Political Economy: Critique of Neoclassical Economics

1. Wrong answers to the wrong questions: Demand Political Economy: Critique of Neoclassical Economics

2. Why Political Economy? Reject questions asked by mainstream economics Neoclassical economics asks the wrong questions… Assumptions of individual utility/profit maximisation omit social interaction, social conflict, gender issues, etc. Equilibrium hangup ignores dynamic processes… Internally inconsistencies in mainstream economics Provides wrong answers to questions it does ask Demand theory can’t derive downward sloping market curve Profit maximising firms don’t produce where marginal revenue equals marginal cost General equilibrium can’t be in equilibrium… How do neoclassical economists cope?

3. Why Political Economy? Ignore the problem!: Capital aggregation problem (Cambridge Controversies) ignored Income distribution adding up problem (Shaikh) ignored… Assume the problem away: Assume identical consumers to avoid demand curve aggregation problem (SMD conditions)… In a nutshell: “assume a miracle…”

4. Great appeal of neoclassical economics: an apparently coherent picture of a complex system Individual preferences generate demand curves Profit maximising generates supply curves Intersection determines prices & outputs Markets harmonise in general equilibrium Welfare maximised by free market Great weakness of neoclassical economics All steps in above process have logical flaws Firstly, a recap of the neoclassical vision With a satirical flavour whenever the theory glosses over a crucial problem: But it all looks so neat!…

5. Consumer demand Consumer’s demand determined by preferences A rational consumer… Does not let income affect tastes; Always prefers more to less; Gets less utility out of each additional unit (diminishing marginal utility); Can always tell which bundle he/she prefers End result Tastes can be represented by indifference map; Prices & incomes determine budget; Interaction of these determines demand curve; Fall in price necessarily increases consumer’s welfare

6. Consumer demand Indifference curves show tastes Z X Biscuits • Points on Z preferred to X • Prices & Income gives budget • Budget line II: banana price p1 cheaper than p2 for line I; Y W q1 q2 q3 III II I Bananas • Hey presto: • downward sloping demand curve! • consumer welfare  as P  • Points of tangency give maximum utility at given relative prices p1 p2 Price of Bananas Consumer Surplus • Price/quantity combos show the demand curve p3 q1 q2 q3 Bananas

7. Consumer demand Z • A caveat: income & substitution effects • Can get upward-sloping demand curve if (positive) income effect outweighs (negative) substitution effect • Solution: “Hicksian compensated demand curve” • Notionally reduce income back to original indifference curve… X Y W q1 q2 q3 III II I Bananas • Hicksian demand curve necessarily slopes down p1 p2 Price of Bananas p3 q1 q2 q3 Bananas

8. Consumer demand • Now add lots of consumers together… • And we get a downward sloping demand curve where consumer welfare rises as price falls: Price of Bananas The demand curve Bananas • Now stage two: the upward-sloping supply curve

9. Supply • Producers are short run profit maximisers • Goods produced by combining factors of production • In the short run, the quantity of one factor is fixed • Output is increased by adding more of the variable factor (labour) to the fixed factor (capital) • Production function therefore displays diminishing marginal productivity: output eventually rises at diminishing rate • Falling marginal product • Rising marginal cost:

10. Supply • Marginal product can initially rise… • But ultimately it falls… • Falling marginal product mean rising marginal cost Zero marginal product Banana Output Rising marginal product Maximum marginal product A B Labour Input • Divide cost of input (constant wage) by additional amount produced (falling) and you have rising marginal cost: Marginal Product Infinite marginal cost Lowest marginal cost A B Labour Input (capital fixed)

11. Supply • Firms profit maximise by equating marginal revenue & marginal cost because that identifies the biggest gap between total revenue and total cost: Slope of TR=MR Slope of TC=MC • Marginal revenue falls with rising output for a monopoly • But a competitive firm is so small that, as a price taker, it doesn’t affect market price. So its total revenue is a straight line Maximum profitwhere MR=MC

12. Supply • Since price is constant for a competitive firm, marginal revenue equals price: • Competitive firm maximises profit by supplying on marginal cost curve • Marginal cost curve becomes firm’s supply curve • Sum of all firms’ MC curves is industry supply curve:

13. Supply & Demand • “Houston, we have equilibrium”… • With maximum social welfare P • Unless there’s a monopoly S PM>MC Consumer Surplus • But assuming all markets are competitive, we can have general equilibrium… PC=MC Producer Surplus D MR QM QC Q

14. Price Supply Price Supply Price Supply Demand Pe Demand Pe Demand Pe Quantity Qe Quantity Qe Quantity Qe Price Supply Demand Pe Quantity Qe General equilibrium • All markets in instantaneous equilibrium • Complete coordination of all markets without external intervention Was equilibrium good for you too? • Social welfare maximised by the free market… • But now let’s check the fine print:

15. Z X Z X Y Y Consumer Demand • Adding lots of consumers together… • With one individual • unambiguous link between preferences (indifference curves) & demand curve • Fall in price unambiguously benefits consumer • With more than one individual: Biscuits • “Houston, we have a problem…” Bananas

16. Consumer Demand • Two different incomparable sets of indifference curves • Point of tangency for one won’t be for the other • Income effect may work in opposite directions for two consumers (one might consume less as price falls, the other more) • Income effects of changing prices • Change in relative prices changes income/wealth • One-person analysis assumes prices can be changed without affecting income; • Can’t assume same for 2 or more persons • Can’t alter prices without affecting incomes

17. Consumer Demand Z • E.g., banana price rise increases wealth… • With one consumer, no problem keeping prices & income/wealth separate: X Biscuits • With two consumers, even if their tastes are identical, can no longer separate prices from incomes/wealth Y W q1 q2 q3 III II I Bananas • Any shape of market demand curve can result… • Two outcomes of these dilemmas: p1 • Demand rises as price rises p2 Price of Bananas p3 q1 q2 q3 q3 q1 Bananas

18. Consumer Demand • (1) Standard individual “law of demand” (that demand rises as price falls) does not apply at market level • Market demand curves can have any shape at all: • “…every polynomial … is an excess demand function for a specified commodity in some n commodity economy… every real-valued function is approximately an excess demand function.” (Sonnenschein 1972: 550) • (2) To guarantee that a market demand curve slopes down like an individual demand curve, consumers effectively need to be identical and have tastes that don’t change with income:

19. Consumer Demand • If • (1) The marginal propensity to consume a good is the same for all consumers • i.e., you have the same marginal propensity to buy Da Vinci’s original manuscripts as Bill Gates; • Bill Gates has the same marginal propensity to buy methylated spirits as a derelict; AND • (2) The marginal propensity to consume a good doesn’t change with income • When Bill Gates earned $100 a week, he spent the last $10 on pizza • Now that he earns $100,000,000 a week, he spends $10,000,000 on pizza… • Then the market demand curve will slope downwards…

20. Illustration • Standard neoclassical “utility function” Cobb-Douglas: • Add budget constraint: • “Lagrange multipliers” to derive demand curve: • Yields individual demand curve: • Add numerous identical consumers…

21. Illustration • So far so good… • But complications here for utility functions where Engels curves are not straight lines • Breaches “WARP” • However so far Y treated as given • But changing relative prices will change incomes • Consider “initial endowment” of goods; change in price of one changes wealth—moves budget line • Full illustration would require “GE” model, but…

22. Illustration • Consider Y which varies between 1 & 1000, & • Depends on relative prices of A & B where • Illustration only, but graphical simile for Sonnenshein’s “every real-valued function is approximately an excess demand function” • Sample demand curve for B:

23. Consumer Demand • Conditions to avoid this outcome in effect amount to: • All consumers are identical • All commodities are identical • i.e., “model” only works with one consumer & one commodity • When scaled to > 1 consumer and > 1 commodity, aggregation effects mean what applies at individual level doesn’t apply at aggregate • Result is general: • Doesn’t depend on “perverse” utility functions • Makes it impossible to derive meaningful aggregate (market) “laws” from principle of individual utility maximisation

24. Consumer Demand • … market demand functions need not satisfy in any way the classical restrictions which characterize consumer demand functions… The importance of the above results is clear: strong restrictions are needed in order to justify the hypothesis that a market demand function has the characteristics of a consumer demand function. Only in special cases can an economy be expected to act as an ‘idealized consumer’. The utility hypothesis tells us nothing about market demand unless it is augmented by additional requirements.’ (Shafer & Sonnenschein 1982: 671-2 [emphasis added]) • Ironically, neoclassical economics began in part as reaction to “class analysis” of classical school…

25. Consumer Demand • “If we are to progress further we may well be forced to theorise in terms of groups who have collectively coherent behaviour. Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” (Kirman 1989: 138) • Ironically, neoclassicals have proven that class-based analysis is necessary! • Post Keynesians & Marxists work in terms of groups (workers, capitalists, bankers) rather than individuals • Failure to derive aggregate demand function from individual an example of “emergent property”

26. Consumer Demand • In general market demand curves (derived from neoclassical theory) look like this: • So rather than this: Price of Bananas The demand curve Bananas • Even if consumers utility maximise! • Which they don’t…

27. Z X Biscuits Y W Bananas Indifference Curves • “Seen any good indifference curves lately?” • Dilemma: indifference curves play crucial role in theory, but unobservable • Samuelson suggested a solution: “revealed preference” • Induce consumer’s preference map from their purchasing decisions. • What we want to find is

28. Indifference Curves • What we can know is what a consumer actually buys at different prices: • Samuelson argued we can infer the indifference map from these… • Using “revealed preference” & the axioms of rational behaviour • Consumer can rank all bundles in terms of preference/indifference • More preferred to less • If A pref B & B pref C then A pref C Biscuits Y W X q1 q3 q2 P3 P2 P1 Bananas

29. Biscuits A Bananas Biscuits C A B Bananas Indifference Curves • All points in box preferred to A (non-satiation) • Can build up “map” of consumer’s tastes by offering different bundles of goods at different prices, seeing which bundles chosen… • “reveal” preferences • If A preferred to B & C at one price, must be preferred at any price (completeness & transitivity; tastes independent of income) • A must be on higher curve than B or C…

30. Indifference Curves • Sippel (1997) attempted to do just this: “reveal” preferences of experimental subjects • 10 sets of Budget & relative prices presented • Budgets/prices chosen to test aspects of theory (e.g., “Homogeneity degree zero”—double prices & incomes, “should be” no change in consumption • Choose from 8 goods at each budget/price combo • Computer automatically calculated budget cost • Consume choices in next hour from one of ten sets

31. Good Max. Amount (if all budget spent on one good) Video clips 30-60 minutes Computer games 27.5-60 minutes Magazines 30-60 minutes Coca cola 400ml-2 litres Orange juice 400ml-2 litres Coffee 600ml-2 litres Candy 400gms-2 kilos Pretzels, peanuts 600gm-2 kilos Indifference Curves • Goods on offer: • Unlimited amount of time to choose • 60 minutes to consume one choice set

32. Indifference Curves • Key propositions being tested: • “Weak Axiom of Revealed Preference” WARP • If A  B then never B  A • If consumer chooses bundle A once when B also affordable, then consumer will always choose A instead of B, regardless of relative prices • “Strong Axiom of Revealed Preference” SARP • If A  B & B  C then never C  A • Formal definition of a utility maximiser • “Generalised Axiom of Revealed Preference” GARP • If A  B & B  C then pC * A  pC * C • If A  B & B  C then A more expensive than set C at prices when C declined in favour of B

33. Exp. 1 & 2 Consistent % Inconsistent % Number of violations per person (max possible 45) 1-2 3-4 5-6 7-8 9-10 11-20 > 20 SARP 8.3 91.7 7 3 - - - - 1 GARP 58.3 41.7 3 1 - - - 1 - SARP 26.7 73.3 7 4 - 1 4 3 3 GARP 36.7 63.3 8 1 2 3 1 1 3 Indifference Curves • Results first experiment (12 subjects) • 11 of 12 subjects violated SARP & WARP • 5 out of 12 violated weaker test GARP • Results second experiment (30 subjects) • 22 of 30 subjects violated SARP & WARP • 19 of 30 violated weaker test GARP

34. Indifference Curves • Sippel’s interpretation of results • In general “not too favourable to the neoclassical theory of consumer behaviour…” (p. 1438); but • Low number of inconsistencies (median 2 out of 45—but average higher) • Subjects did try to “select a combination of goods that came as close as possible to what they really liked to consume given their respective budget constraints” (1439) • “They spent a considerable amount of time on their decisions (typically 30-40 minutes)” • How serious are violations of axioms?…

35. Indifference Curves • Use waste of income from inconsistent choice as guide to how significant were deviations from “rationality”: • Afriat index: ratio (pB * A / pB * B) when (from previous experimental round) A  B • Where consumer chooses A when B affordable, use formula “A  B if (e * pA * A)  (pA * B)” • Consumer deemed to prefer A over B if A (say) 11% more expensive than B & consumer still chooses A (here e=0.9) • Like having “thicker indifference curves”

36. Indifference Curves • With thicker indifference curves, more combinations are shown as “indifferent”: Biscuits • e=1: C  B  A C A • e=.95: C  B & A but B  A B • Choosing A or B appears “rational” for e=.95 but not for e=1 Bananas • The “good” news: number of apparent violations of GARP dropped significantly for e<1 • The “bad” news: even “throwing a dart”—totally random choice—appeared rational for e<0.95! • For e=.9, random choice appeared more rational than what human subjects did!

37. % Experimental subjects violating GARP % of times randomly chosen set violated GARP e Exp 1 Exp 2 Exp 1 Exp 2 1 41.7 63.3 61.3 97.3 .99 25 26.7 46.8 65.2 .95 8.3 10 16.8 12.8 .90 8.3 3.3 1.5 0.4 Indifference Curves

38. Indifference Curves • Several other careful attempts to interpret results • But overall judgment: • “We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who do appear to be optimising, the majority of them do not… we … call the universality of the maximising principle into question.” (1442) • So if people aren’t maximising their utility, what are they doing? • Are they being “irrational”? No! • It’s the neoclassical definition of rational behaviour that is irrational!

39. How “rational” is optimising? • Neoclassical model a “toy” model of behavior • Only 2 commodities, unspecified quantities • Let’s make it real: • Shopping in a supermarket with 1,000 different commodities • Decide whether to or not to buy one unit of each • How many bundles do you have to consider? • For the textbook toy model, only 4: • (0 bananas, 0 biscuits; 1 banana, 0 biscuits; 0 bananas, 1 biscuit; 1 banana, 1 biscuit) • In the supermarket?

40. How “rational” is optimising? • Number of choices is: • Number of units being considered + 1 (0 or 1) • Raised to the power of how many goods • 2 in textbook model—so only 4 combinations: • 2 goods, 2^2 = 4 combinations • 3 goods, 2^3 = 8 • 4: 2^4 = 16 • supermarket 1,000 goods • How many combinations?

41. How “rational” is optimising? • 21000, or roughly 10300. • So is that big, or what? • Spelling it out in full, it’s: • 10,720, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000 combinations! So is that big, or what?

42. How “rational” is optimising? • How big a brain would you need to remember that many combinations? • Pretend each neurone could remember the utility of 100,000,000,000 combinations • Your “grey matter” weighs about a kilo: 100,000,000,000 neurones, each weighing 1/100,000,000 grams • Quick quiz: a brain this big would weigh… • (1) More than your brain? • (2) More than an elephant? • (3) More than the planet? • (4) More than the Sun? • (5) More than the Galaxy? • (6) More?

43. How “rational” is optimising? • (6) 10224 times as much as the entire universe! • If you could recall utility of each combination in 1/10,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000th of a second, how long would it take to remember the maximum? • 10200 seconds: 10180 times the age of the universe! • What’s going on? • The “curse of dimensionality”: number of combinations grows exponentially as more options considered • Impossible to consider even tiny fraction of options in effectively finite time • Dimensionality overwhelmed Sippel’s subjects, even with just 8 commodities & experimental setup replicating neoclassical theory

44. How “rational” is optimising? • Rational behavior is not considering all options, but • Reducing number you do consider in a way that • Makes deciding in finite time possible • Doesn’t obviously rule out good combinations • We use “heuristics”: sensible “rules of thumb” • We do consider our budgets when deciding tastes • We use habit, convention, culture • Buy much the same combination each week • We segment our purchases: x% on food, y% on clothing… • Tastes evolve over time (with marketing trying to manipulate development)

45. How “rational” is optimising? • These non-optimising behaviors make choice possible • E.g., segmentation: rather than “optimise” over everything in supermarket, segment into “fruit”, “meat”, “spices”, “hygiene”, etc. • Say 1000 products in supermarket, 100 in each segment • Unsegmented optimising: “Buy/not buy”: 10300 combinations • Segmented optimising (split budget up beforehand): “Buy/not buy”: 1031 combinations—10269 less: could remember everything with a brain weighing only… 1 million tonnes! • More than segmentation needed! But optimising behaviour is clearly not rational

46. What should economists do instead? • Abandon ambition to build coherent model of aggregate (market) behavior from isolated individuals • Model “at some reasonably high level of aggregation” (Kirman)—classes (capitalists, bankers, workers…) • “Renegade” neoclassical group SFEcon doing this • Model actual behavior at individual level • “Satisficing” (Herbert Simons) rather than optimising; multi-agent modelling • Generate non-coherent model of aggregate behaviour (waves of demand, non-equilibrium dynamics, co-evolution of products and demand) • These approaches being taken by Marxist, Post Keynesian, Evolutionary economists; but not by mainstream neoclassicals (best offer “game theory”)

47. Political economy attitude • “Methodological individualism” of neoclassical economics fails on own grounds • Internally inconsistent • Does not reach results they desire • Socially coherent approach of Marxists, Post Keynesians, Evolutionary, Feminist economists superior • Even if comparatively under-developed • Methodological individualism should be abandoned in favour of analysis of social groups/classes, income distribution between classes, etc. • Next lecture, invalidity of theory of supply even if market demand curve exists