Microfoundations

Last updated

Microfoundations are an effort to understand macroeconomic phenomena in terms of economic agents' behaviors and their interactions. [1] Research in microfoundations explores the link between macroeconomic and microeconomic principles in order to explore the aggregate relationships in macroeconomic models.

Contents

During recent decades, macroeconomists have attempted to combine microeconomic models of individual behaviour to derive the relationships between macroeconomic variables. Presently, many macroeconomic models, representing different theories, [2] are derived by aggregating microeconomic models, allowing economists to test them with both macroeconomic and microeconomic data. However, microfoundations research is still heavily debated with management, strategy and organization scholars having varying views on the "micro-macro" link. [3] The study of microfoundations is gaining popularity even outside the field of economics, recent development includes operation management and project studies. [4]

History and Importance

History

The microfoundations project originated in the post-Second World War neoclassical synthesis where it is generally believed that neoclassical microeconomics fused with Keynesian macroeconomics. [5] The ‘neoclassical microeconomics’ in mention is the Marshallian partial-equilibrium approach, which emerged from the Walrasian general equilibrium theory. [5] However, the Walrasian general equilibrium theory presents another trend to the synthesis as it attempts to theorise the economy as a whole and is viewed as an alternative to macroeconomics. This approach is considered to be the trigger for exploring microfoundations, [1] however, the notion of a gap in the “micro-macro” link has been and continues to be explored in various theories and models.

Critics of the Keynesian theory of macroeconomics argued that some of Keynes' assumptions were inconsistent with standard microeconomics. For example, Milton Friedman's microeconomic theory of consumption over time (the 'permanent income hypothesis') suggested that the marginal propensity to consume (the increase of consumer spending with increased income) due to temporary income, which is crucial for the Keynesian multiplier, was likely to be much smaller than Keynesians assumed. For this reason, many empirical studies have attempted to measure the marginal propensity to consume, [6] and macroeconomists have also studied alternative microeconomic models (such as models of credit market imperfections and precautionary saving) that might imply a greater marginal propensity to consume. [7]

One particularly influential endorsement of the study of microfoundations was Robert Lucas, Jr.'s critique of traditional macroeconometric forecasting models. After the apparent shift of the Phillips curve relationship during the 1970s, Lucas argued that the correlations between aggregate variables observed in macroeconomic data would tend to change whenever macroeconomic policy changed. This implied that microfounded models are more appropriate for predicting the effect of policy changes, using the assumption that changes of macroeconomic policy do not alter the microeconomics of the macroeconomy. [8]

In terms of solutions, DSGE modelling with representative agents has been the most prevalent among literatures. This approach "makes the microeconomic and the macroeconomic level of analysis coincide: a single agent, a utility maximizing individual, represents an entire sector, which may be, for instance banks, consumers, or firms". [9] Therefore, DSGE modelling connects both microeconomic and macroeconomic theories, thus embodying the basis of microfoundations.

Importance

It is suggested that modern mainstream economics is based entirely on DSGE models. [10] [5] Therefore, the importance of microfoundations lies in its synonymous relationship with DSGE. [11]

The Smets-Wouters model is one example of the importance of microfoundations as it is regarded as a benchmark model for analysing monetary and fiscal policy. [12] The model offers three main advantages of microfoundations:

1.    Microfoundations provides a modelling structure where data may not be very informative.

2.    Microfoundations avoids the Lucas Critique as it is able to relate the reduced-form parameters to deeper structural parameters.

3.    Microfoundations provides a basis for estimating the optimality and desirability of policy.

While these points summarise the desire to adopt DSGE models - or microfoundations - there are limitations to the model with scholars stating that their forecast performance can be poor in terms of their ability to forecast individual variables. [5] Therefore, there is continuous debate on the microfoundations project and its efficacy with an overall lack of consensus.

Microfoundations Research and Development

"Micro" and "Macro" Research

Specialization in the management and organizational sciences has led to a divide between “macro” and “micro” areas. [13] Research in macro management mainly focuses on the organizational or firm level, while research in micro areas mainly examines individual and group levels within organizations. [14] For example, macro research domains typically include strategic management and organization theory, whereas micro includes areas such as organizational behaviour and human resource management. [14] Most early macroeconomic models, including early Keynesian models, were based on hypotheses about relationships between aggregate quantities, such as aggregate production, employment, consumption, and investment. Critics and proponents of these models disagreed as to whether these aggregate relationships were consistent with the principles of microeconomics. [15] There, bridging these two domains continues to be a topic of debate for organizational, management and strategy scholars. [16] As a result, microfoundations has become a topic of greater interest to researchers as it explores how micro and macro areas connect.  

The Microfoundations Project

The microfoundations project was developed on the basis that if macroeconomics is associated with aggregate economic models, and microeconomics is associated with the individual behaviours of households and firms, "microfoundations was taken to be the demand that macroeconomic models have microeconomic foundations". [17] Therefore, microfoundations research focuses on the influences of individual actions and interactions on firm heterogeneity. [14] As stated by Felin and Foss (2005), “organizations are made up of individuals, and there is no organization without individuals”. [18] Thus, the specific level of the microfoundations project is the individual level as it focuses on this elementary truth. However, there are various assumptions and half-truths that have been explored by scholars within microfoundations research.

Assumptions

There are two main assumptions that the microfoundations project rests upon:

  1. Firstly, it is possible to establish empirically adequate theory of individual behaviour. [19]
  2. Secondly, the theory can be transformed into a theory of the economy using aggregation procedures, without having to make any substantive assumptions about the economy. [19]

However, in addition to these assumptions, various scholars have indicated that microfoundations is understood to be "an application of underlying standpoint, methodological individualism," [5] a concept which also has ambiguity in its meaning. Nevertheless, microfoundations research only means that individual behaviour must be shown to be consistent with macro entities. While there may be various outlooks on the topic, the general consensus implies that to bridge macro and micro theories and models, microfoundations should be adopted.

Controversy

Some, such as Alan Kirman [20] and S. Abu Turab Rizvi, [21] argue on the basis of the Sonnenschein–Mantel–Debreu theorem that the microfoundations project has failed.

Jackson and Leelat (2017) show that representative agents do not exist for most commonly used demand functions. As a consequence, welfare implications based on representative agent models need not hold for individuals in an economy. [22]

This further implies that current macroeconomic models based on representative agents are not factually micro-founded. Much of the contemporary macroeconomic research, therefore, is not based on simple representative agents, but they often allow for rich heterogeneity of agents' behavior.[ improper synthesis? ]

See also

Related Research Articles

Economics Social science

Economics is "the social science that studies the production, distribution, and consumption of goods and services."

Microeconomics Behavior of individuals and firms

Microeconomics is a branch of mainstream economics that studies the behavior of individuals and firms in making decisions regarding the allocation of scarce resources and the interactions among these individuals and firms. Microeconomics focuses on the study of individual markets, sectors, or industries as opposed to the national economy as whole, which is studied in macroeconomics.

Macroeconomics Study of an economy as a whole

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

Neoclassical economics is an approach to economics in which the production, consumption and valuation (pricing) of goods and services are observed as driven by the supply and demand model. According to this line of thought, the value of a good or service is determined through a hypothetical maximization of utility by income-constrained individuals and of profits by firms facing production costs and employing available information and factors of production. This approach has often been justified by appealing to rational choice theory, a theory that has come under considerable question in recent years.

In economics, general equilibrium theory attempts to explain the behavior of supply, demand, and prices in a whole economy with several or many interacting markets, by seeking to prove that the interaction of demand and supply will result in an overall general equilibrium. General equilibrium theory contrasts to the theory of partial equilibrium, which analyzes a specific part of an economy while its other factors are held constant. In general equilibrium, constant influences are considered to be noneconomic, therefore, resulting beyond the natural scope of economic analysis. The noneconomic influences is possible to be non-constant when the economic variables change, and the prediction accuracy may depend on the independence of the economic factors.

New Keynesian economics School of macroeconomics

New Keynesian economics is a school of macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of new classical macroeconomics.

Economists use the term representative agent to refer to the typical decision-maker of a certain type.

Macroeconomic model Model used in Macroeconomics

A macroeconomic model is an analytical tool designed to describe the operation of the problems of economy of a country or a region. These models are usually designed to examine the comparative statics and dynamics of aggregate quantities such as the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the level of prices.

The Sonnenschein–Mantel–Debreu theorem is an important result in general equilibrium economics, proved by Gérard Debreu, Rolf Mantel, and Hugo F. Sonnenschein in the 1970s. It states that the excess demand curve for a market populated with utility-maximizing rational agents can take the shape of any function that is continuous, has homogeneity degree zero, and is in accordance with Walras's law. This implies that market processes will not necessarily reach a unique and stable equilibrium point.

Mainstream economics is the body of knowledge, theories, and models of economics, as taught by universities worldwide, that are generally accepted by economists as a basis for discussion. Also known as orthodox economics, it can be contrasted to heterodox economics, which encompasses various schools or approaches that are only accepted by a minority of economists.

In economics, aggregate behavior refers to economy-wide sums of individual behavior. It involves relationships between economic aggregates such as national income, government expenditure and aggregate demand. For example, the consumption function is a relationship between aggregate demand for consumption and aggregate disposable income.

Economics education or economic education is a field within economics that focuses on two main themes:

Dynamic stochastic general equilibrium modeling is a macroeconomic method which is often employed by monetary and fiscal authorities for policy analysis, explaining historical time-series data, as well as future forecasting purposes. DSGE econometric modeling applies general equilibrium theory and microeconomic principles in a tractable manner to postulate economic phenomena, such as economic growth and business cycles, as well as policy effects and market shocks.

The neoclassical synthesis (NCS), neoclassical–Keynesian synthesis, or just neo-Keynesianism was a neoclassical economics academic movement and paradigm in economics that worked towards reconciling the macroeconomic thought of John Maynard Keynes in his book The General Theory of Employment, Interest and Money (1936). It was formulated most notably by John Hicks (1937), Franco Modigliani (1944), and Paul Samuelson (1948) dominated economics in the post-war period and formed the mainstream of macroeconomic thought in the 1950s 1960s, and 1970s.

New classical macroeconomics School of thought in macroeconomics

New classical macroeconomics, sometimes simply called new classical economics, is a school of thought in macroeconomics that builds its analysis entirely on a neoclassical framework. Specifically, it emphasizes the importance of rigorous foundations based on microeconomics, especially rational expectations.

History of macroeconomic thought Aspect of history

Macroeconomic theory has its origins in the study of business cycles and monetary theory. In general, early theorists believed monetary factors could not affect real factors such as real output. John Maynard Keynes attacked some of these "classical" theories and produced a general theory that described the whole economy in terms of aggregates rather than individual, microeconomic parts. Attempting to explain unemployment and recessions, he noticed the tendency for people and businesses to hoard cash and avoid investment during a recession. He argued that this invalidated the assumptions of classical economists who thought that markets always clear, leaving no surplus of goods and no willing labor left idle.

Julio Rotemberg Argentine-American economist

Julio Jacobo Rotemberg was an Argentine/American economist at Harvard Business School. He was known for his collaboration with Michael Woodford on the first New Keynesian DSGE model, especially on monopolistic competition. He was also known for an alternative model of sticky prices.

New neoclassical synthesis Fusion of macroeconomic schools of thought

The new neoclassical synthesis (NNS), which is now generally referred to as New Keynesian economics, and occasionally as the New Consensus, is the fusion of the major, modern macroeconomic schools of thought - new classical macroeconomics/real business cycle theory and early New Keynesian economics - into a consensus view on the best way to explain short-run fluctuations in the economy. This new synthesis is analogous to the neoclassical synthesis that combined neoclassical economics with Keynesian macroeconomics. The new synthesis provides the theoretical foundation for much of contemporary mainstream macroeconomics. It is an important part of the theoretical foundation for the work done by the Federal Reserve and many other central banks.

Nicolai J. Foss is a Danish organizational theorist, and entrepreneurship and strategy scholar. He is currently a professor at the Copenhagen Business School where he has spent most of his career. Foss' main contribution to organization theory is through the micro-foundational perspective in organization theory and management - examining how individual behaviors aggregate to affect the behavior of larger groups and organizations.

In economic theory and econometrics, the term heterogeneity refers to differences across the units being studied. For example, a macroeconomic model in which consumers are assumed to differ from one another is said to have heterogeneous agents.

References

  1. 1 2 Maarten Janssen (2008), 'Microfoundations', in The New Palgrave Dictionary of Economics, 2nd ed.
  2. • Thomas Cooley, ed., (1995), Frontiers of Business Cycle Research, Princeton University Press. Description and preview. ISBN   0-691-04323-X.   Michael Woodford (2003), Interest and Prices: Foundations of a Theory of Monetary Policy, Princeton University Press. Description and Table of Contents. ISBN   0-691-01049-8.
  3. Barney, Jay; Felin, Teppo (May 2013). "What Are Microfoundations". Academy of Management Perspectives. 27 (2): 138–155. doi:10.5465/amp.2012.0107. JSTOR   43822016. S2CID   154370237 via JSTOR.
  4. Locatelli, Giorgio; Greco, Marco; Invernizzi, Diletta Colette; Grimaldi, Michele; Malizia, Stefania (2020-07-11). "What about the people? Micro-foundations of open innovation in megaprojects". International Journal of Project Management. 39 (2): 115–127. doi:10.1016/j.ijproman.2020.06.009. ISSN   0263-7863.
  5. 1 2 3 4 5 Denis, Andy (2016-01-02). "Microfoundations". Review of Political Economy. 28 (1): 134–152. doi:10.1080/09538259.2016.1108132. ISSN   0953-8259. S2CID   219717048.
  6. Robert J. Barro (1993), Macroeconomics, 4th ed. ISBN   0-471-57543-7.
  7. Angus Deaton (1992), Understanding Consumption, Oxford University Press. Description and chapter-preview links. ISBN   0-19-828824-7.
  8. 'The Smets-Wouters model': ECB webpage with discussion of advantages of microfounded macroeconomic models Archived 2009-02-26 at the Wayback Machine
  9. Duffee, Gregory R. (2013-01-01). "Bond Pricing and the Macroeconomy". Handbook of the Economics of Finance. 2: 907–967. doi:10.1016/B978-0-44-459406-8.00013-5. hdl: 10419/101349 . ISBN   9780444594068. ISSN   1574-0102.
  10. Caiani, Alessandro; Caverzasi, Eugenio (2017), "Decentralized Interacting Macroeconomics and the Agent-Based "Modellaccio"", Introduction to Agent-Based Economics, Elsevier, pp. 15–64, doi:10.1016/b978-0-12-803834-5.00004-7, ISBN   978-0-12-803834-5 , retrieved 2021-04-24
  11. Sbordone, Argia M.; Tambalotti, Andrea; Rao, Krishna; Walsh, Kieran James (2010-10-01). "Policy Analysis Using DSGE Models: An Introduction". Rochester, NY. SSRN   1692896.{{cite journal}}: Cite journal requires |journal= (help)
  12. Tovar, Camilo E (2008). "DSGE models and central banks" (PDF). BIS Working Papers.
  13. Aguinis, Herman; Boyd, Brian K.; Pierce, Charles A; Short, Jeremy C (March 2011). "Walking New Avenues in Management Research Methods and Theories: Bridging Micro and Macro Domains" (PDF). Journal of Management. 37 (2): 395–403. doi: 10.1177/0149206310382456 . S2CID   145547164 via Sage Publications.
  14. 1 2 3 Molina-Azorín, José F. (2014). "Microfoundations of strategic management: Toward micro–macro research in the resource-based theory". Business Research Quarterly. 17 (2): 102–114. doi: 10.1016/j.brq.2014.01.001 . S2CID   153647466 via Science Direct.
  15. E. Roy Weintraub (1977). "The Microfoundations of Macroeconomics: A Critical Survey," Journal of Economic Literature, 15(1), pp. 1-23.    • _____ (1979). Microfoundations: The Compatibility of Microeconomics and Macroeconomics, Cambridge. Description and preview.
  16. Barney, Jay; Felin, Teppo (May 2013). "What Are Microfoundations". Academy of Management Perspectives. 27 (2): 138–155. doi:10.5465/amp.2012.0107. JSTOR   43822016. S2CID   154370237 via JSTOR.
  17. Rizvi, S. Abu Turab (1994), "The Microfoundations Project in General Equilibrium Theory", Cambridge Journal of Economics, 18 (4): 357–377, doi:10.1093/oxfordjournals.cje.a035280
  18. Felin, Teppo; Foss, Nicolai J. (2005). "Strategic organization: a field in search of micro-foundations". Strategic Organization. 3 (4): 441–455. doi:10.1177/1476127005055796. S2CID   14824908 via Sage Publications.
  19. 1 2 Salehnejad, R. (2006-11-28). Rationality, Bounded Rationality and Microfoundations: Foundations of Theoretical Economics. Springer. ISBN   978-0-230-62515-0.
  20. Kirman, Alan P (1992). "Whom or What Does the Representative Individual Represent?". Journal of Economic Perspectives. 6 (2): 117–136. CiteSeerX   10.1.1.401.3947 . doi:10.1257/jep.6.2.117. ISSN   0895-3309.
  21. Rizvi, S. Abu Turab (1994), "The Microfoundations Project in General Equilibrium Theory", Cambridge Journal of Economics, 18 (4): 357–377, doi:10.1093/oxfordjournals.cje.a035280
  22. Jackson, Matthew O.; Yariv, Leeat (2015). "The Non-Existence of Representative Agents". SSRN Working Paper Series. doi:10.2139/ssrn.2684776. ISSN   1556-5068. S2CID   153412547.