Representative agent
Encyclopedia
Economist
s use the term representative agent to refer to the typical decision-maker of a certain type (for example, the typical consumer, or the typical firm).
More technically, an economic model
is said to have a representative agent if all agents
of the same type are identical. Also, economists sometimes say a model has a representative agent when agents differ, but act in such a way that the sum of their choices is mathematically equivalent to the decision of one individual or many identical individuals. This occurs, for example, when preferences are Gorman aggregable
. A model that contains many different agents whose choices cannot be aggregated in this way is called a heterogeneous agent model.
The notion of the representative agent can be traced back to the late 19th century. Francis Edgeworth (1881) used the term "representative particular", while Alfred Marshall
(1890) introduced a "representative firm" in his Principles of Economics. However, after Robert Lucas, Jr.'s critique
of econometric policy evaluation spurred the development of microfoundations
for macroeconomics, the notion of the representative agent became more prominent and more controversial. Many macroeconomic models today are characterized by an explicitly stated optimization
problem of the representative agent
, which may be either a consumer or a producer (or, frequently, both types of representative agents are present). The derived individual demand or supply curves are then used as the corresponding aggregate demand or supply curves.
Hartley (1997) discusses the reasons for the prominence of representative agent modelling in contemporary macroeconomics. The Lucas critique
(1976) pointed out that policy recommendations based on observed past macroeconomic relationships may neglect subsequent behavioral changes by economic agents, which, when added up, would change the macroeconomic relationships themselves. He argued that this problem would be avoided in models that explicitly described the decision-making situation of the individual agent. In such a model, an economist could analyze a policy change by recalculating the decision problem of each agent under the new policy, then aggregating these decisions to calculate the macroeconomic effects of the change.
Lucas' influential argument convinced many macroeconomists to build microfounded
models of this kind. However, this was technically more difficult than earlier modelling strategies. Therefore, almost all the earliest general equilibrium macroeconomic models
were simplified by assuming that consumers and/or firms could be described as a representative agent. General equilibrium models with many heterogeneous agents are much more complex, and are therefore still a relatively new field of economic research.
. He provides an example in which the representative agent disagrees with all individuals in the economy. Policy recommendations to improve the welfare of the representative agent would be illegitimate in this case. Kirman concludes that the reduction of a group of heterogeneous agents to a representative agent is not just an analytical convenience, but it is "both unjustified and leads to conclusions which are usually misleading and often wrong." In his view, the representative agent "deserves a decent burial, as an approach to economic analysis that is not only primitive, but fundamentally erroneous."
A possible alternative to the representative agent approach to economics could be agent-based simulation models
which are capable of dealing with many heterogeneous agents. Another alternative is to construct dynamic stochastic general equilibrium
(DSGE) models with heterogeneous agents, which is difficult, but is becoming more common (Ríos-Rull, 1995; Heathcote, Storesletten, and Violante 2009; Canova 2007 section 2.1.2).
Chang, Kim, and Schorfheide (2011) make a point similar to that of Kirman, in the context of a DSGE model where agents are heterogeneous because of uninsured labor income risk. They estimate a representative-agent DSGE model on the basis of the aggregate data implied by their heterogeneous-agent economy, and show that the estimated coefficients are inconsistent with the true parameters of the heterogeneous economy. They point out that
Economist
An economist is a professional in the social science discipline of economics. The individual may also study, develop, and apply theories and concepts from economics and write about economic policy...
s use the term representative agent to refer to the typical decision-maker of a certain type (for example, the typical consumer, or the typical firm).
More technically, an economic model
Model (economics)
In economics, a model is a theoretical construct that represents economic processes by a set of variables and a set of logical and/or quantitative relationships between them. The economic model is a simplified framework designed to illustrate complex processes, often but not always using...
is said to have a representative agent if all agents
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
of the same type are identical. Also, economists sometimes say a model has a representative agent when agents differ, but act in such a way that the sum of their choices is mathematically equivalent to the decision of one individual or many identical individuals. This occurs, for example, when preferences are Gorman aggregable
Gorman polar form
Gorman polar form is a functional form for indirect utility functions in economics. Imposing this form on utility allows the researcher to treat a society of utility-maximizers as if it consisted of a single 'representative' individual. W. M...
. A model that contains many different agents whose choices cannot be aggregated in this way is called a heterogeneous agent model.
The notion of the representative agent can be traced back to the late 19th century. Francis Edgeworth (1881) used the term "representative particular", while Alfred Marshall
Alfred Marshall
Alfred Marshall was an Englishman and one of the most influential economists of his time. His book, Principles of Economics , was the dominant economic textbook in England for many years...
(1890) introduced a "representative firm" in his Principles of Economics. However, after Robert Lucas, Jr.'s critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...
of econometric policy evaluation spurred the development of microfoundations
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....
for macroeconomics, the notion of the representative agent became more prominent and more controversial. Many macroeconomic models today are characterized by an explicitly stated optimization
Optimization
Optimization or optimality may refer to:* Mathematical optimization, the theory and computation of extrema or stationary points of functionsEconomics and business* Optimality, in economics; see utility and economic efficiency...
problem of the representative agent
Agent (economics)
In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
, which may be either a consumer or a producer (or, frequently, both types of representative agents are present). The derived individual demand or supply curves are then used as the corresponding aggregate demand or supply curves.
Motivation
When economists study a representative agent, this is because it is usually simpler to consider to one 'typical' decision maker instead of simultaneously analyzing many different decisions. Of course, economists must abandon the representative agent assumption when differences between individuals are central to the question at hand. For example, a macroeconomist might analyze the impact of a rise of oil prices on a typical 'representative' consumer; but an analysis of health insurance would probably require a heterogeneous agent model (since health insurance, by definition, is a transfer of money from relatively healthy people to others with illnesses requiring expensive care).Hartley (1997) discusses the reasons for the prominence of representative agent modelling in contemporary macroeconomics. The Lucas critique
Lucas critique
The Lucas critique, named for Robert Lucas′ work on macroeconomic policymaking, argues that it is naïve to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data, especially highly aggregated historical data.The basic idea...
(1976) pointed out that policy recommendations based on observed past macroeconomic relationships may neglect subsequent behavioral changes by economic agents, which, when added up, would change the macroeconomic relationships themselves. He argued that this problem would be avoided in models that explicitly described the decision-making situation of the individual agent. In such a model, an economist could analyze a policy change by recalculating the decision problem of each agent under the new policy, then aggregating these decisions to calculate the macroeconomic effects of the change.
Lucas' influential argument convinced many macroeconomists to build microfounded
Microfoundations
In economics, the term microfoundations refers to the microeconomic analysis of the behavior of individual agents such as households or firms that underpins a macroeconomic theory....
models of this kind. However, this was technically more difficult than earlier modelling strategies. Therefore, almost all the earliest general equilibrium macroeconomic models
Dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...
were simplified by assuming that consumers and/or firms could be described as a representative agent. General equilibrium models with many heterogeneous agents are much more complex, and are therefore still a relatively new field of economic research.
Critique
Hartley, however, finds these reasons for representative agent modelling unconvincing. Kirman (1992), too, is critical of the representative agent approach in economics. Because representative agent models simply ignore valid aggregation concerns, they sometimes commit the so-called fallacy of compositionFallacy of composition
The fallacy of composition arises when one infers that something is true of the whole from the fact that it is true of some part of the whole...
. He provides an example in which the representative agent disagrees with all individuals in the economy. Policy recommendations to improve the welfare of the representative agent would be illegitimate in this case. Kirman concludes that the reduction of a group of heterogeneous agents to a representative agent is not just an analytical convenience, but it is "both unjustified and leads to conclusions which are usually misleading and often wrong." In his view, the representative agent "deserves a decent burial, as an approach to economic analysis that is not only primitive, but fundamentally erroneous."
A possible alternative to the representative agent approach to economics could be agent-based simulation models
Agent-Based Computational Economics
Agent-based computational economics is the major aspect of computational economics that studies economic processes, including whole economies, as dynamic systems of interacting agents. As such, it falls in paradigm of complex adaptive systems...
which are capable of dealing with many heterogeneous agents. Another alternative is to construct dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium
Dynamic stochastic general equilibrium modeling is a branch of applied general equilibrium theory that is influential in contemporary macroeconomics...
(DSGE) models with heterogeneous agents, which is difficult, but is becoming more common (Ríos-Rull, 1995; Heathcote, Storesletten, and Violante 2009; Canova 2007 section 2.1.2).
Chang, Kim, and Schorfheide (2011) make a point similar to that of Kirman, in the context of a DSGE model where agents are heterogeneous because of uninsured labor income risk. They estimate a representative-agent DSGE model on the basis of the aggregate data implied by their heterogeneous-agent economy, and show that the estimated coefficients are inconsistent with the true parameters of the heterogeneous economy. They point out that
- 'Since it is not always feasible to account for heterogeneity explicitly, it is important to recognize the possibility that the parameters of a highly-aggregated model may not be invariant with respect to policy changes.'
Literature
- Mauro Gallegati and Alan P. Kirman (1999): Beyond the Representative Agent, Aldershot and Lyme, NH: Edward Elgar, ISBN 1-85898-703-2
- James E. Hartley (1996): 'Retrospectives: The origins of the representative agent', Journal of Economic Perspectives 10: 169-177.
- James E. Hartley (1997): The Representative Agent in Macroeconomics. London, New York: Routledge, ISBN 0-415-14669-0
- Alan P. Kirman (1992): 'Whom or what does the representative individual represent?' Journal of Economic Perspectives 6: 117-136.
- Lucas, Robert E. (1976): 'Econometric policy evaluation: A critique', in K. Brunner and A. H. Meltzer (eds.) The Phillips Curve and Labor Markets, Vol. 1 of Carnegie-Rochester Conference Series on Public Policy, pp. 19-46, Amsterdam: North-Holland.
- Ríos-Rull, José-Víctor (1995): 'Models with heterogeneous agents', Chapter 4 in T. Cooley (ed.) Frontiers of Business Cycle Theory, Princeton University Press.
- Douglas W. Blackburn and Andrey D. Ukhov (2008): 'Individual vs. Aggregate Preferences: The Case of a Small Fish in a Big Pond', Available at SSRN: http://ssrn.com/abstract=941126
- Jonathan Heathcote, Kjetil Storesletten, and Giovanni L. Violante (2009), 'Quantitative Macroeconomics with Heterogeneous Households', Annual Review of Economics 1, 319-354.
- Fabio Canova (2007): Methods for Applied Macroeconomic Research. Princeton University Press.
See also
- Agent (economics)Agent (economics)In economics, an agent is an actor and decision maker in a model. Typically, every agent makes decisions by solving a well or ill defined optimization/choice problem. The term agent can also be seen as equivalent to player in game theory....
- Homo economicusHomo economicusHomo economicus, or Economic human, is the concept in some economic theories of humans as rational and narrowly self-interested actors who have the ability to make judgments toward their subjectively defined ends...
- Aggregate demandAggregate demandIn macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...
- Aggregation problemAggregation problemAn aggregate in economics is a summary measure describing a market or economy. The aggregation problem refers to the difficulty of treating an empirical or theoretical aggregate as if it reacted like a less-aggregated measure, say, about behavior of an individual agent as described in general...