Examples of Economic theories

February 16, 2017
Republican Governor Sam
Economic theorists have worked hard to lower expectations for their field. The standard line (originally due, I think, to Keynes?) is that, unlike a science like biology that can be applied to the real world, economic theory merely gives people a way to think about complex issues in an intellectually disciplined, rigorous manner. One subtext is that economic theory need not be subjected to the rigors of the scientific method; that theory need not match data, and that the criterion for judging a theory a success should basically be that other economists think the theory is cool. Another implication is that the study of economic theory need not ever be justified by the present or future creation of useful technologies. In other words, it doesn't have to be right or useful, only interesting.

In a recent interview, game theorist Ariel Rubinstein says this of his own field:

Is game theory useful in a concrete sense or not? Game theory is an area of economics that has enjoyed fantastic public relations...I think it’s a very tempting idea for people, that they can take something simple and apply it to situations that are very complicated, like the economic crisis or nuclear deterrence. But this is an illusion...I don’t respect the claims that [game theory] has direct applications... Game theory is about a collection of fables. Are fables useful or not? In some sense, you can say that they are useful, because good fables can give you some new insight into the world and allow you to think about a situation differently. But fables are not useful in the sense of giving you advice about what to do tomorrow, or how to reach an agreement between the West and Iran. The same is true about game theory... In general, I would say there were too many claims made by game theoreticians about its relevance. Every book of game theory starts with “Game theory is very relevant to everything that you can imagine, and probably many things that you can’t imagine.” In my opinion that’s just a marketing device... [We do game theory] because it is interesting...I believe that intellectual thinking – philosophy or logic or game theory – is very useful in the cultural sense. It’s part of the culture, it’s a part of our perpetual attempt to understand ourselves better and understand the way that we think. What I’m opposing is the approach that says, in a practical situation, “OK, there are some very clever game theoreticians in the world, let’s ask them what to do.” I have not seen, in all my life, a single example where a game theorist could give advice, based on the theory, which was more useful than that of the layman... I categorically cannot see any case where game theory could be helpful. Naturally, this opens the economics field to the obvious criticism of "Well, fine and good, but then why do we pay econ theory professors so much more than literature professors?" (That, as you might expect, is not a question that many economic theorists are eager to bring up in conversation.)

But here - surprise! - is where I come to game theory's defense. Rubenstein seems to be talking about the national defense applications of game theory, which were much-ballyhooed in the Cold War but (I agree with Rubinstein) were pretty heavily oversold. Yet, although I am not a game theorist, I believe I know of some very useful real-world technological applications of game theory that have nothing to do with nuclear deterrence.

I'm talking about auction theory. Auction theory describes a situation where the sequence of moves is known, and the payoffs are (close to) constant - i.e., just the kind of situation where game theory allows concrete predictions. And lo and behold, auction theory is used to power the internet's most successful advertising technology: Google's AdWords. Everyone except Google has had trouble making money off Web advertising (look at Facebook), but with the help of auction theory, Google has built one of America's most profitable technology businesses.

That's real technology based on economic theory. It's really just one subset of mechanism design, which (people tell me) is the hottest sub-field of game theory right now. Mechanism is deep, pure economics - it's the science of incentives. And because there are real situations in which incentives are observable and well-defined, you can use mechanism design to predict and control the outcomes of certain kinds of transactions and interactions. That's applied economic technology, just as surely as your smartphone is applied computer science technology.

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