For over a century, economists have wrestled with a fundamental question that strikes at the heart of their discipline: should economic theories be judged by how realistic their assumptions are, or solely by how well they predict outcomes? This debate isn’t just academic hairsplitting-it has shaped how economists build models, test theories, and offer policy advice. The journey from cautious moderation to bold apriorism, and finally to the controversial defense by Milton Friedman, reveals how economics evolved its understanding of what makes a theory “good enough.”
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The early days: walking a moderate line
Between 1880 and 1920, the pioneers of economic theory adopted what we might call a diplomatic stance. They knew their assumptions were simplifications-often quite drastic ones. But they argued these simplifications were necessary and, importantly, that they broadly corresponded with observable facts. Think of it like a map: no map shows every tree and rock, but a good map captures the essential features you need to navigate.
Early theorists understood they were making trade-offs. Classical economists carefully distinguished between theorems-logical conclusions that followed from a model’s assumptions-and precepts, which were actual policy recommendations that required additional judgment about history, morality, and institutions. A theorem might tell you that reducing price leads to increased demand, but prescribing a specific price policy required far more than pure theory.
During this period, economists actively called for more inductive studies and emphasized that assumptions should be adjusted based on context. If you were studying agricultural markets in India versus industrial markets in Britain, you’d need different starting assumptions. This moderate stance acknowledged both the power of theoretical reasoning and the importance of empirical grounding.
The shift toward pure logic: embracing apriorism
The 1920s and 1930s marked a dramatic turning point. As economic theory became more mathematically sophisticated and logically rigorous, a new confidence emerged. Why bother with messy empirical verification when you could deduce truths from first principles?
Two key figures drove this shift: Lionel Robbins at the London School of Economics and the Austrian School economists, particularly Ludwig von Mises and Friedrich Hayek. Robbins brought Hayek to LSE in 1931, and together they promoted the view that economics is a system of logical deduction from first principles. In his influential 1932 essay “An Essay on the Nature and Significance of Economic Science,” Robbins defined economics as “the science which studies human behavior as a relationship between given ends and scarce means which have alternative uses.”
This definition was revolutionary because it suggested economics could proceed much like mathematics-building elaborate structures of thought from a few basic axioms about human behavior and scarcity. Robbins was skeptical about the feasibility and usefulness of empirical verification, believing that the power of economics lay in its logical coherence rather than in testing against data.
The Austrian School took this even further. They argued that economic truths could be derived a priori-before experience-from fundamental insights about human action. If we know people act purposefully to improve their situations, we can deduce logical consequences without necessarily testing them empirically. During this period, there was a growing belief that economic theory was its own reward, with less emphasis on whether theories aligned neatly with messy real-world data.
Why the enthusiasm for pure theory?
Imagine you’re an economist in the 1930s watching the Great Depression unfold. Different economists offered radically different explanations and policy prescriptions. The appeal of a more “scientific” economics-one based on rigorous logic rather than shifting empirical interpretations-was enormous. If you could build economics on the solid foundation of logical deduction, perhaps you could avoid the confusion and disagreement that plagued policy debates.
The Friedman revolution: assumptions don’t matter
Just when it seemed the debate might settle, Milton Friedman dropped a methodological bombshell. In his famous 1953 essay “The Methodology of Positive Economics,” Friedman made an argument that shocked many economists and thrilled others: the realism of a theory’s assumptions is irrelevant. What matters, he insisted, is only whether the theory generates accurate predictions.
Friedman famously wrote that “truly important and significant hypotheses will be found to have ‘assumptions’ that are wildly inaccurate descriptive representations of reality”. In fact, he suggested that the more unrealistic the assumptions, the better the theory might be, because such simplifications allow us to extract the essential features that drive outcomes.
Think of Friedman’s favorite example: assuming that expert billiard players calculate angles and velocities like physicists. Obviously, they don’t pull out calculators or do trigonometry. But if they play as if they were making these calculations, then the physicist’s model might predict their shots quite well. The “unrealistic” assumption leads to useful predictions.
Machlup joins the defense
Shortly after Friedman’s essay, Austrian-born economist Fritz Machlup provided additional support in his 1955 paper “The Problem of Verification in Economics”. Machlup had been defending the profit-maximization assumption since 1946, arguing against critics who pointed out that businessmen don’t actually calculate marginal costs and revenues.
Machlup agreed with critics that businessmen lack perfect knowledge of demand and costs, but maintained that assuming profit maximization is appropriate for predicting how firms react to changes. He distinguished between fundamental assumptions-like rationality and consistent preferences-which don’t require independent testing, and specific low-level hypotheses that are empirically testable.
Together, Friedman and Machlup cemented a methodology that continues to dominate mainstream economics: judge theories by their predictive success, not by whether their assumptions mirror reality in detail. This approach freed economists to build highly abstract models without worrying excessively about whether real people or firms actually behaved exactly as the models assumed.
The lasting impact and ongoing controversy
The Friedman-Machlup defense won the day in mainstream economics, but it never silenced critics. Nobel laureate Joseph Stiglitz demonstrated that models based on unrealistic assumptions about perfect information can lead to fundamentally flawed policy recommendations. When economists assumed away information asymmetries-the reality that different people know different things-they missed crucial dynamics in markets.
The 2008 financial crisis reignited these debates. Critics argued that economists had become too comfortable with elegant models built on dubious assumptions, particularly about rational expectations and efficient markets. The failure to predict or prevent the crisis suggested that perhaps Friedman’s methodology had given economists too much license to ignore uncomfortable realities.
Yet defenders point out that all economic theories, whether neoclassical, Keynesian, or Marxian, rely on assumptions and select which facts to emphasize. The real question isn’t whether to make assumptions-that’s unavoidable-but which assumptions prove most fruitful for understanding economic phenomena.
What do you think? Should economists focus primarily on building theories with realistic assumptions that capture how people and institutions actually work? Or is predictive success the only criterion that matters, regardless of whether the underlying assumptions seem far-fetched? As you navigate news about economic policies and forecasts, consider: what assumptions might be hiding beneath the surface of economic predictions you encounter?
References
- https://eh.net/book_reviews/the-methodology-of-positive-economics-reflections-on-the-milton-friedman-legacy/
- https://www.econlib.org/library/Enc/bios/Robbins.html
- https://en.wikipedia.org/wiki/Essays_in_Positive_Economics
- https://www.econlib.org/library/Enc/bios/Machlup.html
- https://en.wikipedia.org/wiki/Problems_with_economic_models
- https://americanaffairsjournal.org/2024/02/how-economic-theory-went-wrong/
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