Worlds Hidden in Plain Sight pp. 9-19
DOI:
2: Bounded Rationality and Other Departures
Authors: George Cowan and Kenneth Arrow
Excerpt
George Cowan: We are eager to know what fresh ideas there are in economics. What particularly intrigues you? What directions are things moving in? What stimulates change? What does the future hold?
Kenneth Arrow: The next big steps forward involve consideration of nonlinear dynamics and future uncertainties. This is the warp and woof of a lot of economic research.
First, let me review some current ideas. The standard picture of the economy is one which assigns a very great weight to the system of prices for directing the way in which the economy functions.
Firms and households are assumed to be rational in the sense that they are trying to maximize something—in the case of firms, their profits. A firm has various ways of combining inputs to produce possible combinations of outputs. Each technologically feasible combination will produce a certain profit at given prices. The firm, therefore, will choose that set of inputs and outputs that maximizes profit. As prices change they choose different combinations and different scales.
Similarly, the household, which is the consumer, is thought of as choosing some bundle of inputs and outputs, the outputs usually being labor, but possibly other commodities that they own, in order to achieve as high a level of satisfaction or utility as is possible. This procedure defines for each firm or household a certain supply and demand for each commodity. The demand for any commodity or the supply will depend not only on the price of that commodity but on the prices of all other commodities. If nothing else, the rise in the price of some other good will reduce the amount of purchasing power available to the consumer for the purchase of this good. In addition, the price of gasoline, for example, affects the extent to which people use automobiles. The result is that for every set of prices there are a lot of supplies and demands that can be added up over all agents in the economy, giving rise to a net demand. An equilibrium set of prices means those prices at which net demand goes to zero for all commodities and supplies and remain balanced.