Lecture Nine

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Lecture Nine

• Scientific Economic Methodology

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Recap

• Neoclassical Microeconomic Basis of Finance
  theory
• Keyness perspective
• uncertainty, not risk
• conventions, not estimating expected returns
• beat the market, not efficient markets
• This lecture
• Methodology of science/economics

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Popper What is a Science?

• Philosopher writing at time of collapse of
  Austro-Hungarian empire (1912-1919)
• Once convinced, then disillusioned by Marxist
  theory of history
• Characterises these, psycho-analysis, astrology,
  etc. as pseudo-science
• Posed question 'What is wrong with Marxism,
  psycho-analysis...? Why are they so different
  from physical theories...?' ... these ...
  theories, though posing as sciences, had ... more
  in common with primitive myths than with
  science... Conjectures Refutations

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Popper What is a Science?

• Rejected conventional explanations (empirical
  inductive method) because pseudo-sciences (e.g.
  astrology heavily empirical)
• Noticed characteristic of pseudo-sciences
  confirmation
• admirers ... were impressed ... by their
  apparent explanatory power. These theories
  appeared to be able to explain practically
  everything that happened within the fields to
  which they referred
• A Marxist could not open a newspaper without
  finding ... confirming evidence for his
  interpretation of history ... in the news, ...
  its presentation and especially of course in
  what the paper did not say.

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Popper What is a Science?

• Argued that confirmation meaningless every
  conceivable case could be interpreted in the
  light of the relevant theory they could not
  be refuted
• Therefore, by exclusion, a true science was one
  which could be refuted
• Developed 6 principles to
• distinguish science from pseudo-science
• distinguish good from bad scientific behaviour

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Popper What is a Science?

• Confirmations should count only if they are ...
  risky ..., if, unenlightened by the theory ...,
  we should have expected an event which ... would
  have refuted the theory.
• Every 'good' scientific theory is a prohibition
  it forbids certain things to happen...
• A theory which is not refutable by any
  conceivable event is non-scientific...
• Every genuine test of a theory is an attempt to
  falsify it, or to refute it...
• Confirming evidence should not count except when
  it is ... a serious but unsuccessful attempt to
  falsify the theory

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Popper What is a Science?

• ...re-interpreting the theory ad hoc in such a
  way that it escapes refutation... is always
  possible, but ... rescues the theory from
  refutation only at the price of ... lowering, its
  scientific status.
• In summary
• the criterion of the scientific status of a
  theory is its falsifiability...

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Popper How does a Science develop?

• The pre-history of a science is myth
• historically speaking all---or very nearly
  all---scientific theories originate from myths
  ...
• How to draw the line between myth science?
• to be scientific, must be capable of
  conflicting with possible, or conceivable,
  observations
• Myths may be important
• a myth may contain important anticipations of
  scientific theories

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Popper How does a Science develop?

• Humans seek regularities, explanations for
  reality theory precedes observation
• Myth provides theories (conjectures) about the
  world
• We test theories by experience some experiences
  contradict myth (refutations)
• Science develops out of myth by conjectures
  refutations
• scientific theories were not the digest of
  observations, but ... inventions--conjectures
  boldly put forward for trial, to be eliminated if
  they clashed with observations with observations
  which were rarely accidental but as a rule
  undertaken with the definite intention of testing
  a theory by obtaining, if possible, a decisive
  refutation.

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Popper The nature of science

• Dogmatism criticism are polar opposites
• Some dogmatism needed to avoid early abandonment
  of theories but
• science is critical (attempts to refute
  theories), psuedo-science is dogmatic (attempts
  to verify)
• science develops by conjecture and refutation ..
  boldly proposing theories ... trying ... to show
  that these are erroneous ... accepting them
  tentatively if our critical efforts are
  unsuccessful.

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Popper The nature of science

• Evolutionary basis to science our conjectures,
  suffer in our stead in the struggle for the
  survival of the fittest.
• Linear nature of science progresses from myth to
  science to better science
• Incremental nature of progress can never attain
  complete truth but each conjecture/refutation
  brings us closer to it

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Popper Problems

• Argues that theory precedes observation but
• Proposes that scientists more wedded to
  observation than theory (which they attempt to
  refute) contradictory
• In practice hard to delineate between myth
  science
• Example (shortly) was Ptolemys theory of
  astronomy myth or science?
• Failure of Poppers Positivism as guide to
  History of Science led to Kuhns Paradigms

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Paradigms

• Scientific community wedded to its view of the
  world--its paradigm
• Theory selects observations which tend to confirm
  it
• Paradigm develops by extending range of phenomena
  it can explain normal science
• Paradigm embodied in texts--previous paradigms
  ignored/forgotten/judged from point of view of
  dominant paradigm
• Anomalies--things which contradict theory--at
  first resisted
• At limits of paradigm, only anomalies left to
  resolve
• Failure to resolve leads to revolution--often
  from outside

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Paradigms

• Paradigm includes
• explanatory view of relevant phenomena (physics,
  chemistry, etc.)
• set of unresolved puzzles
• Normal science as process of resolving these
  puzzles
• Paradigm starts to break down when some puzzles
  fail to be resolved key anomalies
• Switch to new paradigm involves total change in
  world view
• E.g., theory of the cosmos from Aristotle to
  Copernicus

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Astronomy Aristotle/Ptolemy

• Aristotle theory of ordered universe
• 2 parts the earth the heavens
• Earth the place of change
• Heavens the place of perfection
• 5 elements Earth, Water, Air, Fire, Aether
• Earth heaviest, thus earth at centre (explains
  gravity)
• Aether lightest, thus in heavens (explains
  orbits)
• Heavenly bodies on circular orbits in concentric
  spheres around earth in order of Moon, Mercury,
  Venus, Sun, Mars stars

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Astronomy Aristotle/Ptolemy

• Universe finite, compact
• Spheres fit tightly together
• Fixed stars on outer sphere
• Beyond the stars, nothing the Void
• 2 sets of rules
• On earth, decay/change a stone falls to earth...
• In heavens, eternity heavenly bodies rotate
  forever
• Fits with religious view Earthly corruption
  Heavenly perfection

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Astronomy Aristotle/Ptolemy
The Void
The Elements
Earth
Water
The Heavens
Air, Fire
Aether
Moon
Sun
Stars
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Astronomy Aristotle/Ptolemy

• Aristotles system couldnt be maintained
• Not all orbits circular
• Planets reversed direction
• sometimes moved to east across the sky, other
  times to west
• Paradigmatic puzzle how to resolve observed
  behaviour of planets to core of paradigm that
  earth is centre of universe
• Ptolemy solves puzzle with Excentric, epicycle,
  and equant motion

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Astronomy Aristotle/Ptolemy
Eccentricity of orbits explained
Reversal of direction possible
Universal centre
Earth
Centre of rotation

• Core of paradigm maintained
• Puzzle now to accurately place heavenly bodies
  on spheres

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Astronomy Aristotle/Ptolemy

• Ptolemaic view breaks down by Renaissance
• Astronomical tables lose accuracy
• Navigation by mariners relies upon but also
  contradicts Ptolemaic celestial predictions
• Calendar becoming inaccurate
• Equinox moved from 21st to 11th Jan/July
• Copernicus proposes alternative paradigm
• Sun centre of universe (1st proposed by
  Archimedes, 212BC!)
• Earth planets have circular orbits around it
• Stars fixed at great distance (given parallax
  effect)
• Alternative tables slightly more accurate than
  Ptolemaic
• But explanation involves complete shift in
  viewpoint

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Astronomy Copernicus
Explanation for why stars dont move completely
different
No apparent parallax for stars
Must be at enormous distance from earth
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Astronomy Copernicus

• Lukewarm to hostile initial reception
• Clashed with Ptolemaic world view
• How would stones fall to earth if it wasnt
  centre of universe?
• How can stones thrown straight up fall in same
  place if earth rotates/moves?
• Why is there a Void between Saturn the stars?
• Clashes with bible, etc.
• Eventually dominant after 25-50 years

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Astronomy Copernicus
Completely different view of universe Not a
linear change from previous view (as in Popper)
but a complete change in vision a paradigm
shift
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Paradigms vs Positivism

• Ptolemaic view based on myth (religious view of
  universe)
• But were Aristotle et al unscientific?
• Complex model of universe, accurate tables, acute
  observations
• Did they attempt to refute theory?
• No, Ptolemys revised orbs maintains
  earth-centric view
• Was Copernicus accepted as refutation of
  Ptomelys conjecture?
• No, strong resistance
• Paradigm approach regarded as more accurate model
  of scientific behaviour

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The Paradigm develops

• Later work by Feyerabend, Lakatos,
  extends/modifies concept of paradigm
• Lakatos Methodology of Scientific Research
  Programs (MSRP)
• Theories have hard core which adherents do not
  attempt to falsify
• Hard core surrounded by protective belt of
  hypotheses which may be adjusted to defend hard
  core
• Positive heuristic (like Kuhns puzzles
  normal science) where most development effort of
  program occurs
• An MSRP can be progressive (expanding ive
  heuristic) or degenerative (simply adjusting
  protective belt to save hard core from attack)

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Positivist v Paradigm view of Economics

• Positivist view
• ive Refinement of economic theory from
  Physiocrats to neoclassicals -ive utility as
  irrefutable
• Paradigm/MSRP view
• Sequence of paradigms, each with own world
  view, puzzles to solve, anomalies...
• Competing MSRPs, part progressive, part
  degenerative
• Any status as a science?
• Absence of controlled experiment
• Impact of observer on data
• Is economics a science in same sense as
  physics, astronomy?

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Within Economics Instrumentalism

• Friedman (OREF II)
• Proper test of a theory is by its predictions
• Realism of assumptions irrelevant
• the more significant the theory, the more
  unrealistic the assumptions a hypothesis is
  important if it explains much by little OREF
  203
• as if assumptions--firms behave as if
  maximising expected returns, etc.--valid even if
  firms do not consciously do so.
• Reason for paper to counter perennial criticism
  of orthodox economic theory as unrealistic
  OREF 213

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Within Economics Instrumentalism

• Problems with Instrumentalism
• Friedmans defended his economics with
  instrumentalism
• Used by others (see Sharpe on finance, last
  lecture) to likewise defend theories against
  attacks on basis of unrealistic assumptions
• But how have the predictions of these theories
  fared?
• Eventual abandonment of monetarism after
  continual failures to meet monetary growth
  targets
• Current state of finance markets wildly at odds
  with predictions of Efficient Markets Hypothesis
• Even on own grounds, instrumentalism not an
  effective defence of economic theory

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Within Economics Instrumentalism

• Intellectually, many problems with
  Instrumentalism
• Not how orthodox economists actually behave
• They judge theories on the basis of their
  assumptions
• Development of orthodox macroeconomics driven by
  desire to make macroeconomics consistent with
  assumptions of neoclassical microeconomics
• Critical of other theories (Marxian, Post
  Keynesian, etc.) on the basis of their
  assumptions
• (Conventional Marxian) assumption of labor theory
  of value criticised by everyone from Bohm Bawerk
  to Samuelson
• Papers submitted to journals often criticised for
  not making conventional assumptions (rationality,
  etc.)

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Within Economics Instrumentalism

• Logical consistency of assumptions has been
  challenged (Sraffa), not just realism
• Sciences do attempt to build theories which are
  essentially descriptions of reality
• Musgrave (see OREF) argues Friedmans
  significant theory, unrealistic assumptions
  position invalid
• Classifies assumptions into 3 classes
• Negligibility assumptions
• Domain Assumptions
• Heuristic Assumptions

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Within Economics Instrumentalism

• Negligibility Assumptions
• Assert that some factor is of little or no
  importance in a given situation
• e.g., Galileos experiment to prove that weight
  does not affect speed at which objects fall
• dropped two different size lead balls from
  Leaning Tower of Pisa
• assumed (correctly) air resistance negligible
  at that altitude for dense objects, therefore
  ignored air resistance
• Domain assumptions
• Assert that theory is relevant if some assumed
  condition applies, irrelevant if condition does
  not apply

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Within Economics Instrumentalism

• e.g., Newtons theory of planetary motion
  assumed there was only one planet
• if true, planet follows elliptical orbit around
  sun.
• if false planets relatively massive, motion
  unpredictable. Poincare (1899) showed
• there was no formula to describe paths
• paths were in fact chaotic
• planets in multiple planet solar systems
  therefore have collisions
• present planets evolved from collisions between
  proto-planets
• evolutionary explanation for present-day
  roughly elliptical orbits

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Classes of assumptions

• Heuristic
• assumption known to be false, but used as
  stepping stone to more valid theory
• e.g., in developing theory of relativity,
  Einstein assumes that distance covered by person
  walking across a train carriage equals
  trigonometric sum of
• forward movement of train
• sideways movement of passenger

Then says We shall see later that this result
cannot be maintained in other words, the law
that we have just written down does not hold in
reality. For the time being, however, we shall
assume its correctness. (Einstein 1916)
passenger
0.9 c
train
0.9 c
lt 1.0 c
sum
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Within Economics Instrumentalism

• Sun/planets example of the right way to use
  assumptions
• Assume influence of other planets negligible
• Then earth will follow elliptical orbit around
  sun
• Other planets (Jupiter, Saturn) not negligible
• Then elliptical orbit only applies in solar
  systems without large planets (domain assumption)
• Drop assumption of non-impact
• assumption heuristic device on way to more
  general theory
• 3-body problem no general solution possible
• Chaos theory explanation for planet orbits
• More realistic assumption, more accurate theory

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Classes of assumptions

• Friedmans instrumentalism only valid with
  respect to negligibility assumptions, but
• often used by economists to defend domain
  assumptions
• or presented to students as if heuristic
  assumptions
• i.e., implied that more sophisticated models
  remove restrictive assumptions, when in fact
  more sophisticated models often involve even more
  restrictive assumptions
• example Sharpes Efficient Markets Hypothesis

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Just where are markets efficient?

• The Efficient Markets Hypothesis assume
• All investors have identical accurate
  expectations of future
• All investors have equal access to limitless
  credit
• Negligible, Domain or Heuristic assumptions?
• Negligible? No if drop them, then according to
  Sharpe The theory is in a shambles (see last
  lecture)
• Heuristic? No, EMH was end of the line for
  Sharpes logic no subsequent theory developed
  which
• replaced risk with uncertainty, or
• took account of differing inaccurate assumptions,
  different access to credit, etc.

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Within Economics Instrumentalism

• Some assumptions can be challenged for validity
• Risk as proxy for uncertainty (Keynes/Minsky)
• Domain validity of Arrow-Debreu general
  equilibrium with risky but not uncertain future
• cannot apply in this universe
• Nature of fixed capital (Sraffa)
• Internal consistency of marginal productivity
  theory of income distribution (Sraffa/Garengani)
• Equilibrium as normal state of economy (next
  lecture)
• Statics equilibrium as long-run outcome of
  dynamic processes (next lecture)
• Linearity as valid approximation to nonlinear
  processes (next lecture)

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Within Economics Instrumentalism

• Logic aside, Friedmans Instrumentalism still
  dominant in economics
• From critics point of view, simply a way to
  defend neoclassical theory from criticism
• From Lakatos point of view, can be seen as
  protective belt hypothesis to shield hard
  core of neoclassicism from criticism
• Next 3 weeks controversies, criticisms,
  alternatives