John Muth - Holt, Modigliani, Muth, and Simon (1960)

Holt, Modigliani, Muth, and Simon (1960)

Two divergent approaches to economic modeling, which have later become cornerstones of modeling of economic systems, originated at the Graduate School of Industrial Administration (GSIA) at Carnegie Mellon in the late 1950s and early 1960s. At the same time as John Muth was developing the concept of rational expectations, Herbert A. Simon had been refining his ideas on bounded rationality, emphasizing people's limited computational abilities.

Together with their two colleagues at GSIA Charles C. Holt and Franco Modigliani, Muth and Simon collaborated on a book on problems of production scheduling and inventory management for the firm. Their goal was to derive tractable, operational rules that could easily be applied in practice. Rather than a coincidence that the two apparently contradictory approaches to economic modeling were developed at GSIA at the same time, it is more likely that fruitful interaction in the quest to answer a common set of problems led the two researchers to two different solutions.

In an earlier work, Herb Simon had shown that with quadratic costs and under a certain set of assumptions about the probability distributions, optimal decision rules for production and inventories would be linear functions of the variables describing the state. In his model, firms only needed to take into account the expected value and ignore all higher moments of the probability distribution of future sales. This result, known as certainty equivalence, drastically reduces the computational burden on a representative decision maker.

Simon's result that decision makers only focus on expected values of stochastic variables was very sensitive to the assumed structure of the problem, hence indirectly on the formulation of expectations. This lack of a general theory of expectations was an unsatisfactory state of affairs and proved to be key in Muth's approach to solve the problem which has often been termed interaction between expectations and reality. In his article from 1961, Muth writes: "To make dynamic economic models complete, various expectational formulas have been used. There is, however, little evidence to suggest that the presumed relations bear a resemblance to the way the economy works."