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Issue no. 14; June 24, 2002                                                                          back issues at www.paecon.net
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In this issue:
                Economics and physical reality:
                        Dietmar Lindenberger and Reiner Kümmel
                             Thermodynamics and Economics
                        Jane King
                             Assessing economic potential: what the physical sciences have to offer
                What is worth keeping in standard microeconomics?
                        Peter Dorman
                             Doctrine-centered versus problem-centered economics
                        Joseph Halevi
                             High priests and run-of-the-mill practitioners
                        Geoffrey M. Hodgson
                             Theoretical substance should take priority over technique
                        Steve Keen
                             Two perspectives to Guerrien’s question
                        Anne Mayhew
                             Superior Analysis Requires Recognition of Complexity
                        Julie A. Nelson
                             What should be retained from standard microeconomics
                        K.M.P. Williams
                             An American undergraduate point of view
                 And:
                        Frank Rotering
                             Towards a New Economics


Economics and physical reality

Thermodynamics and Economics
Dietmar Lindenberger   (Institute of Energy Economics, University of Cologne, Germany)
Reiner  Kümmel   (Institute of Theoretical Physics, University of  Würrzburg,  Germany)

Since Georgescu-Roegen´s statement on entropy, there has grown a vast literature on the
implications of the laws of thermodynamics for economics. Most of this literature is related
to the environmental consequences of the 2nd law, i.e. that any economic activity unavoidably
causes pollution1. This important insight could, at least to some extent, be integrated into
(environmental) economic theory. Other implications of thermodynamics will probably be more
difficult to be incorporated into the prevailing neoclassical framework, if this is possible at all.
An example is the notion of irreversibility, which implies at least some sort of non-equilibrium.
A corresponding micro-economic modelling approach was proposed recently in this journal [1].
Another example is discussed in the following. We address the issue of appropriately including
the indispensable production factor energy into macro-economic theories of production and
growth, and try to draw some conclusions.

 

In conventional neoclassical theory the production factor energy is either neglected altogether,
which is inconsistent with thermodynamics, or attributed only marginal importance. The
argument is that energy's share in total factor cost is small compared to the cost shares of
labor and capital. However, the recessions after the oil price crises in 1973/74 and 1979/81
have posed the question how a production factor of monetarily minor importance can have
such grave economic consequences.


The conventional view of the low economic importance of energy dates back to the first stages
in the development of neoclassical economic theory. Initially, the focus was not so much on
the generation of wealth, but on its distribution and the efficiency of markets. Consequently,
the early thinkers in economics started with a model of pure exchange of goods, without
considering their production. With a set of assumptions on rational consumer behavior it
was shown that through the exchange of goods in markets an equilibrium results in which
all consumers maximize their utility in the sense that it is not possible to improve the
situation of a single consumer without worsening the situation of at least one other consumer
(Pareto optimum). This benefit of (perfect) markets is generally considered as the foundation
of free-market economics. It shows why markets, where "greedy" individuals meet, work at all.
But later, when the model was extended to include production, the problem of the physical
generation of wealth was coupled inseparably to the problem of the distribution of wealth,
as a consequence of the model structure: Since the neoclassical equilibrium is characterized
by a (profit-maximizing) optimum in the interior -and not on the boundary- of the region in factor
space accessible to the production system according to its state of technology, factor
productivities had to equal factor prices. In the resulting production model the weights with
which the production factors contribute to the physical generation of wealth, i.e. the
elasticities of production, have to equal the factor cost shares. These cost shares, in the
industrialized countries, are typically 0.7 (labor), 0.25 (capital) and 0.05 (energy).


Consequently, according to the neoclassical model, the elasticities of production of the
factors, which -roughly speaking- measure the percentage of output growth if a factor input
increases by one percent, would have to have these values: labor 0.7, capital 0.25, and
energy 0.05. With these input weights a decrease of energy utilisation of up to 7%, as
observed during the first oil crisis between 1973 and 1975, could explain a decrease of value
added of only 0.05(7% = 0.35%. The actually observed decreases of economic output,
however, were roughly ten times larger.


Furthermore, a substantial part of observed long-term economic growth cannot be explained
by the growth of the factor inputs, if these are weighted by their cost shares. Large residuals
remain. In most cases the residuals play a more important role than the explanatory factors,
which, according to Gahlen, makes the neoclassical theory of production tautological [2].
Solow, after noting "...it is true that the notion of time-shifts in the [production] function is a
confession of ignorance rather than a claim of knowledge'' [3], comments: "This ... has led
to a criticism of the neoclassical model: it is a theory of growth that leaves the main factor
in economic growth unexplained'' [4].


As it has been shown recently, the residuals of neoclassical growth theory can mostly be
removed by taking into account the production factor energy appropriately [5-11]. It turns out
that the crucial point is to drop the neoclassical equilibrium assumption, and to determine
the elasticities of production of the factors by purely technological and empirical considerations
instead. Thereby, the previously unexplained technological progress reveals its two principal
elements: The first one is the activation of the increasingly automated capital stock by energy;
and, of course, the people who handle capital have to be qualified appropriately. The second
one consists of improvements of organizational and energetic efficiencies of the capital stock.
The short-term impact of the first element is much bigger than that of the second element,
but the reverse may be true for the long-term impact, if efficiency improvements fundamentally
change the course of economic evolution [11]. The efficiency improvements are identified by
shifts of the corresponding technology parameters in the production functions, whereas energy's
high productive power in increasingly automated production processes is revealed by its high
elasticity of production: Energy's elasticity, in industrial sectors of the economy, is typically
of the order 0.5, i.e. as large as those of capital and labor together. In service sectors it still
exceeds energy's low cost share significantly [7]. Both in industrial and service sectors, labor's
elasticity is far below its cost share. Only in the case of capital, do elasticities of production
and cost shares turn out to be roughly in equilibrium, as neoclassical theory presupposes.2


What are the consequences of these findings? Let us frame one selected point as follows.
If wealth had been distributed according to the "marginal productivity theory", labor would
have received only a share of national income much smaller than the observed 70%. But
apparently, in the past most of the value added by energy was attributed to labor. The
underlying mechanism of distribution was that of wage-negotiations in which free labor
unions, powerful during times of high employment, regularly succeeded in winning wage
increases according to the growth of productivity, i.e. increased production due to increased
and more efficient energy utilization. This way most of the population in the industrialized
countries benefited from the wealth generated by the production factors capital, labor, and
energy.


With increasing automation in production, however, human routine labor becomes more and
more dispensable. A possible consequence is the increasing inequality in the distribution
of income, as can be observed in the US, where, due to flexible labor markets, the hours
worked per year have increased, but the problem of the "working poor" remains unsolved.
Consequently, if society wishes to organize labor markets more competitively, while
socially unacceptable distributional effects are to be avoided, the question arises how the
institutional settings within market-economies have to be adapted to the changing
technological conditions.


Certainly, increased investments in education and the design of appropriate labor market
and social policies are crucial issues. Here, let us address the issue of how such policies
may be financed in a sustainable way. In the past the financial burden resulting from social
policies was mainly put on the production factor labor. This is one of the causes of the
identified disequilibrium between the cost shares and productive powers of labor and energy,
which, in turn, accelerates technical progress towards increasing automation. If this
disequilibrium is sufficiently steep, the newly emerging and expanding sectors of the
economy will no longer be able to compensate for the losses of jobs due to increased
automation in the existing industries, thus destabilizing the system as a whole. Therefore,
in view of social and fiscal stability, it might be worthwhile to consider a shift of taxes and
levies in the industrial countries in such a way that the production factors labor and energy
are burdened more according to their productive contributions to value added.

Notes
1.  I.e., the emission of heat and substances into the environment due to entropy production.
2.  The production systems are operating in boundary cost minima in factor space, where the boundaries, at a
given point in time, are established by the state of technology in information processing and automation and
prevent the system from sliding at once into the absolute
cost minimum of nearly vanishing labor input.

References
[1] Martinás, K., "Is the Utility Maximization Principle Necessary?", post-autistic economics review, issue no. 12,
March 15, 2002, article 4 and references therein, http://www.btinternet.com/~pae_news/review/issue12.htm.
[2] Gahlen, B., Der Informationsgehalt der neoklassischen Wachstumstheorie für die Wirtschaftspolitik, J.C.B.
Mohr, Tübingen, 1972.
[3] Solow, R. M., Investment and Technical Progress, in: Mathematical Methods in the Social Sciences,
K.J. Arrow, S. Karlin, and P. Suppes (Eds.). Stanford, 1960, p. 89-104.
[4] Solow, R.M., Perspectives on Growth Theory, Journal of Economic Perspectives 8, 1994, p. 45-54.
[5] Kümmel, R; Strassl, W.; Gossner, A.; Eichhorn, W., Technical Progress and Energy Dependent Production
Functions, Journal of Economics 45, 1985, p. 285-311.
[6] Beaudreau, B.C., Energy and organization: growth and distribution re-examined, Westwood (CT),
reenwood Press, 1998.
[7] Lindenberger, D., Wachstumsdynamik industrieller Volkswirtschaften - Energieabhängige
Produktionsfunktionen und ein faktorpreisgesteuertes Optimierungsmodell, Metropolis-Verlag, Marburg, 2000.
[8] Ayres, R.U., The minimum complexity of endogenous growth models: the role of physical resource flows,
in: Energy - The International Journal 26, 2001, p. 817-838.
[9] Ayres, R.U., Warr, B., Accounting for growth: the role of physical work, in: Reappraising Production Theory,
Workshop of the Max Planck Institute for Research into Economic Systems, Jena, 2001.
[10] Hall, C; Lindenberger, D.; Kümmel, R.; Kroeger, T; Eichhorn, W. (2001), The Need to Reintegrate the
Natural Sciences with Economics, BioScience 51 (8), 2001, 663-673.
[11] Kümmel, R.; Henn, J.; Lindenberger, D., Capital, Labor, Energy and Creativity: Modelling Innovation
Diffusion, Structural Change and Economic Dynamics, 2002 (in press),
http://theorie.physik.uni-wuerzburg.de/TP1/kuemmel/profile.html  (fields of research, Ref. 14).

SUGGESTED CITATION:
Dietmar Lindenberger and Reiner Kümmel, "Thermodynamics and Economics", post-autistic economics review,
issue no. 14, June 21, 2002, article 1. http://www.btinternet.com/~pae_news/review/issue14.htm




Assessing economic potential:
What the physical sciences have to offer
Jane King   (Resource Use Institute, UK)

Perhaps one of the gaps in traditional economics teaching has been the failure to
incorporate physical science into economic analysis. Economists have traditionally been
wary of intervention by outsiders. Scientists, for their part, have tended to leave analysis
of the economy to those trained in economic techniques. Economics and Science rest
on different paradigms. However co-ordination between the two can offer new insights in
a situation where economic development is increasingly coming up against physical
constraints whether in terms of limited resources, such as oil, water or fish, or of the
amounts and nature of pollutants we exude.1  I am one of a growing number of people
who believe that economics urgently needs to find a way of dealing with these physical
realities. But to do so, it will have to innovate in a fundamental way: it will have to use, in
addition to monetary evaluation, a system of physical evaluation.

Money and energy: two units of account
In an unconstrained world the appropriate unit of account for economic analysis would
undoubtedly remain that superb concept already devised to assign values and preferences
within a given range of economic possibilities - namely money.  The drawback is that in
looking into the future, and in particular the long-term future, estimates have to be made of
the evolution of monetary value; and as we all know in the case of projected oil prices, such
estimates can be notoriously misleading. Indeed they can in certain cases even lead one
beyond the range of theoretical physical possibility.  Monetary evaluation is admirably
suited to analysing past economic behaviour or to evaluating short-term trends, but it
cannot be relied on for exploring economic potential with a longer time horizon. 

 

 An alternative numeraire is offered through Natural Capital Accounting (NCA), an approach
based on physical principles.2  NCA reflects the fact that production or  delivery of a service,
is a process of reducing the entropy of the set of components that go to produce the final
product;  an inevitable conclusion from the second law of thermodynamics.

 

It follows that in order to reduce the entropy of a system, somewhere else there has to be
a sacrifice of negative entropy of at least equal magnitude. In practical terms that sacrifice
is the effort involved  in terms of the energy required to create the inputs well as the fuel
needed to operate the economy. In other words the dissipation of a non-renewable resource.
Output is thus quantitatively linked to input as a causal relationship. Production can only
occur if the necessary inputs are physically available. Significantly the different linkages do
not vary over time, give or take a certain amount of technological improvement.

 

Modelling the economy in physical terms
Natural Capital Accounting can be articulated through the generic model known as ECCO
(Evaluation of Capital Creation Options) and can be applied with appropriate modifications
to different regions or countries (a world ECCO model also exists).  It should be made clear
that rather than conflicting with established economic approaches ECCO in fact complements
them. Its purpose is not to explore the collective economic behaviour of individuals in a
somewhat different manner from the traditional, but to determine the physical potential for
growth of the economic system as a whole. That potential will depend on the policies imposed
on the model by the user  which might, for example be the outcome of an econometric forecast.
It cannot be denied that what is not physically possible can never be economically possible.

 

This is not the place to give an exhaustive description of the structure and application of
ECCO, for which refer to www.eccosim.org.uk Briefly, it is a holistic dynamic simulation
model of an economic system. The potential supply of human-made capital is set against
the demands implicit in the user's policies. All transformations (such as the formation of
physical capital) require a reduction in entropy. That reduction is measured in terms of the
consumption of depletable natural capital expressed in energy units of standard quality. It
follows that a unit of human-made capital produced may then be quantified in terms of the
energy embodied in it.

 

A useful aspect of Natural Capital Accounting models is that assumptions do not have to be
made about economic growth rates. Potential growth rates evolve from the models themselves
according to the policies imposed on them by the model user. If sufficient human-made capital
cannot be created to meet demands, then something within the system will ultimately give.

 

By way of example the following sectors are included in a current European model.

  •  Manufacturing
  •  Construction
  •  Market services to industry
  •  Market Services to people
  •  Non-market services (government - health - education)
  •  Non-energy physical resource extraction
  •  Fossil-energy extraction by type - coal, lignite, natural gas, oil
  •  Electricity generation by type - nuclear, coal, natural gas, hydro, other
  •  Domestic housing
  •  Transport - roads, rail, air & infrastructure
  •  Consumption - consumer goods, services, transport, fuels
  •  Agriculture, forestry and fishing
  •  Water
  •  Capital transfers (external to EU), balance of international payments
  •  Internal and external debt
  •  Income re-distribution (pensions, benefits), average (EU-wide) taxation
  •  Environmental significant outputs - CO2, SO2
  •  Employment - by different sectors.

The application of Natural Capital Accounting
The purpose of Ecco models is not to forecast the behaviour of the economy but rather to
determine whether the economic objectives set by decision makers can lead to the desired
results, and what trade-offs may thereby ensue. Given that ECCO is not  an optimisation
model, there is never any unique solution.  The model provides many indicators which may
be selected as criteria of success. It is up to the user to decide which. Seeking an
acceptable outcome is an iterative procedure. 

Many of the policies explored by ECCO models relate to the environment, but by no means
all. A few are given by way of example.

  • How fast is it possible to develop an alternative energy regime in view of declining
    supplies of fossil-based fuels?  To what extent would the material quality of life be
    affected?
  • Is it possible to sustain the economy in the future without nuclear energy?
  • What is the effect, in terms of resource use, of different modifications to the
    transport system
  • What are the implications for the economy of attempting to meet the Kyoto and
    subsequent
    agreements on limiting CO2 emissions?
  • How fast and for how long can the material standard of living be increased
  • What is the effect on the economy of  demographic growth rates

 

There is much talk today about the over-compartmentalisation of knowledge and the need for
"interdisciplinarity". How different the world was two centuries ago. In the Edinburgh of that time
Adam Smith,  David Hume the philosopher and James Hutton the geologist, met in the street,
dined and argued together. In Paris Voltaire, de Bourgainville, the explorer, Fourier, the
mathematician and Lavoisier the chemist all lived in a Paris that was then a compact city.
They shared each other's  knowledge and wisdom.  Today not one of us can absorb the huge
body of skills and understanding that has been built up in these last centuries. However what
we can do, indeed must do, is to link up the relevant parts of economics and science within a
single system  including both the economy and the biosphere within which it operates.

Notes
1. Crane, D.C. Balancing pollutant emissions and economic growth in a physically conservative world, Ecological
Economics, 1996,16, pp 257-268
2. Slesser, M &King, J 'Not By Money Alone: Economics as nature intended' , ISBN 1-897766-72-6, Jon Carpenter
Publishing, Oxford, 2002
_____________________________
*Jane King may be contacted at  king@rui.co.uk or kingslesser@btinternet.com

SUGGESTED CITATION:
Jane King, "Assessing economic potential: what the physical sciences have to offer", post-autistic economics
review, issue no. 14, June 21, 2002, article 2. http://www.btinternet.com/~pae_news/review/issue14.htm




What is worth keeping in standard microeconomics?
For background to this debate, see post-autistic economics review, issues no. 12, March 15, 2002,
http://www.btinternet.com/~pae_news/review/issue12.htm and no. 13, May 2, 2002, 
http://www.btinternet.com/~pae_news/review/issue13.htm



Doctrine-centered versus problem-centered economics
Peter Dorman   (The Evergreen State College, USA) 
 
Bruce Caldwell's response to Bernard Guerrien illustrates exactly what is wrong with
mainstream economics as it is taught and applied: it is doctrinaire.  He believes that he has
made an advance over more typical teaching approaches by scaling down the math, but I
can see no change in the overall project of imposing a dogma in the name of an academic
discipline.  It is sad to have to conclude this, given Caldwell's large contributions to economic
methodology, but there it is.

His examples of "economic reasoning" for the improvement of undergraduate minds are worth
a closer look.  I could take up all of them, but I will confine myself to the two that are given
the most attention, the role of price supports in agriculture and the advantages of free trade
over protection. 

Agriculture
Agricultural policy has many dimensions.  It is a social policy that can support, change or
weaken rural culture.  It is certainly an ecological policy, whether by intent or not.  It influences
food security in the face of ineradicable uncertainties in supply.  It is competition policy,
favoring either centralized or decentralized market structures.  And, or course, it has a political
economic dimension, responding to the various interest groups that have a stake in the
choices made by government.

 

What do Caldwell's price ceiling diagrams tell us?  If they are like all the other price ceiling
diagrams I have seen, they announce that, as a first-round effect, price supports are
economically inefficient, sending false signals to the marketplace and incurring deadweight
loss.  The second-round effect, alluded to by Caldwell, is political: there is rent-seeking that
further absorbs resources and distorts policy.

 

It seems obvious to me that the price ceiling analysis, while it has some value, is hopelessly
inadequate as a primary guide to what to do about agriculture.  The role of uncertainty and time,
of environmental externalities and public goods (such as a healthy rural culture) ought to be
central to any serious analysis of this topic, and to short-circuit the process in the way Caldwell
describes is to abandon higher-order for lower-order thinking.  In practical terms, it also silences
students, because their common-sense intuitions about agriculture (many of my own students
have rural backgrounds) often have no standing amid the supply and demand curves.

 

Trade
Caldwell would have students learn the theory of comparative advantage as a guide to making
sense of globalization and combating the naive belief that interference with trade can ever be
a good idea.  He talks in precise dollar terms about the cost per job saved by tariffs on steel,
as though the complex effects of such a policy can be perfectly know and calculated.   Yet
trade policy is complex, and it is fair to say that economists have not yet put together a
convincing model of how the system works.  In particular, comparative advantage depends on
the assumption of balanced trade at the margin - that every extra dollar or euro of imports will
be automatically and simultaneously balanced by an equivalent additional value of exports. 
If this were true in the real world, of course, we would have a simpler, more pleasant life: no
country would experience balance of payments crises, there would be no pressure on
countries to be "competitive", and one policy alone - free trade - would be all we would need
to follow.  (For a more extended critique of this sort of cost-of-protectionism analysis, see
Dorman, 2001.)

 

Unfortunately, life is not like that.  Laid off steel workers will not automatically find jobs in
exporting sectors, and not only because they have the wrong skills or live in the wrong cities,
but also because the effect of more steel imports may simply be that the trade deficit
increases.  (Yes, I know, there is also a theory that says that this can't happen because it
would require investors to change their already-perfect international allocation of asset
positions.  No comment!)  This doesn't mean that protective tariffs are a desirable policy
response, just that an a priori dismissal of them contradicts the creative, disciplined thinking
that teachers ought to encourage in their students - and that denying the legitimacy of
reasonable ideas that might occur to students pushes them into passivity or out the door
altogether.

 

Conclusions
I have two concluding thoughts.  First, the level of math is not the issue.  One can be dogmatic
with blackboard diagrams and open-minded with reams of equations.  In general, less math is
generally better, because it lowers the barrier to critical thinking, but simply getting rid of math
is not the point.  Second, the solution is not to replace one dogma by another or even by a
menu of competing dogmas, but to redefine, for our students and ourselves, economics from
being a doctrine-centered to a problem-centered enterprise.  Instead of agreed-upon theories
dictating simplified or completely fictitious examples (with their widgets, perfectly behaved
functions, etc.), real-life cases in all their messiness should be the measure of any theories we
throw at them.  Such an economics would not only be post-autistic, but also a lot more fun.

Reference:
Dorman, Peter. 2001. "The Free Trade Magic Act", Economic Policy Institute Briefing Paper.  For details visit
http://www.epinet.org/briefingpapers/dorman-bp2/dorman-bp2.pdf

SUGGESTED CITATION:
Peter Dorman, "Doctrine-centered versus problem-centered economics", post-autistic economics review,
issue no. 14, June 21, 2002, article  3. http://www.btinternet.com/~pae_news/review/issue14.htm




High priests and run-of-the-mill practitioners
Joseph Halevi   (University of Sidney, Australia)


Geoff Harcourt and Bernard Guerrien are speaking about two different sentences in the same
paragraph, as it were. Harcourt points out that textbooks usually treated the microeconomic
theory of perfect competition as approximating some immanent tendencies of actual economic
behaviour. Guerrien notes that the perfectly competitive model has got nothing to do with a
market economy, it rather requires a centralised system. Both statements are correct. Many
textbooks still present the competitive model as a first approximation and they are wrong of
course precisely on the account of Guerrien's observations. I tend to agree with Guerrien's
view that Stiglitz's asymmetric information stories do not represent novel findings or new
theoretical developments but they simply introduce imperfections in an otherwise standard
approach.  In other words, Stiglitz's reasoning would not exist without having at its foundations
traditional micro-theories. I think that this is true also for macroeconomic models which
once were flagged as most innovative such as those pertaining to rationed equilibria. They
all postulate the existence, somewhere, of a Walrasian equilibrium.

 

Thus the substantive issue is whether or not there is something to be retained from
micro-theory.  My own answer is in the negative. The existing body of microeconomics
has no cognitive content in relation to its object of inquiry. In this respect Bernard Guerrien,
a mathematician who has brought out before any English speaking economist the significance
of the Sonnenschein-Mantel-Debreu theorems, has done extremely valuable work in pointing
out the lack of interpretative value in the standard approach.1  I do not agree with the view
that bits and pieces may be salvaged  and retained on the account of their practicality. If the
demand curve can be of any shape, that is if there is no compelling reason to assume that
the demand curve should be downward sloping then there is no point to retain the theories
built upon that premise just for practical matters. Practicality is in itself a constructed
process and if it is based on particular premises which have no reason to be selected as
the more relevant ones, it becomes a trivial ex-post rationalization as well as justification of
the theory. These sort of things belong more to the domain of the sociology and politics of
research and of ideas in general, yet they have nothing to do with the cognitive dimension
of a particular theoretical construction.  I would extend my negative conclusions also to
macroeconomic theory as taught in most textbooks. The latter is even in a worse shape
than micro-theory since it is heavily biased towards representative agent's models and
flawed aggregate notions such as capital as a factor of production. Micro-macro theory as
it stands today in textbooks provides neither a form of basic reasoning in practical terms,
nor does it help to apprehend economic concepts. Just consider the most crucial of them:
price. No price is determined the way traditional theory would like us to believe. If anything,
prices are likely to be determined in a monetary manner and they are connected to the
process of production and the formation of multiple profit margins and rates of profit.
Furthermore a classification of price behaviour would show many different forms of
adjustments hardly having anything to do with the fairy tale taught in standard lectures. 

 

While micro-macro textbooks may easily be disregarded with no loss of knowledge as to
the functioning of contemporary societies, the teaching of traditional economics, and indeed
all of economics, should be linked to Joan Robinson's principle of critically knowing a
subject in order not to be fooled by its high priests and run of the mill practitioners. This is
especially true when in today's polity economics performs the same role of theology in the
past as the conduit for the expression of social, economic and political interests.

Note
1. Bernard Guerrien, Concurrence, flexibilité  et stabilité, Paris: Economica, 1989.
_____________________________
Joseph Halevi is co-editor of Restoring Demand in the  World Economy: Trade, Finance and Technology

SUGGESTED CITATION:
Joseph Halevi, "High priests and run-of-the-mill practitioners", post-autistic economics review, issue no. 14,
June 21, 2002, article 4. http://www.btinternet.com/~pae_news/review/issue14.htm




Theoretical substance should take priority over technique
Geoffrey M. Hodgson   (University of Hertfordshire, UK)

Essentially, neoclassical theory involves actors who are rational in that their behaviour is
consistent with the maximisation of utility with a given preference function. Two other features
follow. The concept of maximisation points towards equilibrium outcomes and a disposition
towards equilibrium conceptions and solutions. Furthermore, the concept of capable preference
involves a more-or-less well-defined choice set, involving either certainties or calculable
probabilities. As a result, chronic information problems such as radical uncertainty, ignorance
or interpretative ambiguity are excluded.

 

I would prefer to define neoclassical economics in this way, and not in terms of any ideology
or predisposition towards competition or markets. I agree entirely with Bernard Guerrien on
this point. Theorists have attempted to apply the neoclassical approach to socialist planning
and capitalist monopoly, as well as to competitive markets. Just as we have individualistic,
pro-market neoclassical economists (such as Milton Friedman) we have liberal or social-
democratic neoclassical economists (such as Kenneth Arrow and Paul Samuelson) and
also 'Marxist' neoclassical economists (such as Oskar Lange, John Roemer and Jon Elster).
The essential core of neoclassical theory involves rationality, equilibrium and adequate
information. This theoretical core is quite adaptable, and has served a variety of ideological
positions, from left and right.

 

Having defined neoclassical theory, we can now attempt to answer Guerrien's question. What
is 'worth keeping'? Many mainstream economists today, especially in the last 20 years,
accept some of the limitations of the neoclassical core theory. For example, Herbert Simon's
concept of bounded rationality is now acknowledged. Many experimental economists are
sceptical of the neoclassical axioms. Yet still the core neoclassical assumptions still
dominate the journals and textbooks.

 

When we ask 'what is worth keeping?' there are really two questions here. One concerns
what should be taught on the economics curriculum. The second concerns the adoption,
application or development of a theory by a researcher. I'll deal mainly with the first question
and touch briefly on the second.

 

There are several reasons why the curriculum is still dominated by the neoclassical approach.
Among these, economics has almost turned into a branch of applied mathematics, where the
application and development of the technique has become more important than the explanation
of the (economic) phenomena involved.

 

A second reason is equally important: heterodox critics of neoclassicism have failed to develop
a substantial alternative theory that addresses the questions of individual agency and choice
that should be part of the core of any viable analysis. The development of such a theoretical
alternative is a major priority. There is progress, but it is frustratingly slow, and it is discouraged
by the prevailing incentive structures of modern academic economics.

 

So, where do we go from here? The first injunction is: concepts have first priority, mathematical
techniques second. Those that complain that it is necessary to devote an entire curriculum to
neoclassical theory, on the grounds that there is 'not enough time available' to teach anything
else, are typically driven by techniques, not by concepts. They stress the paraphernalia of
technique rather than core ideas. They are often ignorant of the theoretical alternatives that
do exist.

 

Pedagogic economies can and must be made. The core ideas of neoclassical theory should
not be excluded from the curriculum but placed alongside alternatives. For example, the
psychological assumptions that underlie 'rational economic man' should be made explicit
and compared with other psychological approaches. Just as much emphasis should be placed
on the conceptual limitations of game theory as on its techniques. Students should be
encouraged to identify, compare, contrast and criticise key ideas.

One of the problems now is that teachers of economics have been trained in a technical
fashion and are ignorant of from where the key concepts come. Economists should regain
and enhance the capacity to scrutinise concepts, and give those abilities more weight than
mere competence with techniques. The awful truth is that the reform of economics may now
require the retraining of a whole generation of teachers of economics.

 

An important first step in revitalising economics would be to give more space and prestige to the
methodology of economics and the history of economic thought, where greater understanding
of the meaning and historical evolution of concepts and ideas can be obtained. Conceptually
minded and critically able economists will once again be attracted to the profession.

 

Another vital step would be to introduce a plurality of theoretical approaches. Overall, in the
curriculum, neoclassical theory should be just one approach alongside institutional, evolutionary,
behaviouralist and other alternatives.

 

Turning to the second question: what use is neoclassical economics as a theoretical approach?
This question is very complicated and an adequate answer would take much more space than
I have available here. But I would like to stress the following points. First, for all their defects,
the different versions of neoclassical theory have enormous heuristic power. It is a good
intellectual work-out to read and criticise some parts of neoclassical theory. Second,
neoclassical theorists such as Alfred Marshall, Leon Walras and Vilfredo Pareto were subtle
and powerful thinkers and it is still worth reading their texts. Third, and above all, neoclassical
approaches are deeply flawed but we have not yet developed an adequate alternative.

 

The development of an alternative to neoclassical theory must involve adequate answers to
a number of key questions. For example: how are market prices formed? I do not believe
that Marxian or Sraffian theories are sufficient here because they both lack an adequate
conceptualisation of the human agency and decision-making processes. Evolutionary and
institutional approaches may provide an answer, but as yet one has not emerged.

 

Of course, a new economics will create new questions, as well as providing new answers
to old questions. But it will not replace neoclassical theory unless it can show overall
superiority in both respects. The task of developing a new theory is an urgent priority.
What is required is a new generation of theorists, with a broad and critical training in
economics, which is lacking in the modern curriculum. Dealing with the first 'what is worth
keeping?' question may well provide a solution to the problem raised with the second.
_____________________________
Prof. Hodgson's latest book is  How Economics Forgot History: The Problem of Historical Specificity in Social Science.
Also see http://www.geoffrey-hodgson.ws/wsn565D.html


SUGGESTED CITATION:
Geoffrey M. Hodgson, "Theoretical substance should take priority over technique", post-autistic economics review,
issue no. 14, June 21, 2002, article 5. http://www.btinternet.com/~pae_news/review/issue14.htm




Two Perspectives to Guerrien's Question
Steve Keen   (University of Western Sydney, Australia)

There are many perspectives from which Guerrien's question "Is There Anything Worth
Keeping in Standard Microeconomics?" can be answered. I will consider two: the empirical
and the mathematical.

The Empirical Perspective

There is little doubt that the conventional theory of the firm and of consumer behaviour are
bad empirics.

On the former front, there are now numerous surveys in economic literature which establish
that what neoclassical economics teaches as "the" behaviour of the firm -- profit maximisation
by equating rising marginal cost to falling marginal revenue -- applies to at best less than 5
per cent of firms and 5 per cent of products. Research into the actual cost structure facing
most products, have routinely found that in 95 per cent or more of cases, marginal costs
remain constant or fall across the relevant range of output. Research into the actual behaviour
of firms shows similarly that, in 95 or more per cent of cases, firms chase the maximum
possible level of sales without any consideration of declining marginal revenue (Fred Lee is
the modern chronicler of this literature, with his book Post Keynesian Price Theory being the
ultimate reference).

Similarly, the vision of consumers deciding what to purchase by working out the point of
tangency between the budget hyperplace and indifference hypercurve has failed miserably
in experimental work. The latest and best reference on this, Sippel 1997, concludes very
honestly with the observation that the theory failed to predict students behaviour in a very
well designed controlled experiment, and that as a consequence economists "should therefore
pay closer attention to the limits of this theory as a description of how people actually behave".

The fact that despite these empirical failures, economists continue to teach the standard
theory of the firm and consumer theory is perhaps the strongest indictment one can give
against standard microeconomics. It has acted as a barrier to an honest confrontation with
the real world, and deserves to be dropped on that ground alone.


But of course, it won't be: because ever since Friedman's defence of the "as if" approach to
economic methodology, economists have felt justified in ignoring the real world since whatever
firms and consumers think they are doing, they must be behaving "as if" they were doing what
economists say they do, otherwise they wouldn't be profit maximisers or rational consumers.

 

The Mathematical Perspective

 

Well, if economists can't be persuaded to consider reality because it conflicts with their
mathematics, we're going to have to turn our attention to the mathematics itself. And it
turns out that there are good mathematical reasons to reject standard microeconomics.

Let's take first of all the theory of consumer behaviour. The standard presentation-of a
consumer making a choice between two commodities-makes the exercise appear simple.
But whoever heard of a consumer living on just two commodities? Yet each additional
commodity considered involves an additional set of axes-three for three commodities,
4 for four-and each axis increases by an order of magnitude the number of choices facing
the consumer.


Once we get anywhere near the number of commodities and number of units per commodity
that a typical Western consumer buys on a monthly basis, the number of choices explodes
to such a level that simple "rational" utility maximisation is inconceivable. For example, if
we simply consider a purchase of less than ten items each from a set of 30 commodities, the
number of combinations to be considered is 1030 (to put this number in perspective, the age
of the universe is under 1018 seconds).


This "curse of dimensionality" is a well-known phenomenon in computer science, and it is
well-known that an exhaustive maximisation approach is simply impossible with such problems.
Instead, consumers have to be following algorithms that drastically reduce the choice space:
letting their choices be guided by custom, convention, habit, income-constrained tastes, etc.
The conventional, simplistic vision of consumers as rational utility maximisers is a positive
hindrance to serious study of the interesting question of how consumers manage to make
consumption decisions in the face of overwhelming choice. By not honestly considering the
mathematical implications of their theory of consumer behaviour, economists are practicing
bad mathematics.


The same applies in the theory of the firm, where students start off being taught bad
mathematics. All economists know the "perfect competition" assumption that the derivative
of the market demand curve with respect to the output of a single firm is zero. Not enough
know that George Stigler-hardly a radical there-pointed out in 1957 that this is mathematically
invalid: if the market demand curve is negatively sloped with respect to market output, it is
negatively sloped with respect to the output of a single firm. This is a simple application of
the chain rule for a continuous function (and also a product of the assumption of atomism).

A minority of economists appear to know Stigler's attempt to get around this by redefining
marginal revenue for the individual firm as market price plus market price divided by the
number of firms times the market elasticity of demand, coupled with the assertion that "this
last term goes to zero as the number of sellers increases indefinitely" (Stigler 1957: 8). Too
few realise that this was a sleight of hand: the term is a constant if there is a minimum firm
size, and therefore the firm's marginal revenue is always less than price.


So-called mathematical economists have attempted to evade this by assuming that each
industry consists of an infinite number of firms each producing an infinitesimal output (not
an infinitesimal fraction of total industry output, but an infinitesimal output!). But this makes
a mockery of the theory of exchange-how can consumers buy a single unit of anything if
they have to go to an infinite number of producers to buy a single unit?-and of the theory
of production itself-how can diminishing marginal productivity apply (the foundation of the
proposition that marginal cost rises) if the minimum firm size is zero?

All these nonsense propositions have been put forward to defend the indefensible concept
of perfect competition, and they are propositions that any decent applied mathematician
would reject outright.

 

Yet this kind of behaviour-proposing decision processes that are empirically impossible,
making assumptions that are absurd in order to preserve an initial proposition that has
been shown to be fallacious-is a direct consequence of adherence to the conventional
theory of microeconomics. It is bad, unscientific behaviour, that should have no place in
a serious discipline.


References
Lee, F., (1998). Post Keynesian Price Theory, Cambridge University Press, Cambridge.
Sippel, R, (1997). 'Experiment on the pure theory of consumer's behaviour', Economic Journal 107: 1431-1444.
Stigler, G.J. (1957). "Perfect competition, historically considered", Journal of Political Economy, vol. 65: 1-17.
_______________________________
Steve Keen is the author of Debunking Economics: The Naked Emperor of the Social Sciences

SUGGESTED CITATION:
Steve Keen, "Two perspectives to Guerrien's question", post-autistic economics review, issue no. 14, June 21,
2002, article 6. http://www.btinternet.com/~pae_news/review/issue14.htm




Superior Analysis Requires Recognition of Complexity
Anne Mayhew   (University of Tennessee, USA)

Neoclassical microeconomic theory is, both in its simple, and in its most rarefied forms,
a theory of how a unit will respond when faced with the commercial logic that says buy
cheap, sell dear, and if you don't cover your costs over some reasonable period of time,
you will cease to exist.   It does not matter whether the prices to which the unit responds
are changed through competitive or uncompetitive markets or by an auctioneer; the analysis
is of response to price. 

 

The question to ask, in answering Guerrien's question, is whether or not the commercial
logic is applicable to units whose behavior one wishes to analyze.  The sleight of hand
performed at the beginning of most introductory economic textbooks, and assumed
thereafter in more advanced work, is that given conditions of unlimited wants and limited
resources, the logic does apply widely.  The wants can be wants for revenue for firms, utility
for consumers, benefits for recipients of government services.  If the wherewithal to get those
wants (costs of inputs for firms, work or disutility for consumers, tax revenues for governments,
resources for all of society) are limited then commercial rationality is assumed to be the only
possible rationality; the alternative is assumed to be irrationality.

 

The power of economic analysis described by Bruce Caldwell (PAE Review no. 13)  in his
defense of the use of microeconomic  theory is the power to explain the impact of price
ceilings or floors, price supports, and the like given that the units involved react to price
according to the commercial logic.  I would agree with Caldwell that if this condition is met,
then microeconomic theory does have wide applicability.

 

However, there is a large issue that requires further exploration, and it has nothing to do
with the contestable assumption that wants are unlimited and resources finite.  I am quite
prepared to grant these assumptions for short-term analysis of many economic issues. 
What I am not prepared to grant is that two additional conditions for application of the
commercial logic are in fact met by most of the economic units with which economic
analysis must deal if such analysis is to be useful in thinking about economic issues.  

 

The first condition is that there must be a numeraire that can be used to perform the double-
entry bookkeeping that is core to the commercial logic.  A numeraire, or common measurement
for otherwise diverse elements, is required to know if you are buying cheaply and selling dearly,
and, in fact, is required if the commercial logic is to have any meaning at all.

 

From this observation follows the second condition that must be met if commercial logic
is to apply: the goals of the units being analyzed must be the goal of having commonly
measured inflows at least equal to or in excess of outflows.  However, as is widely recognized
the goals of many social units, such as families and even large commercial corporations,
are multiple and cannot be toted up as a simple double-entry bookkeeping exercise.  To take
a simple example: children are not produced in accord with variation in the current, or even
projected, price of labor, so that even if the amount of labor offered from an existing stock of
people varies with price (a doubtful assumption), labor markets will also be rendered slightly
odd by virtue of the failure of the model of commercial logic to capture the full array of relevant
variables.  For large firms with political, social and market power, long-term strategies of
location, survival, and other goals are likely to outweigh and obscure the simple application
of commercial logic.

 

Where both numeraire and the simple commercial goal exist, microeconomic theory can be
a useful way of describing probable action and outcomes.  Many of Bruce Caldwell's examples
of the power of economic reasoning probably meet these requirements.  If new rental housing
is added in response to expected revenues from rent, and if apartment rental rates weigh
heavily in consumer demand, then rent control may reasonably be expected to result in
shortages.  If, however, as is apparently the case with minimum wages, there are other
factors that weigh more heavily than price on behavior of units involved (relatively fixed staffing
requirements, number of unskilled people in the labor force, and so on) then neoclassical
price theory becomes less useful.  It is certainly less useful in exploring the behavior of large,
international corporations with multiple goals, and of families with a variety of lifestyle options,
than it is in explaining the behavior of small firms that operate in markets consisting of other
such firms. 

 

The answer to Guerrien's Essay is, therefore, it depends on what you are analyzing.  There
is certainly something worth keeping in standard microeconomics, but we should not be
deluded by  the fancier ways of articulating what remains a simple model, a model so simple
that it cannot capture the complexity of interaction in economies.  Superior analysis requires
recognition of this greater complexity. 

SUGGESTED CITATION:
Anne Mayhew, "Superior Analysis Requires Recognition of Complexity", post-autistic economics review,
issue no. 14, June 21, 2002, article 7. http://www.btinternet.com/~pae_news/review/issue14.htm




What Should be Retained from Standard Microeconomics
Julie A. Nelson   (Global Development and Environment Institute, Tufts University, USA)


Bernard Guerrien's question, "Is There Anything Worth Keeping in Standard Microeconomics?"
is one that I have been thinking about a lot, recently.  In working with colleagues on writing an
alternative Principles of Microeconomics textbook, we've had to address the question of what
it is that we actually want students to know.

 

My co-authors and I come from a variety of backgrounds-ecological, social, feminist,
institutionalist, and radical.  While, to have a chance at adoption in most departments, a
textbook must cover a number of neoclassical concepts, we've given ourselves some leeway
in putting these "in context," and in deciding which to stress, and which to downplay. 

 

We certainly don't think that the number one priority is to inculcate students into adopting a
free market ideology, which is the apparent goal of many of the currently available textbooks. 
Nor should it be to teach students about the elegance of mathematical and graphical modelling. 
Even if that were to remain a priority at more advanced levels (which we would debate), the
vast majority of Principles students will use their knowledge for citizenship, not further study.
Lastly, we don't think, given the pressing nature of real-world economic problems, that our
number one priority should be to tell beginning students about our internal professional debates
about philosophy and methodology.  So what should we teach?

 

We've rejected the usual emphasis on models of "producer and consumer choice," with all
its focus on technique and all its bizarre assumptions (e.g., that efficiency is the only goal,
that households are not productive, that perfect competition is the default scenario). But-and
here we differ from Guerrien-we do see value in teaching some parts of the standard introductory
microeconomics toolbox.  For example:

  • The general notion of choice. Choice behavior is one facet of human economic behavior-
    though not the only one.  Putting choice in context means also recognizing the roles of
    habits or customs (as stressed by institutionalists) and power (as stressed by radical
    economists) in explaining behavior. Certain traditional microeconomic concepts like
    opportunity cost, and "rational" (read: reasonable) economic decision-making,  in the
    sense of weighing both costs and benefits in coming to a decision, we have concluded,
    are worth teaching. 
  • Supply and demand curves.  We introduce these as mental constructs that can give
    us some insight into real-world price variations, not as curves that exist "out there" in
    the world. While we also (for adoptability of the book) expose students to marginal cost
    curves and utility theory, we demonstrate that the usefulness of supply and demand
    analysis does not depend on identifying supply curves with marginal cost curves, nor
    with identifying demand curves with the result of indifference curve analysis.  In fact,
    our central example in the supply and demand chapter is a highly politicized national
    market for petroleum.  Further elaboration introduces students to the relevance of
    elasticities for business and government policymaking.
  • Gains from trade.  Ricardo's old England-and-Portugal story is the basis for the neoliberal
    push for globalization today, so it is important that students understand the argument. 
    However, we also complement this story with a discussion of the drawbacks of trade. 
    In addition, we include transfer as an important form of distribution right alongside
    exchange, bringing discussions about intra-household and government transfers into
    the core of analysis.

 Our book, Microeconomics in Context, takes well-being as the goal of economic activity. 
Teaching from it will probably feel less "secure" for many instructors in that it will hold fewer
cut-and-dried answers and subjects for chalk-and-talk lectures, and more opportunities for
discussion.  But, we believe, such teaching will be a considerably more intellectually
challenging and socially responsible.

 

Of course, much of Bernard Guerrien's criticism might more aptly be taken to apply to
advanced graduate work and professional research-Slutsky matrices and general equilibrium
theory are not usually the stuff of Principles classes. I would attribute much of our profession's
fascination with mathematical elegance, over understanding of the real world, to warped
notions of "rigor" and a misguided attempt to achieve certainty and absolute control (see
Nelson essay in post-autistic economics review, Issue no. 9,  20 October 2001).  By keeping
our eyes on the more pragmatic goal of developing and disseminating economic knowledge
in the service of promoting well-being, I think we can keep what is useful in existing bodies
of work-even neoclassical-while working towards developing new and more adequate forms
of research and teaching.
______________________________
Julie A. Nelson is the author of  Feminism, Objectivity, and Economics (London: Routledge, 1966) and (with
Marianne A. Ferber) Beyond Economic Man: Feminist Theory and Economics (Chicago: Uni. of Chicago Press,
1993).  She may be contacted at julie.nelson@tufts.edu.

SUGGESTED CITATION:
Julie A. Nelson, "What should be retained from standard microeconomics", post-autistic economics review,
issue no. 14, June 21, 2002, article 8. http://www.btinternet.com/~pae_news/review/issue14.htm.




An American Undergraduate Point of View
on Economics Education
K.M.P. Williams   (Wells College, USA)

As an economics student who has recently had to suffer through the course material, I
would like to contribute to the debate regarding "what should be kept in microeconomics". 
To this end, I have posed two questions.

 

My first concerns the definition of economics. Widely used micro and macro textbooks define
it as the study of the distribution of scarce resources.  I wanted to know what future teachers,
especially future social studies teachers who are likely to introduce students to economics,
thought economics was. Through email, I surveyed education students at Wells College,
asking them, "What is the definition of economics?"  I received 16 responses. Here are some
samples, the first three from students intending to teach high school social studies.

  • "The way money and things representative of money are used by people. (??? who
    knows???)"
  • "Economics is the study of income and commerce - it is the management of money." 
  • "I'm not entirely sure, to be honest. I guess I would say the study of the economy."
  • "Economics was the most boring and un-interactive class I have ever taken of which I
    remember absolutely nothing!" 
  •  "Economics is the study of money and consumerism."
  •  "I would define economics as the science that deals with income and expenditures."