Every Economic Model Is Wrong… But That Doesn't Mean They're Not Useful

from the hating-on-economists dept

Fred Wilson has a thought-provoking post on his blog, asking what if the economic model you’re basing business decisions on is wrong? He’s building off of an Umair Haque blog post, asking whether or not economists matter any more, because the models they use are wrong. I think there’s some truth to both of these pieces — and I know both Fred and Umair, and enjoy exchanging ideas with both — but it feels like they’re throwing a pretty big baby out with the bathwater.

I don’t think it’s that the “old models” don’t work any more. The problem is simply that they’re models, not crystal balls. Every model has faults (that’s why it’s a model, rather than the real thing). What makes economics so difficult is that any real scenario involves too many variables to accurately model. Each modeling attempt tries to account for the most important of those variables, and assumes the impact of the rest washes out. However, changes in the world may impact one variable a lot more than expected, or change the relationship between variables — and that’s what throws a model out of whack. Every economic model is wrong because it simply cannot account for every human variable out there.

But, that doesn’t mean you ignore what the models tell you. You can still learn quite a lot from those models — including why they’re wrong, and how to improve on them. So, for example, when Haque discusses Starbucks and Microsoft, as if basic economic models failed them, I disagree. I just think they didn’t put enough weight into some important variables in their models. Starbucks, for example, failed to recognize the importance of “culture” in its equation, but that doesn’t mean the whole equation was wrong.

It’s certainly tempting to throw out the old models when they’re proven incorrect, but that makes you lose a real learning opportunity. You should start from the position that all models are incorrect from the beginning — and as each model is proven incorrect, figure out why so you can correct and improve, rather than simply tossing the whole thing out.

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Comments on “Every Economic Model Is Wrong… But That Doesn't Mean They're Not Useful”

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Adam (profile) says:

Economies are Chaotic

Economic models share their shortcomings with weather forecasting. Weather is chaotic, i.e. extremely sensitive to initial conditions in the prediction calculation, but nonetheless, weather predictions are worth the effort. Economic models can also be extremely sensitive to initial condition assumptions and can be easily influenced by those assumptions. Unfortunately, most economic predictions don’t include the assumptions on which the prediction is based.

Dave says:

The biggest problem

Economic models assume that there is a point at which rationality precludes certain effects.

Unfortunately, greed tends toward a maximum and human greed has shown no upper bound. So, trying to model a variable with no upper bound breaks any model that requires access to finite resources.

Throwing away the model doesn’t help, but relying on it past the point where it’s wrong is the failing of most corps and governments.

silentsteel (profile) says:

The major flaw in Economics

From my perspective, The greatest flaw in Economics lies in the fact that is is classified as a social science, which by that classification implies that people are inherently involved. People, and their ability to act like lemmings will skew a model entirely because the model can not take into account exactly why the human psyche does what it does. Individuals, as mentioned above, have an unknown ability for greed that no model can account for.

Socialism and capitalism face the same issues. Both look outstanding on paper, but neither works well in a pure state.

interval says:

Mike; you wrote:
“Starbucks, for example, failed to recognize the importance of “culture” in its equation…”

I don’t disagree with you, I just don’t understand what you mean. How so? Whenever I walk into a Starbucks I see nothing but “culture”, or attempts at making whatever they consider culture fit into their retail strategy. Was it the wrong “culture”? I kind of thought Starbucks was losing becuase they were charging way too much for their coffee in a down economy. Just trying to understand the example.

Comboman says:

Re: Re:

Starbucks failure was not realizing that their business model did not scale up infinitely. They thought if they went from 1 store on each block to 2 stores on each block that they would make twice as much money, without realizing that the number of customers stayed the same and each store only made half as much money.

bloke says:


Econimic models can work to the intended outcome if the structure and result is beneficial to all involved. Progress should not be deterred as long as we acknowledge the producers of the economic models success.
I have witnessed and been a part of success in less facvorable conditions than some of the represented economic models simply due to the fact I had a committed group around me willing to do their individual part.
It does take that type of effort to manage whatever model you chose, we can control that.

lotfy says:


I think that models uncredibilities dwell in excessive allegations about economic forecast and the fact that a host of specialists think of some equations as being secular prophecies that can’t in any case be renounced and that any mistake thereof stems form irrationality not from retrospective economic models. the entire sotry is about prediction.

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