Download Principles of Modern Economics: A Sketch

Principles of Modern Economics: A Sketch
Classical Theory
Modern “micro-economics” is also referred to as “neo-classical” theory, since it
represents developments of “classical” theory, the theory put forward by Adam Smith,
Thomas Malthus, Jean Baptiste Say, Ricardo and J.S. Mill. But it is important to see
that the innovations of the neo-classical theory (to be sketched below) did not alter
fundamentally the framework assumptions of the classical theory.
A number of “laws” were articulated by the “classical” writers. We identify the central
ones.
1.
The Law of the Market.
As Adam Smith put it: “The price of every particular commodity is regulated by the
proportion between the quantity which is actually brought to the market, and the demand
of those who are willing to pay the natural price of the commodity” (Smith, Wealth of
Nations, 1776).
2.
The Iron Law of Wages.
In Ricardo’s formulation: “The natural price of labor is that price which is necessary to
enable the workers one with another, to subsist and to perpetuate their race with either
increase of diminution” (Principles of Political Economy, 1817).
3.
Law of Rents.
Again, quoting Ricardo: Where here is “an abundance of rich and fertile land, on the
common principles of supply and demand, no rent could be paid …for nothing is given
for the use of air and water, or any other of the gifts of nature which exist in boundless
quantity. It is only, then, because land is not unlimited in quantity and uniform in quality,
and because of the progress of population, land of an inferior quality, or less
advantageously situation, is called into cultivation, that rent is ever paid for the use of it”
(ibid.).
4.
The Laws of Population
According to Malthus, “population is necessarily limited by the means of subsistence,”
“population invariably increases where the means of subsistence increases unless
prevented by some powerful and obvious checks,” and “these checks are all resolvable
into moral restraint, vice, and misery” (Essay on the Principle of Population, 1798).
5.
Say’s Law.
Aggregate demand and aggregate supply are not independent of each other, because the
component demands come from the supplies of other industries. If therefore these
supplies increase, aggregate demand increases; if they decrease, aggregate demand
decreases. Hence in perfect competition, over production is impossible (paraphrased from
Say, Treatise on Political Economy, 1803).
6.
The Law of Diminishing Returns
As Nassau Senior put it with special reference to agriculture: “That, agricultural
Skill remaining the same, additional labor employed on the land within a given district
produces in general a less proportionate return, or, in other words, …though with every
increase in labor bestowed, the aggregate return is increased, the increase of the return is
not in proportion to the increase of labor” (Senior, 1836).
From these “Laws,” two very different “visions” were produced:
The Pessimistic Vision (leading the idea that political economy was “a dismal
science.”)
Because of the Law of Markets (1), increasing population will lead in the long run
to decreasing real wages until subsistence is reached (Law 2), checking population
growth by vice and misery (Law 4). Similarly, diminishing returns on agriculture (Law 6)
under increased population leads to every increasing disparity between the size of the
population and output. Finally, with increasing population, additional and increasingly
poor land is called into use, increasing rents to the point that even subsistence wages are a
burden and entrepreneurial initiative is halted (Law 3).
The Optimistic Vision
Because of the Law of Markets (1), increased population will lead to decreased
labor costs ( Law 2), diminishing the costs of production, increasing profits, and
stimulating investment. In turn, increased production following from increased capital
investment creates effective demand, preventing a general glut and increasing the
national wealth (Say’s Law): “…in proportion as capital is accumulated, the absolute
share of the total product falling to the capitalist increases, and his proportional share is
diminished: while both the absolute and relative share of the product, falling to the
laborer is augmented….If this law is established, the obvious deduction is a harmony of
interests between laborers and those who employ them” (Bastiat, The Harmonies of
Political Economy, 1860).
In either case, since the “Laws” were seen as immutable, optimists and pessimists
shared in the view that little could be done to alter outcomes. To be, for the optimists who
came to dominate thinking, interference of any sort was genuinely pernicious!!
The “argument” of the Optimists continues to be maintained by so-called “supplyside” theory—best articulated in popular terms by Presidential candidate Stephen Forbes.
As we shall see, the center of the Keynesian position is rejection of Say’s Law, but as
Schumpeter(History of Economic Analysis: Oxford) says, the main thrust of modern neoclassical theory is fundamentally classical and optimistic.
The Neo-Classical “Revolution”
This turns on the development (in the 1870s) of the concept of “marginal
utility,” the idea that
(a) There are different categories of “wants” which define “goods” and which can
be subjectively arranged, and
(b) Within each category there is a definite sequence of want-satisfactions for a
additional increments (marginal addition) of each good.
Given then “the marginal utility of a thing to anyone diminishes with each
increase in the amount of it he already has” (law of diminishing marginal utility), we can
deduce that:
In order to secure the maximum of satisfaction from any good that is capable of
satisfying different wants (including, critically, labor, money or anything else), an
individual (or firm) must allocate it to these different uses in such a way as to equalize its
marginal utility in all of them. (The use of calculus as a tool enables us to treat additional
“units” as finite but infinitely small. )
The foregoing generalization separates classical from neo-classical theory in that
the concept can be applied to both the demand and supply side. On the demand side,
consumers rationally allocate “budgets” so as to equalize the marginal utilities; on the
supply side, producers allocate “factors” of production to equalize marginal utilities.
Thus, workers and capitalists each receive exactly what they contribute as their marginal
product. The wage, then, will equal the marginal product that the last worker adds to the
output.
(From Pareto on, the assumption that utilities were cardinal was dropped (they are
not additive); the Marshallian condition of maximizing satisfactions (price-ratio = ratios
of mu’s) is replaced with price ratio = rate the consumer can substitute one for other (of
two goods) without gaining or losing satisfaction: generating so-called “indifference
curves.”)
General Equilibrium Theory
Daniel Hausman distinguishes ‘equilibrium theory’ from ‘general equilibrium theory.’
Equilibrium theory may be defined in terms of the following (presumed ‘laws’). These
comprise the core of mainstream micro-economics:
1. For any individual A and any two options x and y, one and only one of the following
is true: A prefers x to y, A prefers y to x, A is indifferent between x and y.
2. A’s preferences among options are transitive.
3. A seeks to maximize his or her utility where the utility of an option x is greater
than the utility of an option y for A if and only if A prefers x to y. The utilities of
options are equal just in case the agent is indifferent between them.
4. If option x is acquiring commodity bundle x’ and option y is acquiring commodity
bundle y’ and y’ contains at least as much of each commodity as x’ and more of at
least one commodity, then all agents prefer y to x.
5. The marginal utility of a commodity c to an agent A is a decreasing function of the
quantity of c that A has.
6. When we increase an inputs into production, other things being equal, output
increases, but, after a certain point, at a decreasing rate.
7. Increasing all inputs into production in the same proportion increases output by
8.
that proportion. The production set is weakly convex and additive.
Entrepreneurs or firms attempt to maximize their profits.
Most (all?) economists would concede that none of the foregoing, at least without severe
qualifications, are true.1 People are not rational in the relevant sense, decisions about
preferences are not made pairwise, firms do not usually maximize profits, transaction costs
are totally ignored, etc., etc.2
General equilibrium theory adds a host of (sometimes unspecified) additional
‘assumptions.’ These are easily as dubious as the foregoing ‘laws.’ For example, one needs
to assume that there are many buyers and sellers in every market, that each may enter and
leave easily, that everyone has the relevant informa tion, that there is an interdependence
among the many markets, that commodities (including labor) are infinitely divisible, etc.
(This last is critical insofar as calculus is the indispensable tool for writing and solving
simultaneous equations which define equilibrium. Does, e.g., labor have a marginal
product?)
Equilibrium is, by definition, a condition of efficiency (‘getting the price right’).
Efficiency is Pareto optimality. ‘A distribution of goods or a scheme of production is
inefficient when there are ways of doing still better for some individuals without doing any
worse for others.’ ’ We can separate the two components here. Production is efficient when
there is no way to produce more of some commodity without producing less of another.
Since, however, there is ‘consumer sovereignty’ where markets are competitive, consumers
have decided on the bundle to be produced. But since we are at equilibrium, the distribution
will also be efficient: There will be no distribution which improves the circumstance of at
least one with someone’s situation being worsened. But is easy to show that there are many
different distributions which are “efficient,” and not all are to everyone’s advantage.
Economists often argue that if an actual market is not working out to everyone’s advantage,
that is because the conditions of the market are not being satisfied. Perhaps somebody is
behaving irrationally, a price is being arbitrarily enforced, etc. But even if the economy were
(magically) to be a equilbrium as that is defined in theory, one cannot jump to the
conclusion that everyone is better off than they would be under either some inefficient
arrangement or some alternative efficient arrangement. 3
Market Efficiency
However, it is possible to show that even if the theoretical conditions are met, it is highly
dubious that we will have efficiency. Many different lines of argument are available. One
line of argument regards externalities. Roughly, externalities are side effects, spillover costs
or benefits for third parties. Polluting smoke from a steel mill is a negative externality.
Plainly, with externalities there will be a misallocation of resources. Thus the (real) costs of
producing steel are not included in the supply schedule and thus, social utility is not
optimized. We can introduce a point made earlier about markets. We need to know the type
of property relation to determine if some ‘externality,’ for example, air pollution, is Paretorelevant. This is nowhere a given: it is always decided and raises the question of who
decides?
Second, the Prisoner’s Dilemma shows that two rational economic actors (actors who
satisfy 1-5) need not end up with the best result. One needs to show, accordingly, that such
situations never or rarely arise, e.g., that inflationary pressure is not best explained in terms
of rational strategies pursued by workers and consumers.4
A third line of argument is Arrow’s paradox. On the neoclassical view, we have
individual preferences which via the mechanism of the market result in a social preference.
Arrow established a series of conditions, ‘social choice functions,’ which restrict ways that
the social preference could be derived from individual preferences. All are fairly obvious:
rationality, the idea that as more people prefer some alternative, then this alternative ought
not to lose ground as a social preference, that ‘irrelevant alternatives’ must be independent,
and ‘non-dictatorship,’ that no individual’s preference automatically defines social
preference. The independence condition says that ‘the social choice made from any environment depends only on the orderings of individuals with respect to alternatives in that
environment.’ (This precludes substitutes and duplicates and is assumed in 1. above.) Arrow
demonstrated that ‘no social choice function fulfilling these conditions could guarantee
satisfactory results when there were more than two individuals in the society and more than
two alternatives to choose from’ (Dyke, p. 113). This has implications for democratic
theory; but it shows, I think, now uncontestably, that a fundamental error of equilibrium
theory is the assumption that market behavior consists of simply pairwise choices between
bundles: the assumption of the independence of irrelevant alternatives. Indeed, as Dyke
says, ‘if the market must fulfill the condition of the independence of irrelevant alternatives,
then a market hardly ever exists’ (p. 116).
Finally, the foregoing assumes that efficiency can be defined in terms of exchange
values. But surely this is not a reasonable notion. An economy could produce ‘efficiently’
(as defined above) and wastefully and destructively. Destructive but efficient production
violates the environment, perhaps making it unfit for human life. Wasteful, but efficient
production generates commodities which fail to serve human needs and wants, or fails to do
so as well as it might. Star Wars technology is a good example of the former; poor quality
housing an example of the latter. But, of course, since, contrary to neo-classical theory,
consumers are not sovereign, this is to be expected.
The Keynesian “Revolution”
Despite what may be excusable confusion, Keynes was no radical in his theorizing,
conserving almost all the elements of the legacy derived from Marshall and Pigou. Most
critical was his demolition of Say’s law, the idea that in competitive markets a general glut
or unemployment could not occur.5 Presumably, where commodity and labor markets are
perfectly competitive, a wage reduction expands employment which expands consumption.
There would be always a wage rate, not matter how low, which produced full employment.
This is Keynes’s summary of his rejection of this idea:
When employment increases, aggregate real income is increased. The psychology of the
community is such that when aggregate real income is increased aggregate consumption
is increased, but not so much as income. Hence employers would make a loss if the
whole of the increased employment were to be devoted to satisfying the increased
demand for immediate consumption. Thus, to satisfy any amount of employment there
must be an amount of current investment sufficient to absorb the excess of total output
over what the community chooses to consume when employment is at the given level.
For unless there is this amount of investment, the receipts of entrepreneurs will be less
than is required to induce them to offer the given amount of employment. If follows,
therefore, that, given what we shall call the communities propensity to consume, the
equilibrium level of employment...will depend on the amount of current investment. The
amount of current investment, in turn, will depend on what we shall call the inducement
to invest; and the inducement to invest will be found to depend on the relation between
the schedule of the marginal efficiency of capital and the complex rates of interest on
loans of various maturities and risks.
...There is no reason in general for expecting [the equilibrium level of employment]
to be equal to full employment. The effective demand associated with full employment is
a special case, only realized when the propensity to consume and the inducement to
invest stand in a particular relationship to one another... But it can only exist when, by
accident or design, current investment provides an amount of demand just equal to the
excess of the aggregate supply price of the output resulting from full employment over
what the community will choose to spend on consumption when it is fully employed.
The now familiar state policies follow: Governments can affect total spending and total
employment either by monetary policies, which lower interest rates (e.g., increasing the
supply of money) or fiscal policies which expand total spending by increasing public
spending, without raising taxes, or decreasing taxes without reducing public spending or by
both increasing government spending, through increasing the public debt, and decreasing
taxes, the policy of Ronald Reagan. The lynchpin of Keynesian “fine tuning” is a
sufficiently large amount of government spending, best achieved, for political reasons,
through defense spending (War-Keynesianism).
Peter T. Manicas
For class use
1.
In addition to Karmarck, Economics and the Real World (handout), for some exceptional doubt offered by
the discipline's most leading lights, see the AEA Presidential Addresses of Wassily Leontieff, `Theoretical
Assumptions and Nonobserved Facts,' American Economic Review, 61 (1971), James Tobin, `Inflation and
Unemployment,' Ibid., 62 (1972), and Robert Solo, `On Theories of Unemployment,' Ibid., (1980). Similar
themes have been expressed by other notable insiders, e.g., Lester Thurow, Dangerous Currents (New York:
Random House, 1983) and (Lord) Thomas Balough, The Irrelevance of Conventional Economics (New York:
Liveright, 1982).
A heroic approach is well articulated by unreconstructed positivists who deny that the forgoing are
'laws' and argue that a model need have any reality to be both explanatory and predictive. That is, the key
assumptions need not be true. See Milton Friedman's classic `On the Methodology of Positive Economics'
(1952), reprinted in many places, including Hausman, op. cit. But putting aside the question of how false
premises could be explanatory, it is quite clear that modern micro-economic theory is not predictive, and thus
fails even in the instrumentalist terms accepted by positivists.
Business school professionals are also usually critical as regards the usefulness of micro-economic
models. For some examples, see Alfred R. Oxenfeld (ed.), Models of Markets (New York: Columbia
University Press, 1963). For example, `market models admit time considerations only in a limited and
contrived manner...But investment represents the concern of major executives, rather than clerks, for the very
reason that markets are dynamic and are buffeted by many forces that vary over time...In other words,
executives who are estimating of the pattern of revenues and costs over the life of an investment--and the
length of its life--get relatively little help from market models of price theory' (p. 63).
2.
R.H. Coase has famously argued that the existence of transaction costs `implies that methods of
coordination alternative to the market, which are themselves costly and in various ways imperfect, may
nonetheless be preferable to relying on the pricing mechanism, the only method of co-ordination normally
analysed by economists' ('The Institutional Structure of Production,' in Coase, Essays on Economics and
Economists (Chicago: University of Chicago Press, p. 8). This was Coase's 1991 Nobel Laureate Address. The
view just summarized was a major reason for his prize. Tr ansaction's costs, e.g., contracts to be drawn up,
inspections to made, arrangements to settle disputes, processing costs, are the least of it. Notice Coase's
assumption that the market is what is defined by neo-classical price theory.
3.
Rawls's important work on justice connects here. For him any just system must be efficient (and hence must
have market arrangements which satisfy the constraints of general equilibrium theory). But he examines four
efficient arrangements. We sketch the three most interesting: `In the system of natural liberty the initial
distribution is regulated by the arrangements implicit in the conception of careers open to talents' (or formal
equality of opportunity) (p. 72). On the `liberal interpretation,' `fair equality of opportunity'(or substantive
equality of opportunity) replaces `careers open to talents.' The `democratic interpretation' adds to fair equality
of opportunity, `the difference principle.' This identifies one Pareto-optimality, a condition in which
inequalities are justified only insofar as the least advantaged are better off than they would be under any
alternative arrangement. The argument against equality is that because equality would be inefficient, the worst
off are better off in an efficient system which satisfies the difference principle. Rawls argues that in a counterfactual `original position,' `rational' individuals would not, accordingly, choose equality, but would choose his
two principles of justice.
Rawls allows that a market socialism could be just in his terms. Following a line of arguement
developed by Barone and then Schumpeter (Capitalism, Socialism and Democracy, 19 ), Rawls distinguishes
the allocative and distributive functions of markets. Assume then that all institutions are as they are, except
that their are no capitalists. Corporations are publically owed and 'profits' are collected as taxes. Remaining
are labor and commodity markets. A 'budget' office functions to distribute including making decisions about
resources for savings, consumption, etc.
4.
See C. Dyke, Philosophy of Economics (Englewood Cliffs: Prentice-Hall, 1981), for a very useful
introduction to this topic and the next. I draw on his account.
5.
The `law,' named for Jean Baptiste Say (1803?) was a lynchpin of both classical and neo-classical theory. In
Ricardo's crisp formulation: `No man (sic) produces but with view to consume or sell, and he never sells but
with an intention to purchase some other commodity...By purchasing them, he necessarily becomes either the
consumer of his own goods, or the purchaser and the consumer of the goods of some other person...
Productions are always bought by productions, or by services...' Quoted from Robert Lekachman, `How
Useful is Keynes Today?,' in Lekachman, Keynes and the Classics (Boston: D.C. Heath, 1964). This is most
useful introductory volume.