History of economic thought 4 General equilibrium , theories of growth

1. History of economicthought 4General equilibrium, theories of growth Bernard Chavance ABIK, June 2010

2. AN ambitious program for neoclassicaleconomics • Hicks, Value and capital,1939 • K. Arrow and G. Debreu, ‘The Existence of an Equilibrium for a Competitive Economy’, Econometrica, 1954 • G. Debreu, The Theory of Value: An axiomatic analysis of economic equilibrium, 1959 • K. Arrow and F. Hahn, General Competitive Equilibrium, 1971

3. Kenneth Arrow (b. 1921)

4. Gérard Debreu (1921-2004)

5. ‘Nobel Prize’ in economics • A prize of the Bank of Sweden ‘in memory of Alfred Nobel’ • Arrow, 1962 • Debreu, 1983

6. Rediscovering Walras • A problematic of General equilibrium, different of Marshall’s approach of partial equilibrium • The question of general interdependence of markets • The simultaneous equality of supply and demand on all markets • Three main questions: existence, uniqueness and stability of equilibrium

7. Main hypotheses • Rational economic agents: • Consumers want to maximize their utility • Producers want to maximize their profits • Preferences of consumers are given • Perfect competition: no agent can influence prices, they are all « price-takers » • Constant returns to scale • A « market participant » or « market secretary » centralizes all information and sets prices through a trial-and-error process

8. A complete system of future contingent markets • A surprising hypothesis of contingent markets • Setting all contracts for the future period at t0 • The case of ‘an umbrella bought on October 1st and deliverable in Cambridge on December 31st if it rains’ • A method to introduce time … at the same time denying it… • Reducing dynamics (evolution in time) to statics (equilibrium without time)

9. A mathematical formulation and demonstration • Importance of mathematics in neoclassical economics, from the 1940-1950s • Walras demonstration of general equilibrium was: as many equations as variables, result in one solution (linear algebra) • Referring to new mathematics • Topology • Fixed point theorem

10. A grand theory • Existence of general equilibrium is demonstrated • The theory may be refined and extended in diverse directions • General equilibrium of perfect competition is a Pareto optimum (the most efficient situation possible for the economy, where all agents get the maximum compatible returns) • Welfare economics theorem: a general equilibrium is a Pareto optimum

11. The implicit normative stance of neoclassicaltheory • General equilibrium does not exist in the real world • Comparing « imperfect » historical situations with the abstract (perfect) ideal of general equilibrium and Pareto optimum • Policy conclusions: reduce the gap between the imperfect economic state of affairs and the ideal state demonstrated by the theory • Neoclassical theory thus gives a strong confidence to its followers, who believe they do know what should be the best solution to economic problems

12. DISTURBING conclusions: Internalproblems • The existence of general equilibrium mathematically demonstrated (initial brilliant success) • … but later questioned (Debreu-Sonnenschein-Mantel theorem, 1972-74) • Uniqueness not demonstrated • Stability not demonstrated

13. Arrow & Hahn, 1971 • Book General Competitive Equilibrium: a general summary of the theory • Underline the problem of abstracting from money and uncertainty • Difficulty to integrate the government and monopolies

14. External critiques • Total absence of realism of hypotheses (perfect competition, full and transparent information, market participant, future contingent markets, no increasing returns …) • A moneyless economy • No uncertainty • No conflicts • A paradox of a centralized system (with a central coordinator) to describe a decentralized, market economy • Confusing formalization with scientific rigour

15. Theories of economicgrowth

16. Harrod-domar model • Roy Harrod: a young colleague of Keynes • Extending the macroeconomic approach to the question of growth • Natural and warranted rates of growth • Conclusion: growth is likely to be very unstable • A « knife-edge » path of growth

17. The standard neoclassical model (Solow, 1956) • Robert Solow (‘Nobel’ Prize in 1987) • The aggregate production function : Y = f (K, L) • The stability of the growth path is maintained through the flexibility of factors’ prices • The principal engine of growth is technical progress • … but the latter is supposed to be exogenous (to be generated outside the economy) R

18. Robert Solow (‘Nobel’p. 1987)

19. Equilibriumthrough time • The concept of ‘balanced’ growth • … or how to keep equilibrium through time • … an extension of the general equilibrium approach

20. Three conclusions of the neoclassicalgrowth model • 1. increasing capital relative to labor produces economic growth, as people can be more productive given more capital • 2. poor countries with less capital per person will grow faster than rich countries with ample capital : catching-up • 3. because of diminishing returns to capital, economies will eventually reach a point at which no new increase in capital will create economic growth : ‘steady state’

21. Kaldor and economicgrowth • Explaining « stylised facts » of growth (in the 1950s): • Steady growth of production in volume, and of labor productivity • Steady increase in K/L • Stability of the profit rate on capital • Stability of distribution (wages/profit shares) • Significant differences in the growth of labor productivity and of production in different countries

22. Kaldor’s contribution • The role of distributional conflicts in stabilizing economic growth • Cumulative and circular causality: chain reactions in economic development • Virtuous and vicious circles: back to unequal development • A criticism of neoclassical growth theory • « The irrelevance of equilibrium economics » (1972)

23. Endogenousgrowththeory • Paul Romer, Robert Lucas • A renewed neoclassical approach, referring to the aggregate production function • Growth is endogenous, it is generated from within the economic system • The role of Research and Development, of education, of innovation, of infrastructures • Human capital matters, it has increasing rates of return • Restoring a role for the economic intervention of the state

24. Institutional change • … as a source of economic growth • … developed in the works of Douglass North • … see lectures about « Institutional Economics » !