Postmodern Economists, Empiricist Sociologists? The Problem of Unobservables

A few days ago, I ran into one of my favorite economics PhD students at my favorite Coffee Shoppe. When I first started meeting the economics PhD students here at Michigan (through the first-year econometrics sequence), I was surprised by how… normal they all seemed. They were interested in economics, but they were not “market fundamentalists” or die-hard Hayekian libertarians. For example, they by-and-large seemed to agree that development economics had failed the poorer parts of the world over the last few decades, in part due to its own hubris. We didn’t agree on everything, but we had a lot of common ground. I began to wonder if the arrogant, imperialist economist was a myth, at least among Michigan students (who tend to focus on labor and development, and less so on micro-theory, for example).

Then I met this particular grad student – call her L. The first time I had a conversation with her came during a discussion of precisely the role of economics in development. Before class one day, she was arguing with another student that it was important for economists not to know too much about the countries they were working in – that it would be at best worthless and at worst outright harmful. The job of the economist was to bring the Theory and let local experts worry about the quirky details of the specific place. I wish I’d had a tape recorder!

When I ran into L this past week, though, our conversation was not about development but rather the role of unobservables in theoretical and empirical work. She was reading about factor analysis, and asked me what I thought about it, and I replied something cheeky about economics being a shockingly postmodern discipline* in that they were quite comfortable analyzing the world in terms of, and coming up with measures of, unobservable quantities (the classic example is apparently “effort” in labor studies). Sociology is not free of this habit – and I’m not particularly opposed to it – but I think it’s interesting how crucial unobservable concepts are to economic theory and yet how ruthlessly positivist the rhetoric surrounding economic knowledge can be. Leave “culture” to the lesser mortals, we economists deal with cold, hard rational money and resources. I’m exaggerating, of course, but I think there might be a significant grain of truth there.

A classic example of this kind of problem is Harison White’s (1981) Where Do Markets Come From?. White rejects existing economic explanations for the origins of stable markets as being impossible because they require actors acting on knowledge they cannot have, e.g.“Firms can observe only volumes and payments, not qualities or their valuations…” (p. 520) White then generates different circumstances under which firms’ mutual observations of each other, and knowledge of their own internal cost structures, leads to different possible stable markets. It’s a very dense model I don’t claim to fully understand, but one of the central distinguishing claims White makes is that he can explain markets without reference to actors acting on unobservables.

A similar story popped up in the literature I’m currently knee-deep in concerning the rise of agency theory and “shareholder value” as a logic/conception of control/model of the firm/etc: the problem of profit. In an important sense, there are two very different kinds of profit discussed in the academic and business literature, economic profit and accounting profit. Accounting profit shows up in balance sheets and refers to the money left over after paying expenses. It’s observable – and manipulable, but different from what economists are talking about. Here’s Froud et al. (2000):

“[E]conomic profit is an unobservable concept of mainly theoretical interest to economists, whereas accounting profit is an observable magnitude of interest not only to companies themselves but to those who make economic decisions to contract with the firm and to those who comment on corporate performance.” (777)

In an excellent paper in a similar vein, Espeland and Hirsch (1990) give numerous examples of the kinds of manipulations possible of accounting profits that, they argue, made possible the conglomerates of the 1960s. Especially popular tricks allowed firms to count the earnings of acquired firms retroactively, thus increasing the apparent profitability of the firm post-merger (I don’t want to butcher the details, go look at the paper if you are curious). I’m not so interested in overt frauds – a la Enron – as the general problem of needing to make choices to end up with a balance sheet that lists a certain amount of profit. Even well-intentioned accountants not trying to defraud anyone, following generally accepted practices, make choices that in turn define the observed (accounting) profits. And on the basis of those observed figures, business decisions are made (by investors, executives, etc.).

So, where does this all get us? I’m not entirely sure, but I’m enjoying thinking through these issues – how do you study decision-making? Is it reasonable to say that (economic) sociology has focused more on the kinds of tools available to the people making decisions while economics has focused narrowly on more abstract, and unobservable, constructs?

Alright, back to writing.

* If I recall, Lyotard talks about game theory is a great example of a postmodern science concerned with narratives and possible worlds.

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2 Comments

  1. Can you recommend anything discussing the epistemic value of simulating decision-oriented interactions, the outcome of which is not observable?

    • Check out the literature on complex systems, especially agent-based models. Within that, I don’t have a particular recommendation, unfortunately.