In a previous post, I had a look at some major problems in the theoretical foundations of pretty much all macroeconomic models. To recap, they were as follows:
In this post, I’m going to give an overview of some major theoretical issues in modern economics.
In a typical undergraduate economics degree, you spend a lot of time drawing pictures like this:
Imagine I offer you the chance to play the following game. The pot starts at \( $ 2\). I flip a coin repeatedly. Each time it comes up tails, the pot doubles. The first time a heads appears, the game ends and you leave with the pot. How much would you be willing to pay to play this game?
Expected utility theory was first influentially expounded by Swiss mathematician Daniel Bernoulli in the 1700s. It seeks to answer the question of how to weigh up alternatives that are uncertain. For example, say I gave you the option of \( £100 \), or a bet consisting of a \( 50-50 \) chance of receiving \( £250 \), how should you choose? While it may seem easy to answer a single question like this, it turns out that building a general framework for how to make such decisions is not so easy, and if you proceed naively you can easily come a cropper.
It’s an economic theory which, in a nutshell, says that full employment and funding of various other government programmes can be guaranteed by printing money, and the inflation that would normally ensue can be kept under control by taxation.
Indeed.
Milton Friedman was a Nobel prize-winning economist whose ideas became deeply influential both inside and outside academia. He broadly advocated for free markets with minimal government intervention. For example, he opposed the military draft, minimum wage laws and occupational licensing, and supported school vouchers and legalisation of drugs and prostitution. He was an advisor to Ronald Reagan and Margaret Thatcher, and he is widely thought of as the intellectual father of the ideology of neoliberalism.
The efficient market hypothesis is, roughly speaking, the idea that asset prices ‘reflect all available information’. This means that the only way to consistently outperform the market is to have access to information that isn’t widely known, or to get lucky.
In particular, it implies that even the fanciest of funds, managed by very smart people with fancy degrees from even fancier universities, will on average fare no better than a monkey throwing darts at a list of stocks.