1. Confessions of a Theorist: Why Reality is Overrated1 Bart Lipman Boston University March 28, 2013 1 Very loosely based on Dekel and Lipman, How (Not) to Do DecisionTheory (2010).

2. Quotes about Economic Theory:

3. Quotes about Economic Theory: Pure theorists sometimes . . . prefer a theory that is so pure as to be uncontaminated with any material content. Joan Robinson

4. Quotes about Economic Theory: Pure theorists sometimes . . . prefer a theory that is so pure as to be uncontaminated with any material content. Joan Robinson Page after page of professional economic journals are lled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions. Wassily Leontief

5. Quotes about Economic Theory: Pure theorists sometimes . . . prefer a theory that is so pure as to be uncontaminated with any material content. Joan Robinson Page after page of professional economic journals are lled with mathematical formulas leading the reader from sets of more or less plausible but entirely arbitrary assumptions to precisely stated but irrelevant theoretical conclusions. Wassily Leontief An economist is someone who sees something that works in practice and wonders if it would work in theory. Ronald Reagan

6. Ironically, the only one of the three who gets it right is the onewhos not an economist.Reagans line is correct about how theory (often) works and how itshould work.

7. Ironically, the only one of the three who gets it right is the onewhos not an economist.Reagans line is correct about how theory (often) works and how itshould work.In my view, economic theory is not about guring out what factsare true in the world. Thats what empirical work is for.

8. Ironically, the only one of the three who gets it right is the onewhos not an economist.Reagans line is correct about how theory (often) works and how itshould work.In my view, economic theory is not about guring out what factsare true in the world. Thats what empirical work is for.When empiricists nd a new fact, it might be an interesting fact tothink about from a theoretical point of view.

9. Ironically, the only one of the three who gets it right is the onewhos not an economist.Reagans line is correct about how theory (often) works and how itshould work.In my view, economic theory is not about guring out what factsare true in the world. Thats what empirical work is for.When empiricists nd a new fact, it might be an interesting fact tothink about from a theoretical point of view.The relationship between economic theory and reality is tenuous.

10. Example: No sensible person has a utility function. Proof:

11. Example: No sensible person has a utility function. Proof:

12. Example: No sensible person has a utility function. Proof:

13. Example: No sensible person has a utility function. Proof:

14. Example: No sensible person has a utility function. Proof:

15. Example: No sensible person has a utility function. Proof:

16. Example: No sensible person has a utility function. Proof: etc., until

17. Example: No sensible person has a utility function. Proof: etc., until

18. Incorrect Responses:1. From economic theory, we know that people have utilityfunctions. Hence such behavior cannot occur.

19. Incorrect Responses:1. From economic theory, we know that people have utilityfunctions. Hence such behavior cannot occur. In mathematics, names are free. It is perfectly allowable to call a selfadjoint operator an elephant and a spectral resolution a trunk. One can then prove a theorem, whereby all elephants have trunks. What is not allowable is to pretend that this result has anything to do with certain large gray animals. Hector Sussman

20. 2. Economists believe that people have utility functions and henceeconomists are idiots.

21. 2. Economists believe that people have utility functions and henceeconomists are idiots.Correct Response: People dont have utility functions, but if itsa useful hypothesis, go for it.

22. So how can false theories be useful?

23. So how can false theories be useful? [A] theory is not like an airline or bus timetable. We are not interested simply in the accuracy of its predictions. A theory also serves as a base for thinking. It helps us to understand what is going on by enabling us to organize our thoughts. Faced with a choice between a theory which predicts well but gives us little insight . . . and one which gives us this insight but predicts badly, I would choose the latter . . . Ronald Coase

24. General principles are unlikely to be accurate but may be morecomprehensible and hence more useful than detailed, accuratespecications.

25. General principles are unlikely to be accurate but may be morecomprehensible and hence more useful than detailed, accuratespecications.All understanding is generated by deciding which aspects of realityto ignore.The world never repeats exactly, so if everything is relevant, wecant learn from one situation about another.

26. General principles are unlikely to be accurate but may be morecomprehensible and hence more useful than detailed, accuratespecications.All understanding is generated by deciding which aspects of realityto ignore.The world never repeats exactly, so if everything is relevant, wecant learn from one situation about another. I have a full-size map of the world. At the bottom it says 1 inch = 1 inch. I hardly ever unroll it. Steven Wright

27. Implication: Because models are always false, we should not besurprised when they are refuted.

28. Implication: Because models are always false, we should not besurprised when they are refuted.If they arent refuted, its only because we dont have enough gooddata to reveal the inaccuracies we know are there!

29. Implication: Because models are always false, we should not besurprised when they are refuted.If they arent refuted, its only because we dont have enough gooddata to reveal the inaccuracies we know are there!Experimental/empirical observations refuting the serious parts ofthe theory should concern us, but not those that refute the detailswe chose to ignore. Refutation per se is not surprising.

30. Implication: Because models are always false, we should not besurprised when they are refuted.If they arent refuted, its only because we dont have enough gooddata to reveal the inaccuracies we know are there!Experimental/empirical observations refuting the serious parts ofthe theory should concern us, but not those that refute the detailswe chose to ignore. Refutation per se is not surprising.Hence the question should not be Is the theory true? since theanswer is always no.The question should be Is the theory useful?

31. Uses of Theory:First: Creating a language.

32. Uses of Theory:First: Creating a language.Have to name the relevant objects and create a basic taxonomy.An important rst step, but only a rst step.

33. Uses of Theory:First: Creating a language.Have to name the relevant objects and create a basic taxonomy.An important rst step, but only a rst step. I admit that these terms (nal utility, marginal production, etc.) . . . repel some readers, and ll others with the vain imagination that they have mastered dicult economics problems, when really they have done little more than learn the language in which parts of those problems can be expressed. . . Alfred Marshall

34. Second: Checking an intuition.

35. Second: Checking an intuition.Intuitive reasoning is often wrong.

36. Second: Checking an intuition.Intuitive reasoning is often wrong. What I did at the time, a very economist thing to do, was to build myself a little model to prove the point that I believed. So I built a little intertemporal optimizing whatever and to my shock and this is the point, of course, of doing models it actually gave me the opposite answer. Paul Krugman

37. Third: Finding unexpected results which trigger new directions andnew insights.

38. Third: Finding unexpected results which trigger new directions andnew insights.Example. Earliest work on auctions considered independentprivate values.

39. Third: Finding unexpected results which trigger new directions andnew insights.Example. Earliest work on auctions considered independentprivate values.Revenue Equivalence Theorem: A very wide range of auctionsgive the seller same expected revenue.

40. Third: Finding unexpected results which trigger new directions andnew insights.Example. Earliest work on auctions considered independentprivate values.Revenue Equivalence Theorem: A very wide range of auctionsgive the seller same expected revenue.So why are English auctions so much more common than manyauctions which would have same revenue?

41. Third: Finding unexpected results which trigger new directions andnew insights.Example. Earliest work on auctions considered independentprivate values.Revenue Equivalence Theorem: A very wide range of auctionsgive the seller same expected revenue.So why are English auctions so much more common than manyauctions which would have same revenue?This led to research on common value auctions which havesurprisingly dierent properties.

42. Third: Finding unexpected results which trigger new directions andnew insights.Example. Earliest work on auctions considered independentprivate values.Revenue Equivalence Theorem: A very wide range of auctionsgive the seller same expected revenue.So why are English auctions so much more common than manyauctions which would have same revenue?This led to research on common value auctions which havesurprisingly dierent properties.Doesnt prove facts about reality, but suggests interestingconnections between nature of objects and auctions for them.

43. Fourth: Developing an intuition for how things might work.

44. Fourth: Developing an intuition for how things might work.Example: Knowles, Persico, and Todd, Racial Bias in MotorVehicle Searches: Theory and Evidence, JPE, 2001.

45. Fourth: Developing an intuition for how things might work.Example: Knowles, Persico, and Todd, Racial Bias in MotorVehicle Searches: Theory and Evidence, JPE, 2001.Empirical observation: Comparing white and black male drivers,blacks are stopped more often but the rate at which they are foundto be carrying drugs is the same as that of whites.

46. Fourth: Developing an intuition for how things might work.Example: Knowles, Persico, and Todd, Racial Bias in MotorVehicle Searches: Theory and Evidence, JPE, 2001.Empirical observation: Comparing white and black male drivers,blacks are stopped more often but the rate at which they are foundto be carrying drugs is the same as that of whites. Stop Not drugs 0, 10 10, 0 noncriminal work wt 5, 4 wt , 5where 5 < wt < 10.

47. Implication: If police enjoy stopping a particular type, that typeshould carry drugs less often and be stopped equally often as atype with same wages.

48. Implication: If police enjoy stopping a particular type, that typeshould carry drugs less often and be stopped equally often as atype with same wages.Group that satises this property: white females.

49. Implication: If police enjoy stopping a particular type, that typeshould carry drugs less often and be stopped equally often as atype with same wages.Group that satises this property: white females.This doesnt prove police arent prejudiced against black males orthat they enjoy stopping white females.This just gives an intriguing interpretation of the data.

50. Fifth: Developing tools.

51. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.

52. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.

53. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.Basic idea is that higher ability students nd school easier andhence go longer; so more schooling signals higher ability.

54. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.Basic idea is that higher ability students nd school easier andhence go longer; so more schooling signals higher ability.Spence assumes: education has no eect on ability,

55. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.Basic idea is that higher ability students nd school easier andhence go longer; so more schooling signals higher ability.Spence assumes: education has no eect on ability, there are nogrades,

56. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.Basic idea is that higher ability students nd school easier andhence go longer; so more schooling signals higher ability.Spence assumes: education has no eect on ability, there are nogrades, all else equal, every student prefers less education, etc.

57. Fifth: Developing tools.Example: Spence, Job Market Signaling, Quarterly Journal ofEconomics, 1974.Spence considers how agents may signal their private information,focusing on potential workers signaling abilities to potentialemployers.Basic idea is that higher ability students nd school easier andhence go longer; so more schooling signals higher ability.Spence assumes: education has no eect on ability, there are nogrades, all else equal, every student prefers less education, etc.None of these things are true, but they make it easier to see theconcept hes exploring. This helps us understand signaling in ageneral way so that we can see how it could work in many verydierent settings.

58. Example: Gul and Pesendorfer, Temptation and SelfControl,Econometrica, 2001.

59. Example: Gul and Pesendorfer, Temptation and SelfControl,Econometrica, 2001.What behavior would indicate that choices are due to temptation?

60. Example: Gul and Pesendorfer, Temptation and SelfControl,Econometrica, 2001.What behavior would indicate that choices are due to temptation?Not enough to observe unhealthy choices. Maybe the person isjust a regular utility maximizer who likes fattening foods.

61. Example: Gul and Pesendorfer, Temptation and SelfControl,Econometrica, 2001.What behavior would indicate that choices are due to temptation?Not enough to observe unhealthy choices. Maybe the person isjust a regular utility maximizer who likes fattening foods.Even harder question: What behavior would indicate that thechooser is subject to temptation but exerted selfcontrol?

62. Gul and Pesendorfers answer: Consider the choice of menus.

63. Gul and Pesendorfers answer: Consider the choice of menus.Suppose someone with a choice between a restaurant with onlyhealthy dishes and another with all those same dishes plus someunhealthy dishes chooses the former.Natural interpretation: He knew hed be tempted by the unhealthydishes.

64. Gul and Pesendorfers answer: Consider the choice of menus.Suppose someone with a choice between a restaurant with onlyhealthy dishes and another with all those same dishes plus someunhealthy dishes chooses the former.Natural interpretation: He knew hed be tempted by the unhealthydishes.Suppose it turns out that the rst restaurant is closed, so he has togo to the second one and he chooses something healthy.

65. Gul and Pesendorfers answer: Consider the choice of menus.Suppose someone with a choice between a restaurant with onlyhealthy dishes and another with all those same dishes plus someunhealthy dishes chooses the former.Natural interpretation: He knew hed be tempted by the unhealthydishes.Suppose it turns out that the rst restaurant is closed, so he has togo to the second one and he chooses something healthy.Natural interpretation: He exerted (costly) selfcontrol.

66. Gul and Pesendorfers answer: Consider the choice of menus.Suppose someone with a choice between a restaurant with onlyhealthy dishes and another with all those same dishes plus someunhealthy dishes chooses the former.Natural interpretation: He knew hed be tempted by the unhealthydishes.Suppose it turns out that the rst restaurant is closed, so he has togo to the second one and he chooses something healthy.Natural interpretation: He exerted (costly) selfcontrol.Cant know that this is what causes such behavior, but gives anintriguing interpretation.

67. Last point: We develop these tools in the hopes that well be ableto use them to do better in the future. We do understand somethings better now than economists 50 years ago did.

68. Last point: We develop these tools in the hopes that well be ableto use them to do better in the future. We do understand somethings better now than economists 50 years ago did.I expect that 50 years from now that what we do now will lookpretty primitive.