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Institute of Advanced Study

21st Century Economics

Abstract

All theories are approximations to reality, requiring assumptions - simplifications of reality - to be made. Conventional economics is not necessarily wrong, but the strict assumptions it imposes about how humans behave limit its usefulness and limit the circumstances in which its simplifications are a good approximation to reality. The economics of the twenty-first century is both more realistic, and builds on and develops what went before.

Very important empirical advances have been made in the past 25 years in understanding how humans actually take decisions in a variety of circumstances. Experimental and behavioural economics have shown that, in general, humans reason poorly, especially about the future, and act intuitively. This is in direct contrast to the ‘rational' behaviour assumed in most twentieth century economic theory.

We now have the tools to relax the assumptions of conventional economics and build more realistic models of behaviour, grounded in empirical evidence rather than a priori theorising. Two of the most powerful are the huge advances in the mathematical understanding of networks made in the last decade or so, and the power of modern computers.

A key feature of conventional economics is that the tastes and preferences of individuals are fixed. But in many circumstances, they may be altered by observing the opinions and actions of others. This is what the new science of networks does, it tells us about the ways in which people are connected, and how their behaviour might be altered as a result.

Computing power means that we are no longer restricted to purely analytical solutions to models, which compare different equilibria before and after any postulated changes in circumstances. We can not only examine problems where no analytical solution can be found but, crucially, examine how social and economic processes develop over time, when they may be far from equilibrium, even if one might be presumed to exist.

Insights Paper