbed down from their towers and got to work on the real problems of society.