In response to some comments, I’ve written a little bit about the representative agent assumption in Dynamic Stochastic General Equilibrium Models. I argue that, given the underlying DSGE assumptions, you won’t get very much extra by including heterogeneous agents.
But, I intend to say in the “Where next” section, it seems likely that heterogeneous and boundedly rational individuals, interacting in imperfect and incomplete markets will generate ’emergent’ macro outcomes that are not obvious from the micro foundations. Of course, this is going to be a prospectus for a theory, not the theory itself.
In the meantime, comments on my snippet would be much appreciated.
Commonly, though not invariably [in DSGE models], it was assumed that everyone in the economy had the same preferences, and the same relative endowments of capital, labour skills and so on, with the implication that it was sufficient to model the decisons of a single ‘representative agent’. This assumption has attracted a lot of criticism, and quite a few critics have suggested that models that take account of individual differences in tastes and endowments would yield more realistic results.
Such criticisms are somewhat off the point in relation to micro-based macro models. As long as the agents in such a model are rational optimizers in the standard sense of neoclassical microeconomics, any initial differences in tastes or endowments will be evened out by trade in competitive markets. In a standard market equilibrium, everyone will have the same preferences ‘at the margin’, namely the preferences given by market prices. If, for example, the market price of oranges is twice the market price of apples, then market equilibrium requires that everyone who trades in that market should be willing, at the margin, to trade two apples for an orange, regardless of whether they prefer to consume a lot of apples and a few oranges, or vice versa. In standard micro-based macro models, this means that not much is lost by aggregating all the participants in a market, and then working with an average or ‘representative’ agent.