Tuesday, October 15, 2013

Coase and Hayek on Economic Models

Ronald Coase and Friedrich Hayek developed two distinct and sometimes incompatible research programs (i.e., when it comes to the purpose of the law in society, their views diverge). However, their research programs are profoundly complementary in the way both Coase and Hayek viewed the purpose of economic models. In economics today models are generally used a simplified representations of reality. The implied assumption within this view is that any simplifying assumptions may affect our ability to describe minute details of reality, but that these assumptions would not obscure the qualitative features of the reality contained in our models. However, this was not the view Coase and Hayek held. In fact, they championed showing explicitly how the assumptions underlying some of the most popular economic models create a world in which the fundamental economic entities like firms, markets, or prices have no purpose.

In Coase's and Hayek's views, models were not supposed to be simplified descriptions of reality but tools for examining the implications of our assumptions. These models would help us understand the implications of our assumptions by providing a picture of a strange world that could never exist. What these models would help us illustrate then are the features of reality that give rise to social institutions we observe (like prices, markets, firms, law). Coase showed that the model of perfect competition cannot help us understand the function of the market and firms in society. Furthermore, Coase demonstrated that this model is also helpless in providing an understanding of the origin of externalities. On the other hand, those who use the model of perfect competition as a benchmark for defining externalities imply that this model is not only how reality might be but also how it should be. Hayek showed that the model of perfect competition, which presupposes that all relevant information is available to all market participants, has no purpose for market prices. Nevertheless, the "perfectly competitive price" holds such a prominent place in contemporary economic theory. This indicates that Hayek and Coase had quite a different perspective than do most contemporary economists.  

An example that I spent some time researching is the model of national comparative advantage. This model produces a national production possibilities frontier using two homogeneous inputs. Prices have no purpose in this model and all international trade could be performed by central governments. According to this model, there is no need for private property, firms, and markets. International exchange in the model of national comparative advantage, in which private property, firms, and markets are not present, would occur in exactly the same way that it occurs when these institutions are present. Thus, the model of national comparative advantage cannot help us understand the role of firms, markets, prices, and private property in international trade.

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