A new paradigm for the introductory course in economics

Samuel Bowles, Wendy Carlin 06 September 2017

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Don’t let the students know! What we teach them in our intro classes bears little resemblance to how we do economics ourselves. The great mid-20th century thinkers – John Maynard Keynes, Friedrich Hayek, and John Nash – initiated a process that eventually transformed how we now understand the economy, in three ways. Only one of these made it into today's principles course.

Just a dozen years after the publication of The General Theory of Employment, Interest and Money (Keynes 1936), aggregate demand became a core concept in a textbook written by Paul Samuelson that would displace Alfred Marshall’s Principles of Economics (1890) as the dominant English-language introductory text.

Samuelson’s Economics (1948) quickly became the standard for what every economist ought to know, creating what Thomas Kuhn described as a new paradigm. By this he meant a set of concepts basic to how a group of scholars understand the world, as embodied in the introductory textbooks that are widely accepted in the field. In economics this is exemplified by the works of Marshall and Samuelson and, before them, John Stuart Mill’s Principles of Political Economy (1848).

Hayek’s main idea – that information is incomplete and asymmetric and that the market is an information-processing system – became the foundation of new theories of the competitive process and of incomplete contracts in labour and credit markets.

Nash pioneered the development of game theory, drawing on the ideas of John von Neumann and Oskar Morgenstern to model strategic interactions among economic or political actors. His work provided a new lens through which we could study economic situations. In Nash's world, people take account of the likely responses of others to the actions that they take, rather than acting as a price-taker for a fixed set of prices.

The contributions of Keynes, Hayek, and Nash – aggregate demand, the central economic role of limited information, and strategic interactions modelled by game theory – were extended by many others and have become foundations of economic thinking. Before the end of the 20th century, all three innovations had become standard postgraduate economic instruction, as a quick glance at the tables of contents of leading texts (Mas-Colell et al. 1995, Romer 1996) would show.

What economists know, and what students get

Things are radically different at the undergraduate level. The Samuelsonian paradigm is basically Marshall plus Keynes, and this remains the basic content of the dominant textbooks today. Asymmetric and local information, and strategic social interactions modelled by game theory are mentioned, if at all, at the end of the introductory course, or as special topics,. (Von Neumann had commented – surely ungenerously – about Samuelson that “...even in 30 years he won’t absorb game theory”.)

Understandably, students think information problems and strategic interaction are simply refinements of the standard model, rather than challenges to two of its foundations – price-taking as the benchmark for competitive behaviour, and complete contracts (and hence market clearing in competitive equilibrium) made possible by complete information.

CORE’s introductory text, The Economy, attempts to do for information economics and strategic social interaction what Samuelson did for aggregate demand. CORE has made these concepts part of the foundation of an economic paradigm that can be effectively taught to introductory students. This new open-access online text, simultaneously published as a conventional book, is now available (The CORE Team 2017).1

The Economy takes on board the fundamental innovations of Hayek and Nash used in contemporary economics research. But concerns about climate and other market failures as well as economic instability provide reasons to doubt Hayek’s argument that governments should limit their activities to enforcing property rights and other rules that permit markets to function.

Likewise, behavioural experiments and research on human cognitive capacities call for a more empirically grounded conception of human behaviour than is present in Nash’s work. Integrating both limited cognitive capacities with greater capacities for cooperation among individuals provides a more adequate foundation. Keynes’ contribution is similarly in need of modification. We provide both models and evidence to question his optimism that government demand-management policies could substantially eliminate involuntary unemployment in the long run.

In Table 1 we contrast the foundational tenets of the standard paradigm, as represented by Samuelson, with that represented by CORE. By the 'benchmark model' we mean the standard case presented to students, from which 'deviations' are studied. For example, competitive markets are treated as the standard case, with monopolistic competition as an extension.

Table 1 Samuelsonian and CORE paradigms

The emerging paradigm in the right-hand column of Table 1 provides a very different vision of the economy. An illustration is the view of competitive behaviour. In "The meaning of competition" Hayek (1948) pointed out that, if we assume a state of equilibrium among price-taking traders, this effectively precludes a serious analysis of competition, which he defines, following Samuel Johnson, as “the action of endeavouring to gain what another endeavours to gain at the same time.”

He continued:

"Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called 'perfect competition' prevails? I believe that the answer is exactly none. Advertising, undercutting, and improving (“differentiating”) the goods or services produced are all excluded by definition – 'perfect' competition means indeed the absence of all competitive activities."

To study the process of competition in The Economy, we replaced the passive price-taker of perfectly competitive equilibrium with the 'perfect competitor' (Makowski and Ostroy 2001). This active competitor exploits available (but incomplete) information to appropriate any possible rents that may exist when an economy is not in equilibrium, under some conditions driving the dynamic process to a Pareto-efficient equilibrium, even when there are impediments to competition.

The new paradigm not only provides a more convincing story about how an economy might reach a competitive equilibrium, it also fundamentally alters the nature of that outcome. When lenders and borrowers, and employers and employees, are modelled as principals and agents with asymmetric information, who interact under an incomplete contract, credit and labour markets do not clear in competitive equilibrium (Stiglitz 1987).

Introducing students to quantity constraints at the outset eliminates the need for ad hoc assumptions to explain the credit constraints underpinning the Keynesian multiplier, persistent unemployment, and other macroeconomic phenomena. Students also get an empirically based perspective on how markets work when reputation, personal loyalty and social norms play an essential role (Brown et al. 2004).

Teaching economic concepts by engaging with real problems

The gap between concerns about major economic problems that bring students to our classrooms, and the topics we teach, is a second motivation for the CORE Project. During the past four years we have asked, in classrooms around the world: “what is the most pressing problem that economists should address?” The word cloud below shows what students at the Humboldt University in Berlin told us. The size of each word or phrase is proportional to the number of students who brought it up.

Figure 1 Humboldt University student responses from 2016 to the question: "What is the most pressing problem that economists should address?"

Word clouds from students in Sydney, London and Bogota are barely distinguishable from Berlin (you can see them at www.core-econ.org). Even more remarkable, in 2016 we asked the same question to new recruits – mostly economics graduates – at the Bank of England, and professional economists and other staff at the New Zealand Treasury and Reserve Bank. Both responded with a similar concern about inequality. Word clouds from France gave greater prominence to unemployment. All of them highlight climate change and environmental problems, automation, and financial instability.

In the left-hand column of Table 2, we indicate some of the most important problems that students and others have told us that “economists should address”. In the right-hand column, we indicate some of the concepts essential to understanding these problems. Comparing the right-hand columns in Tables 1 and 2 shows the similarity between the list of concepts essential to addressing the problems that students are concerned about, and the list of new developments in economics that have been given insufficient attention in our introductory courses. Addressing student concerns and updating the intro course to reflect what economists now do are strongly complementary objectives.

Table 2 Problems and concepts

CORE’s problem-based approach to teaching concepts and models narrows the gap between what the students get and how we do economics in another way as well. Economics has become an increasingly empirical subject (Angrist et al. 2017), but the data appear in the standard texts primarily to illustrate models derived axiomatically, not – as in the CORE pedagogy – as the basis for defining real economic problems that models should be capable of illuminating.

The emerging paradigm in the right-hand column of Table 1 is not fully developed, and it is not as conceptually simple as the Marshall-Walras-Keynes benchmark. But the simplifications underlying the standard paradigm are increasingly recognised as so at variance with the observable facts that this model is often inappropriate.

An illustration: let us assume complete information, and its corollary, complete contracts. Another mid-20th-century economist, Abba Lerner, attributed the success of the standard paradigm to this assumption:

An economic transaction is a solved political problem ... Economics has gained the title Queen of the Social Sciences by choosing solved political problems as its domain.” (Lerner 1972)

Lerner went on to argue that the conflict of interests that exists in every transaction is fully resolved in a contract that will be enforced by the courts, not by the parties to the transaction. “The solution is essentially the transformation of the conflict from a political problem to an economic transaction.”

The standard model isolates economics

If we insist on employing only the standard competitive model, based on complete contracts, there is no room for politics. If the worker did not work as hard as she agreed to, then she simply would not be paid. The employer would have no need to exercise any power over the employee – for example through the threat of the sack – because the contract was sufficient in itself to guarantee the outcome needed for the firm to make profits. This aspect of the standard paradigm was what motivated Samuelson’s remark:

In a perfectly competitive market, it really doesn’t matter who hires whom, so have labour hire capital.” (Samuelson 1957)

If we assume a complete employment contract, this also means that the employer would have no need to be concerned about the prospective employee’s preferences, for example, the employee's work ethic, or the worker's desire to spend the day messaging friends. A result of these and other assumptions of the old benchmark model was that economists could assume that “the Queen of the Social Sciences”, could reign alone, ignoring the insights of:

  • Legal scholars, who study real contracts and the challenges of enforcement.
  • Psychologists and sociologists, who seek to understand the motivations and thought processes of real people.
  • Philosophers and ordinary citizens, who are animated by concerns of economic justice, and individual freedom and dignity.
  • Political scientists, whose studies of power are essential to understanding the the top-down structure of a firm.
  • Historians, anthropologists and archaeologists, who study the variety of institutions governing our economic lives and the social dynamics that have will continue to shape our development into the future.
  • Biologists, ecologists and others, who see the economy as a part of the biosphere with unavoidable external effects on its functioning and even sustainability.

The paradigm that motivates CORE draws upon these insights to help us to understand how prices, wages and interest rates and the degree of inequality are determined and how the aggregate economy functions.

It works

Does the one year CORE introductory course prepare students for the standard curriculum in subsequent years?

It is taught at UCL by Antonio Cabrales and Wendy Carlin, Sciences Po by Yann Algan and at the Toulouse School of Economics by Christian Gollier. At UCL, we compared the exam results for the unchanged standard second year courses of cohorts that had taken the CORE course and that had not. In their intermediate micro and macro sequence, CORE students did markedly better than previous cohorts. (There was no change in the student performance in second-year econometrics, dispelling any thoughts that the CORE cohort was simply brighter!). This is far from the only way to evaluate the new curriculum; but it is encouraging. Our interpretation is that the CORE cohort was more engaged with economics and excited about going on.

References

Angrist, J, P Azoulay, G Ellison, R Hill and S Feng Lu (2017), "Economic Research Evolves: Fields and Styles", American Economic Review: Papers and Proceedings 107(5): 293-97.

Brown, M, A Falk and E Fehr (2004), "Relational Contracts and the Nature of Market Interactions", Econometrica 72(3): 747-80.

CORE Team (2017), The Economy, Oxford: Oxford University Press (free online at http://www.core-econ.org).

Hayek, F (1948), Individualism and Economic Order, Chicago: University of Chicago Press.

Keynes, John Maynard (1936), The General Theory of Employment, Interest and Money, London: Palgrave Macmillan.

Lerner, A (1972), "The Economics and Politics of Consumer Sovereignty," American Economic Review 62(2): 258-66.

Makowski, L and J Ostroy (2001), "Perfect Competition and the Creativity of the Market," Journal of Economic Literature XXXIX: 479-535.

Marshall, A (1890), Principles of Economics, London: MacMillan & Co.

Mas-Colell, A, M D Whinston and J R Green (1995), Microeconomic Theory, New York: Oxford University Press.

Mill, J S (1848), Principles of Political Economy with some of their Applications to Social Philosophy, London: John W. Parker

Romer, D (1996), Advanced Macroeconomics, New York: McGraw-Hill.

Samuelson, P (1948), Economics, New York: McGraw-Hill.

Samuelson, P (1957), "Wages and Interest: A Modern Dissection of Marxian Economics," American Economic Review, 47(6): 884-921.

Stiglitz, J (1987), "The Causes and Consequences of the Dependence of Quality on Price," Journal of Economic Literature 25(1): 1-48.

Endnotes

[1] CORE authors are Yann Algan, Timothy Besley, Samuel Bowles, Antonio Cabrales, Juan Camilo Cardenas, Wendy Carlin, Diane Coyle, Marion Dumas, Georg von Graevenitz, Cameron Hepburn, Daniel Hojman, David Hope, Arjun Jayadev, Suresh Naidu, Robin Naylor, Kevin O’Rourke, Begüm Özkaynak, Malcolm Pemberton, Paul Segal, Nicholas Rau, Rajiv Sethi, Margaret Stevens, and Alexander Teytelboym; see the CORE Team (2017).

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Topics:  Education Frontiers of economic research

Tags:  CORE project, education, teaching, Keynes, Hayek, Nash, strategic interaction, Information, incomplete contracts, game theory, interactive learning

Research Professor and Director of the Behavioral Sciences Program, Santa Fe Institute

Professor of Economics, UCL; CEPR Research Fellow

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