The Ceteris Paribus Fantasy

I have referred to the fact that neoclassical models are internally contradictory. In doing so I have a particular criticism in mind: ceteris paribus is automatically violated by almost any change in a neoclassical partial equilibrium model, as changes generate ripple effects throughout the rest of the economy. One of the clearest examples of this is Williamson’s Managerial Utility model – a standard, run of the mill model of oligopolistic firms that most students will encounter. Let’s take a look:

Williamson’s model basically says that some firms do not maximise profit, but have a disconnect between management and ownership. Managers then seek to maximise their own utility rather than that of the owners or the firm. Williamson defines a utility function of a manager as a line where the balance between ‘staff expenditure’ and ‘discretionary profits’ is acceptable:

Manager 1 will be happy with any point on u1, manager 2 with any point on u2, etc.

We then have the relationship between staff expenditure and discretionary profits*:

Combining the two:

The point at which the two curves cross satisfies maximum utility and so determines the level of discretionary profit and staff expenditure.

Here’s the problem: you cannot change staff expenditure whilst holding all other things constant. Why? Because if you change the amount of staff you employ, you will change the wage share of the economy. This will alter the composition of demand for goods and services, generating Cantillion-esque effects and trickling through until it affects the firm in question. This creates a feedback loop, meaning the curves will be shifting constantly.

This is a massive problem with the equilibrium models that are widely used by economists. Arguments of this type do not only apply to theories of the firm – supply and demand and IS/LM are subject to similar criticisms. Whilst some of the qualitative aspects of mainstream economics are acceptable, these types of internally contradictory models have to be abandoned in favour of dynamic ones before it can move forward.

*If you are wondering why on earth these curves are shaped the way they are, you should know this is exactly how economics is taught. You are not told how the diagrams are derived, what purpose they serve, and theories are rarely filtered based on whether or not they are empirically verified. In fact, many models, including this one, are almost impossible to verify empirically.

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  1. #1 by Infinum on November 15, 2011 - 3:10 pm

    That is why macroeconomics based on static or pseudo-dynamic models is plain wrong and useless in real business.
    Economy is intrinsically dynamic and chaotic and should be modeled as such. There are many useful tools in mathematics for analysis of chaos ex. http://en.wikipedia.org/wiki/Chaos_theory.
    The problem is that today’s economists are just clueless and ignorant about all the tools used in modern sciences.

    • #2 by Unlearningecon on November 15, 2011 - 4:51 pm

      Absolutely right. Dynamic models are undoubtedly the way forward – check out David Orrell’s book, Economyths. He is an applied mathematician who works mainly with complex systems such as weather, and has many interesting things to contribute to economics.

  2. #3 by AZ on November 28, 2011 - 1:30 pm

    Great that you mention the problems with equilibrium. I’m a mathematician and not an economist, so I’m not too familiar with how economists justify these things, but it looks to me like a realistic analysis of these equilibrium models is actually quite mathematically delicate and certainly far more intricate than what an introductory economics class would have you believe.

    For example, basic economics asserts that the market settles on the intersection of supply and demand, and marginal cost equals price. But this might not even be a Nash equilibrium for the suppliers! Let’s say 10 suppliers are each selling 100 widgets at $10 a widget. There are 1500 – 50 * x people willing to buy a widget at $x or less (assume no one ever buys more than one widget). So there are 1000 people willing to buy widgets at $10 or less, and 95% of those would still be willing to buy them at $11 or less.

    Now consider what happens if one supplier raises the price to $11 a widget and cuts production to 95 widgets. Well, 900 widgets will be sold at $10, and 95 widgets will be sold at $11. There are 1000 people willing to buy the widgets at $10, but not all of them can, so 100 of them are left without widgets even though they wanted to buy one. Which 100 are these? It would be reasonable to assume that these 100 are chosen from the 1000 at random, so about 95 of them still want to buy widgets at $11. This means the supplier with the elevated price should receive 11 * 95 = 1045 dollars of income at lower production cost, which gives more profit than sticking to the “market” price of $10.

    I’m not claiming that supply = demand is necessarily wrong–the other suppliers would probably respond by increasing their production and price slightly, and then things start to get complicated–but it’s troubling that when this basic theory is taught, quite concrete and realistic scenarios such as the above are generally not addressed. (I am aware that there are some vague hypotheses about how individual firms cannot affect prices, but the point is that whatever these hypotheses are, they do *not* simply say that there are a lot of firms, and it’s not clear that they are realistic even in the most ideal circumstances.)

    • #4 by Unlearningecon on November 28, 2011 - 6:24 pm

      Thanks for your comment – I don’t really have anything to add, other than yes, simple yet damaging criticisms such as yours are generally ignored.

  3. #5 by Luis Enrique on January 10, 2012 - 5:57 pm

    ain’t this the difference between partial equilibrium and general equilibrium analysis and very well known to any economist? You use the partial equilibrium approach when it’s reasonable to say that effects, such as how changes in your staff expenditure change the wage share in the economy, are small enough to be ignored. If you think otherwise, you have to move to general equilibrium.

    This isn’t about not being “dynamic”.

    • #6 by Unlearningecon on January 10, 2012 - 6:04 pm

      ‘such as how changes in your staff expenditure change the wage share in the economy, are small enough to be ignored.’

      I’m not sure if I agree with this. Is it OK to assume CP, but then when it is violated – however little – to ignore that? It seems like special pleading to me; I wouldn’t want to model any other dynamic system that way.

      GE models are ‘more’ dynamic but they are also ergodic, which suggests to me that they are equally flawed, albeit in a different way.

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