An Examination of Theoretical Predictions of the Strength of Economic Forces.

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At times powerful governments seem to be seized by economic forces beyond their ability to control: during a twenty-four hour period, for example, the British government raised interest rates to astronomical levels, swearing under no circumstances to devalue the pound, only to do exactly that. At other times, seemingly minor tinkering with policy can unleash profound and unplanned change: the enormous changes in the former Soviet Union, for example, seem to have been triggered by relatively mild political reforms introduced by Gorbachev in the mid-eighties. Although it is not widely recognized, economic theory predicts that under certain circumstances economic forces will be overpoweringly strong, and at other times extremely weak and susceptible to manipulation. Indeed, the theory can make quantitative predictions about the strength of economic forces. To the extent that such predictions are correct, they are of great value, directing our attention to those types of problems and situations where policy can make a real difference. There are two broad goals of this research: first to use data from experimental economics to validate the theory, and second, to advance the theory to improve its predictive power in assessing situations where economic forces are weak. Experimental data in economics is extremely mixed: sometimes the theory predicts extremely well, and at other times strange anomalies occur, often changing with seemingly trivial modifications in experimental design. What has not been examined carefully is the extent to which the anomalies are correlated with the strength of economic forces involved. Our hypothesis is that the theory predicts well when economic forces are strong, and that it predicts poorly when economic forces are weak. This research plans to review a broad cross-section of economic experiments in an effort to determine whether the anomalies are due to the weakness of the economic forces. To the extent that they are, this validates the idea that current theory can assess the strength of economic forces in a useful way. Unfortunately, an implication of our hypothesis is that predictions made by theory will be weakest exactly when the consequences of policy changes will be most profound. Many economists feel that under these circumstances, the ability of individuals to learn and adapt plays an important role. (This is clearly the case in the changes unfolding in the former Soviet Union.) The second major component of this research is to examine the theoretical consequences of learning, and the types of predictions such a theory makes. The goal is to develop useful mathematical approximations for making quantitative predictions.