Lecture Eleven

1. Lecture Eleven Critiques of Economics

2. Dogma versus Debate • Economics differs from “hard sciences” • Normally at least two rival schools • In classical period • Smith, Ricardo, Malthus: objective theory of value • Say (and others): subjective theory • In neoclassical period • Neoclassical • Austrian (anti-equilibrium analysis) • Post Keynesian, Evolutionary, Institutionalist, Marxian, Econophysics… • One dominant, others marginalised but still “professional” • i.e., represented by academic economists rather than “cranks”

3. Dogma versus Debate • Physical sciences normally have just one school of thought • Fundamental concepts agreed upon • Physicists differ by their specialisations only • Except during periods of “paradigm change” • E.g., today, all physicists accept Quantum mechanics, Relativity, & Thermodynamics as fundamental • Then specialise in different aspects • But Quantum mechanics & Relativity are in conflict… • Different schools compete here to try to resolve conflict • String theory was dominant • Failure to produce refutable experiment causing other approaches to arise • Competing “Scientific Research Programs” arising, as Lakatos argued • But agreement on fundamental concepts, and different schools read each others papers…

4. Dogma versus Debate • Different schools of thought in economics • Don’t agree of fundamentals • Generally don’t read each others papers • But asymmetric: • members of some non-mainstream schools do read mainstream papers to critique them; • most mainstream economists don’t read (or even know about) non-mainstream theories • So there is critique, but rarely debate • Many disputes really contests over “theory of value” • One school disputes “hard core” of the other • Critique really is re-phrasing of one school’s core beliefs in terms of the others • Necessarily incompatible

5. Dogma versus Debate • E.g., “Diamond-Water paradox” • Diamonds comparatively useless, but high price • Water very useful, but low price: • “The things which have the greatest value in use have frequently little or no value in exchange; • and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. • Nothing is more useful than water: but it will purchase scarce anything; • scarce anything can be had in exchange for it. • A diamond, on the contrary, has scarce any value in use; • but a very great quantity of other goods may frequently be had in exchange for it.” (Smith, Wealth of Nations, Book I)

6. Dogma versus Debate • Neoclassical/subjective theory of value explanation • Marginal utility of diamonds much higher than water • Alleged classical/objective theory had no explanation • But classical school did have a “labour-value” solution: • Diamonds much scarcer than water • More effort needed to produce them • Effort to mine diamonds vs effort to draw water explains relative prices • Both sides rejected each other’s explanation • At issue is incompatibility of “hard core” beliefs • Significant disputes are about internal consistency • Most prominent early critique: Neoclassical/Austrian critiques of labour theory of value

7. Bohm-Bawerk & the transformation problem • Labour theory of value asserts • Surplus Value comes from labour only • Surplus Value is the only source of profit • Assumes rate of surplus value constant across industries • No real explanation as to why… • Assumes tendency for rates of profit to equalise across industries • Desire for maximum return will cause capitalists to move capital from low to high return industries • But ratio of “constant capital” (commodity input) to “variable capital” (labour) differs between industries • So rates of profit should differ…

8. Bohm-Bawerk & the transformation problem • How to make values consistent with equalised rates of profit? • Engels promised Marx would provide solution in Volume III of Capital (edited by Engels & published after his death) • Marx’s “solution” was a pair of tables • One with values, different amounts of surplus and differing rates of profit • Other with values, same amounts of surplus and same rate of profit • Sum of rows and columns the same. • Just arithmetic, not analysis • First major evaluation made by Austrian economist Eugene von Böhm-Bawerk:

9. Bohm-Bawerk & the transformation problem • “I cannot help myself: I see here no explanation and the reconciliation of a contradiction, but the bare contradiction itself. • Marx's third Volume contradicts the first.” • (Karl Marx and the Close of His System, p. 30.) • Transformation problem still debated today • By remaining groups trying to preserve labour theory of value (mainly TSS School: “Temporal Single System”) • Failure of Marx & successors to solve problem assisted decline of Classical School, rise of Neoclassical in late 19th century • And it had its critics…

10. Veblen & “evolutionary science” • Neoclassical theorists had ambitions to be dynamic & evolutionary: • “The main concern of economics is thus with human beings who are impelled, for good and evil, to change and progress. • Fragmentary statical hypotheses are used as temporary auxiliaries to dynamical—or rather biological—conceptions: but • the central idea of economics, even when its Foundations alone are under discussion, • must be that of living force and movement.” (Marshall, Principles, p. 22) • But in practice, never moved beyond static analysis • Thorstein Veblen posed question “Why not?”:

11. Why is economics not an evolutionary science? • Veblen • “father” of institutional economic thought • Co-developer of evolutionary economics (Schumpeter) • In 1898, scathing critique of neoclassical economics: • “Why is economics not an evolutionary science?” • Argued that • True sciences seek explanation of actual phenomena in terms of cause and effect • Neoclassical theory instead based on ideal ideas of what behaviour should be • Therefore unable to explain what is observed except as exceptions to what should be observed • Rather than explaining what is observed • proposes idealised interpretations of what should be observed…

12. Why is economics not an evolutionary science? • E.g., Money: “should be” only a medium of exchange • Actual role of money in society not really analysed; just figure of speech “medium of exchange” asserted: • “it is this facile recourse to inscrutable figures of speech as the ultimate terms of theory that has saved the economists from being dragooned into the ranks of modern science… • By their use the theorist is enabled serenely to enjoin himself from following out an elusive train of causal sequence. • He is also enabled, without misgivings, to construct a theory of such an institution as money … without descending to a consideration of the living items concerned, • except for convenient corroboration of his normalised scheme of symptoms.” (p. 383) • Veblen’s opinion of theory of individual as a utility-maximiser:

13. Why is economics not an evolutionary science? • “The hedonistic conception of man is that of a lightning calculator of pleasures and pains • who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact. • He has neither antecedent nor consequent. • He is an isolated definitive human datum, in stable equilibrium except for the buffets of the impinging forces that displace him in one direction or another. • Self-imposed in elemental space, he spins symmetrically about his own spiritual axis until the parallelogram of forces bears down upon him, whereupon he follows the line of the resultant. • When the force of the impact is spent, he comes to rest, a self-contained globule of desire as before…” (p. 389)

14. Why is economics not an evolutionary science? • Veblen on equilibrium reasoning: • ‘Professor Marshall’s work… remains an inquiry directed to the determination of the conditions of an equilibrium… • It is not … an inquiry into … institutional development … • it is the movement of a consummately conceived and self-balanced mechanism, • not that of a cumulatively unfolding process or an institutional adaptation to cumulatively unfolding exigencies.’ (1919: 173) • The neoclassical view of dynamics is that • “The more ‘dynamic’ the society, • the nearer it is to the static model; • until in an ideally dynamic society, with a frictionless competitive system … • the static state would be attained…” (1919: 190)

15. Why is economics not an evolutionary science? • What should economics really be? • “the theory of a process of cultural growth as determined by the economic interest, • a theory of a cumulative sequence of economic institutions stated in terms of the process itself.’ • It would attempt “to trace the cumulative working out of the economic interest in the cultural sequence. • It must be a theory of the economic life process …” • Neoclassical economics can’t do this because: • “a hedonistic psychology … does not afford material for a theory of the development of human nature… • It is therefore not readily apprehended or appreciated in terms of a cumulative growth of habits of thought…” (p. 163-64)

16. Why is economics not an evolutionary science? • Reception of Veblen by neoclassical economists set standard for later debate between opposing schools: • deny that opponents are economists… • “As to the merits of his work, opinions differ more widely and more fervently than on any other writer of equal prominence. • He is rated among the great economists of history, or as no economist at all; • as a great original pioneer or as a critic and satirist without constructive talent or achievement. • And he was, one might almost say, all of these things; from different standpoints and by different criteria, each of which it is possible to understand and even to appreciate.” (John Maurice Clark, AER obituary for Veblen, 1929, p. 747)

17. Sraffa and “discarding Marshall’s theory” • Veblen dismissive of entire neoclassical vision • Next major critic back on logical soundness of one neoclassical argument: the upward-sloping supply curve: • “I am trying to find what are the assumptions implicit in Marshall’s theory; if Mr. Robertson regards them as extremely unreal, I sympathise with him. • We seem to be agreed that the theory cannot be interpreted in a way which makes it logically self-consistent and, at the same time, reconciles it with the facts it sets out to explain. • Mr. Robertson’s remedy is to discard mathematics… • in the circumstances, I think it is Marshall’s theory that should be discarded.” (Sraffa 1930, p. 93)

18. Sraffa and “discarding Marshall’s theory” • Sraffa’s argument • Basis for rising supply curve is rising marginal cost of production • Rising marginal cost occurs because of diminishing marginal productivity • Marginal productivity falls because • One input to production fixed in short run • One input variable in short run • Adding more of variable input causes less output per additional unit of input • Sraffa disputed assumption of “fixed input” in short run…

19. Sraffa and “discarding Marshall’s theory” • 2 cases • broadly defined industry • e.g., “Manufacturing” • Similarly broad definition for “fixed input” needed • E.g., “Land” or “Capital” • Narrowly defined industry • e.g., “Cardboard boxes” • Similarly narrow definition for “fixed input” needed • E.g., “glue guns” • Sraffa asserted that in either case, assumption undermined concepts of supply & demand analysis • Recap of basic neoclassical idea:

20. Labor cost B Wheat Output C A Wheat Output B A C Labor Input Sraffa and “discarding Marshall’s theory” • Supply curve derived from production function combining • (at least) one fixed input with variable inputs • result: diminishing marginal productivity • productivity may rise as initial variable inputs added • but eventually diminishing productivity sets in Diminishing marginal productivity sole basis for rising marginal cost (variable input cost assumed constant) Flip axes & multiply by wage rate:

21. Sraffa’s Broad critique Diminishing marginal productivity means rising marginal cost, & hence upward-sloping demand curve PF (a) (c) Wheat Fertiliser PW SW MPF (b) (d) P2 D2 P1 D1 Wheat Fertiliser

22. Sraffa’s Broad critique • If broadly define factor/industry, then can regard factor as fixed since attracting additional units difficult • But increasing output of industry will affect incomes of all other industries/factors: • “If in the production of a particular commodity a considerable part of a factor is employed, • the total amount of which is fixed • or can be increased only at a more than proportional cost, • a small increase in the production of the commodity will necessitate a more intense utilisation of that factor, • and this will affect in the same manner the cost of the commodity in question…

23. Sraffa’s Broad critique • and the cost of the other commodities into the production of which that factor enters; • and since commodities into the production of which a common special factor enters are frequently, to a certain extent, substitutes for one another ... • the modification in their price will not be without appreciable effects upon demand in the industry concerned.” (Sraffa 1926) • So demand shifts for each movement along supply curve • Can’t have independent supply and demand curves

24. Sraffa’s Broad critique • Increased usage of fixed resource increases price and changes income distribution • not all land used by agriculture (e.g., fallow, housing) • increased demand for agriculture partly met by switching resources from fallow/housing • prices of land, fertiliser will rise • Supply and demand curves therefore not independent • If not independent, can have indeterminate outcome • No unique “equilibrium” price because demand and supply interdependent

25. Dq2 Dq3 Price/bushel Supply Dq1 ? ? ? Demand Price? (a) Agriculture q3 q2 q1 Wheat Quantity? MPF (b) F Sraffa’s Broad critique Income effects with Broad Definition of Industry Different “demand curve” for every point on supply curve since change in supply changes incomes PL PF PF, PL (c)

26. Sraffa’s Narrow critique • If use narrow definition of industry • (e.g., wheat industry rather than “agriculture”) • Sraffa argued assumption of fixed input much less justifiable • Instead, extra “fixed” input can normally be found if increase supply needed • Increased demand for wheat will mean conversion of land from (e.g.) barley to wheat • Negligible change in cost of land • Fertiliser to land ratio remains constant • Marginal product & thus marginal cost remains constant • Constant cost with narrow definition

27. Sraffa’s Narrow critique • “If we next take an industry which employs only a small part of the ‘constant factor’ • (which appears more appropriate for the study of the particular equilibrium of a single industry), • we find that a (small) increase in its production is generally met much more by drawing ‘marginal doses’ of the constant factor from other industries • than by intensifying its own utilisation of it; • thus the increase in cost will be practically negligible…” (Sraffa 1926)

28. Sraffa’s Narrow critique Constant cost with narrow definition Price of fertiliser unaffected by increased use in wheat production PF (a) (c) Wheat Fertiliser/land ratio held constant at ideal ratio F Horizontal wheat supply curve with constant MPF Supply sets price, demand sets quantity: position of classical school MPF PW (b) (d) D1 D2 Marginal productivity of fertiliser therefore constant P SW Wheat F

29. Sraffa and “discarding Marshall’s theory” • Sraffa’s views debated by profession, but then ignored • From Lakatos perspective “Diminishing marginal productivity” too much a “hard core” belief to allow challenge • Next major critique empirical • Interviews with businessmen found marginal costs constant or falling for most firms • Accidental critique • Originated in “Oxford Study Group” in UK • Intended to help economists & businessmen communicate • Businessmen couldn’t accept economists’ concept of “diminishing marginal productivity” • Economists surveyed business to find out why…

30. The empirical critique • In USA, similar critique arose from WWII rationing • Economists put in charge of price-setting • Key people Gardiner-Means, J.K. Galbraith • Found two different price regimes • Agriculture, raw materials had volatile prices • Manufacturing, services had stable prices • Developed concepts of • “administered prices” • Prices not set by “supply & demand” but by markup on relatively constant average costs of production • “Engineering” explanation for costs • Manufacturing cost structure reflects design of factories to achieve maximum efficiency at maximum output:

31. The empirical critique • E.g., Eiteman & Guthrie 1952 showed managers 8 hypothetical average cost curves: • “6… high at minimum output, … decline gradually to a least-cost point near capacity, after which they rise slightly; • 7… high at minimum output, … decline gradually to capacity at which point they are lowest…” (Eiteman & Guthrie 1952: 835) • 3-5 “neoclassical”: • 3 most like textbook drawing • 6-8 had constant or falling MC: • Text description given to managers as well:

32. The empirical critique Only 18 out of 336 fit neoclassical vision of diminishing marginal productivity, rising marginal cost Almost 2/3rds have lowest unit costs at maximum output

33. The empirical critique • Eiteman’s explanation for these & similar results: • Factories are designed by engineers “so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. • Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. • A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, • a fact that makes it physically impossible for an enterprise to determine a scale of operations by equating marginal cost and marginal revenues.” (Eiteman 1947)

34. The empirical critique • Neoclassical response to this critique: • Friedman’s “Methodology” paper: • “The lengthy discussion on marginal analysis in the American Economic Review some years ago is an even clearer, though much less important, example. • The articles on both sides of the controversy … concentrate on the largely irrelevant question whether businessmen do or do not in fact reach their decisions by consulting schedules, … showing marginal cost and marginal revenue.” • Friedman advised economists to ignore this literature • After making the analogy that billiard players don’t actually use Newton’s mathematics to sink balls…

35. The empirical critique • “ Excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas … , could make lightning calculations from the formulas, and could then make the balls travel in the direction indicated by the formulas. • Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that, unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players.” (Friedman 1953: 21) • This evidence is in part similar to that adduced on behalf of the billiard-player hypothesis--unless the behavior of businessmen in some way or other approximated behavior consistent with the maximization of returns, it seems unlikely that they would remain in business for long.

36. The empirical critique • Let the apparent immediate determinant of business behavior be anything at all--habitual reaction, random chance, or whatnot. Whenever this determinant happens to lead to behavior consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not, the business will tend to lose resources and can be kept in existence only by the addition of resources from outside. • The process of "natural selection" thus helps to validate the hypothesis--or, rather, given natural selection, acceptance of the hypothesis can be based largely on the judgment that it summarizes appropriately the conditions for survival…

37. The empirical critique • “It is only a short step … to the economic hypothesis that … individual firms behave as if … they … calculated marginal cost and marginal revenue … and pushed … to the point at which … marginal cost and marginal revenue were equal. • Now, of course, businessmen do not actually and literally solve the system of simultaneous equations in terms of which the mathematical economist finds it convenient to express this hypothesis… • the businessman may well say that he prices at average cost, with of course some minor deviations when the market makes it necessary. • The one statement is about as helpful as the other, and neither is a relevant test of the associated hypothesis.”

38. The empirical critique • Neoclassical economists behaved “as if” they took Friedman’s advice and ignored this empirical research • Other schools took it seriously—e.g., Post Keynesians • Kalecki, Eichner, Lee-Downward • Developed “cost plus” pricing models • Kornai • Developed “demand-constrained” models to explain why diminishing marginal productivity does not apply • Another sub-school has developed • Experimental Economics • Neoclassical economists continue to be surprised when this empirical information is re-discovered • Blinder 1998 • Next critique after this: Sraffa round two…

39. Sraffa and input-output • In debate over Marshall, Sraffa’s noted inter-dependence of markets: • “and this will affect in the same manner the cost of the commodity in question and the cost of the other commodities into the production of which that factor enters…” • After 1930, Sraffa (based in Cambridge University UK) attempted to state this problem rigorously • Published “Production of Commodities by Means of Commodities: Prelude to a Critique of Political Economy” in 1960 • Argued marginal productivity theory of income distribution invalid • Position disputed by neoclassical economists in Cambridge University, USA: the “Cambridge Controversies”…

40. The “Cambridge Controversies” • Neoclassical theory argues that • increasing supply of factor of production will reduce its price • reducing its price will increase its use in production • Factor’s price equals its marginal product • Direct relationship between supply of factor and its price • Models production as • involving “factors of production” (Land, Labour, Capital) as inputs and goods as outputs • versus classical position: goods produced using goods and labour as inputs • The neoclassical position of profit and capital is…

41. Labour Output Capital Capital The “Cambridge Controversies” Increasing supply… Decreasing price... Diminishing marginal product Increasing use of factor relative to others... Marginal Product Rate of profit is the marginal product of capital… Capital

42. The “Cambridge Controversies” • Sraffa, 1960 • Take economy in full general equilibrium • All “marginal” changes complete • What determines prices in full equilibrium if all marginal changes are over? • Self-reproducing system of commodity production • inputs commodities & labour • output commodities • equilibrium prices of outputs must enable their purchase as inputs in next period • System (1): Simple reproduction, commodity inputs only:

43. The “Cambridge Controversies” • 240 qr wheat + 12 t iron + 18 pigs --> 450 qr wheat • 90 qr wheat + 6 t iron + 12 pigs --> 21 t iron • 120 qr wheat + 3 t iron + 30 pigs --> 60 pigs • 450 qr wheat | 21 t iron | 60 pigs (sum of inputs=sum of outputs) • Regardless of demand, prices must allow system to reproduce itself: • 450 qr wheat must buy 240 qr wheat, 12 t iron, 18 pigs • 21 t iron must buy 90 qr wheat, 6 t iron, 12 pigs • 60 pigs must buy 120 qr wheat, 3 t iron, 30 pigs

44. The “Cambridge Controversies” System of production: As a matrix equation: Has the solution: i.e., price system for simple reproduction independent of demand, marginal utility, etc.; depends instead on system of production

45. Amount of A used to produce B Labor fully employed Amount of B produced +ive net output The “Cambridge Controversies” • System (2): Expanded reproduction • surplus produced, split between capitalists and workers • in equilibrium, uniform rate of profit r, wages w

46. The “Cambridge Controversies” • r & w values determine split of surplus between capitalists, workers. To determine prices, must therefore know either r or w beforehand • Distribution therefore not determined by “market” • Instead, different pattern of prices for every pattern of distribution: marginal productivity theory of income distribution incorrect in general equilibrium • But what about validity of production function, isoquants, when marginal changes still relevant?

47. The “Cambridge Controversies” • Neoclassical position (by Samuelson): • Concedes Classical position more factual • output produced by heterogeneous commodities and labour, aggregate capital an abstraction • But neoclassical position still defensible as an abstraction • Samuelson (for neoclassicals) argues • isoquants just a parable we use to teach students • reality is different technologies, each with fixed ratio of capital to labour • increase in price of capital will lead to less capital intensive technology being chosen:

48. Labour Capital The “Cambridge Controversies” Technology 1: low K/L ratio, used when K expensive “Envelope” is isoquant Technology 5: high K/L ratio, used when K cheap Decreasing price of capital means more capital intensive methods used, akin to simple parable that decreased price means more capital used

49. The “Cambridge Controversies” • As an aside, Samuelson ridicules classical theory’s problems with labour theory of value, that capital-labour ratios must be the same in all industries. • Problem: Samuelson assumes each technology can be represented by a straight line relationship between capital and labour • Garegnani shows that straight line relationship only applies if capital to labour ratio is the same in all industries • If K/L ratios differ, each technology will be represented by a curve, not a straight line • Curves can cut each other in more than one place:

50. Labour Capital The “Cambridge Controversies” Technology 1: low K/L ratio, used when K expensive “Envelope” is isoquant Technology 2: only used in intermediate K/L price range Technology 1: could also be used when K cheap Problem known as “reswitching”: simple neoclassical parabledoes not work when multiple industries considered.