2 - The Lucas Critique and Representative Agents

Summary

The Lucas critique is valid, but the Lucas solution developed by mainstream macroeconomics represents an abject failure. Heroic aggregation assumptions are embodied in the creation of a representative agent: even if individual preferences could be taken as well-defined, exogenous, and stable over time, the celebrated Sonnenschein-Debreu-Mantel results show that microeconomic rationality imposes only very weak constraints on the properties of aggregate excess demand functions. Using simple examples, this chapter illustrates how restrictive assumptions are needed to ensure the existence of a representative agent and discusses the implausibility of these conditions being approximately satisfied. The chapter also questions the utility function of the representative agent as the basis for welfare analysis. Although supposedly ‘natural’ and ‘objective’, this approach imparts a systematic bias against the poor and in favor of the rich. As a corollary, moreover, changes in the distribution of income renders the representative agent’s utility function unstable; the Lucas solution is subject to a Lucas critique.