Static Optimization and Economic Theory

Abstract

Optimization occupies a most central place in modern economics. This is due to several reasons. As T. C. Koopmans noted in his 1975 Nobel memorial lecture: “The economist as such does not advocate criteria of optimality. He may invent them.⋯the ultimate choice is made by the procedure of decision making inherent in the institutions, laws and customs of society.” The distinction between positivistic and normative economic behavior is often useful for analytic convenience and many positive behavior may be derived by a process of implicit or subjective optimization. For example the shadow price of a constrained resource may be more realistic in reflecting its scarcity, though it may not always be realized in the actual market price. Secondly, the concept of an optimum may sometimes be replicated by a market equilibrium as in Adam Smith’s theory of “the invisible hand” of a competitive system and one may ask if the price adjustments in the market tend to be equilibriating or not. Even in game theory models, where different players may pursue different and at times conflicting goals, the concepts of cooperative or noncoopertive equilibrium also involve optimization procedures. Recently the models of rational expectations in macroeconomic theory have emphasized specific normative hypotheses which assume that the agents use optimizing decisions in their expectation formation. Lastly, in dynamic situations over time disequilibrium models are increasingly applied in modern empirical economics which involve sequential search towards the dynamic optimum, or various adjustment costs due to errors.