Debunking Economics, Part XVII: Response to Criticisms (1/2)

Naturally, mainstream economists have been critical of Steve Keen’s Debunking Economics. I will do a brief series within a series to try and respond to some of these criticisms. In this part, I will respond to some of the main critiques of neoclassical theory that have generated controversy: demand curves, supply curves and the Cambridge Capital Controversies. In the next post, I will respond to criticisms of Keen’s own models and his take on the LTV, as well as anything else that has attracted criticism.

Note that this post will assume prior knowledge of Keen’s arguments, so if you haven’t yet read my summaries above (or better still, Keen’s book), then do it now.

Demand Curves

It seems there are some problems in this chapter. Keen mixes up some concepts and misquotes Mas-Collel. Having said that, he is broadly right. This is frustrating for someone on his ‘side,’ because it means mainstream economists can dismiss him when they shouldn’t.

Keen presents a quote from Mas-Colell where he assumes a benevolent dictator redistributes income prior to trade, and asserts that this assumption serves to ensure market demand curves have the same properties as individual ones. In fact, Mas-Colell is using this assumption to ensure that a welfare function, not a price relationship, will be satisfied. It remains true that a PHD textbook still assumes a benevolent dictator redistributes resources prior to trade, and subsequent economists have also used this assumption, which is not a great indicator of the state of economics. However, it was not an assumption used to overcome the Sonnenschein-Mantel-Debreu conditions.

More importantly (wonkish paragraph), it seems Keen lost some nuance in the translation of his critique to layman’s terms. He spends a lot of time talking about the Gorman polar form. This is about the existence of a representative consumer for a set of indirect utility functions (‘indirect’ because it calculates utility without using the quantities of goods consumed), but Keen makes out it is about the aggregation of preferences required for demand curves. Gorman is in many ways similar to, but not relevant to, the discussion of the aggregation of demand curves. Keen also argues that consumers having identical preferences is the same as them being one consumer, but this needn’t be the case: just because you and I have the same preferences, doesn’t make us the same person

Despite this, the competing wealth and substitution effects do create the conditions described by Keen. However, they only apply under general equilibrium – under which wealth effects are present – and not partial equilibrium – under which they are assumed away. Keen does not distinguish between the two.

In summary, Keen is correct that neoclassical economists could not rigorously ‘prove’ the existence of downward sloping demand curves. Keen himself says that it is reasonable to assume that demand will go down as price does, and classical economists were also content with this an observed empirical reality. Neoclassical economists themselves ended up having to defer to empirical reality when faced with the SMD conundrum and thus they had gained no insight beyond the classical economists, except to prove that their preferred technique – reductionism – does not work. For this reason, I interpret the SMD conditions primarily as a demonstration of the limits of reductionism (though some fellow heterodox economists might disagree).

Supply Curves

The proposition here is pretty simple: a participant in perfect competition will have a tiny effect on price. This is small enough to ignore at the level of the individual firm, which is neoclassical economist’s main defence. However they ignore that, as Keen says, the difference is both “subtle and the size of an elephant.” Once you aggregate up a group of infinitesimally small firms making incredibly small deviations from maximising profits, you get a result that is far away from the one given by the neoclassical formula. Result? We must know the nature of the MC, MR and demand curves to know both price and quantity, just as with a monopoly. The neoclassical theory – at this level – has no reason to prefer perfect competition to a monopoly, and a supply curve cannot be derived. From what I’ve seen, the critics ignore the effect of adding up tiny mistakes, instead focusing on how tiny they are on an individual level.

Economists have some other defences, but I interpret them as own goals. For example, there is the argument that, under perfect competition, firms are price takers by assumption. They cannot have any effect on price, by assumption. But this basically amounts to assuming the price is set by an exogenous central authority, which is odd for a model of perfect competition.

Another argument is that setting MC=MR itself is an assumption. This is a strange path to take for a theory that prides itself on internal consistency and profit maximisation. It acknowledges that MC=MR will not quite maximise profits, so amounts to the assumption that firms are not profit maximisers. There is also the similar argument that firms don’t take Keen’s problems into consideration in real life, so they don’t matter. This is a huge own goal, given most textbooks argue that it doesn’t matter what firms do in real life. I’m quite happy to acknowledge it does matter how they actually price – but that would involve abandoning the marginalist theory of the firm and using cost-plus pricing.

So, now that we have all finished discussing how many angels can dance on a pinhead (turns out it was slightly fewer than economists thought), let’s just start using more realistic theories of the firm and forget the mess that is marginalism.

Cambridge Capital Controversies

There are swathes of literature on this and I cannot hope to explore them all. The main thing I have noticed, and want to discuss, is that economists only seem to focus on capital reswitching when discussing this, and defer to empirical evidence to suggest it is negligible. I have a few problems with this:

(1) Empirical evidence is competing and some evidence suggests reswitching is more common than economists would like to think. Furthermore, it is incredibly hard to observe and therefore cannot be dismissed so easily.

(2) Most importantly, the Capital Controversies were not just, or primarily, about reswitching. Sraffa showed a number of things: demand and supply are not an adequate explanation for static resource allocation; the distribution between wages, profits and other returns must be known before prices can be calculated; factors of production cannot be said to be rewarded according to ‘marginal product’. For me these are more important, and are applicable to many models used today, such as Cobb-Douglas and other production functions, and the Solow Growth model.

With all 3 of the examples I have discussed, economists have tried to defer to empirical evidence to dismiss the problems with their causal mechanics. But generally economists do not regard empirical evidence about causal mechanics as important (the primary example being the theory of the firm), instead insisting on rigorous logical consistency. Surely, in order to be completely logically consistent, economists should at least be willing to experiment with the potential effects of SMD and reswitching in general equilibrium models and see what happens? Robert Vienneau has various discussions of this.

The common thread between these is that economists seem incredibly adept at assuming their conclusions. Of course, you can get around any critique with an appropriate assumption, but as I’ve discussed, theories are only as good as their assumptions and assumptions should not be used simply to protect core beliefs and come to palatable conclusions. Having said that, Keen’s book isn’t perfect (which is to be expected if you try and take every aspect of economics on in one book), and there are worthwhile criticisms out there. Nevertheless, Keen’s critique as a whole remains in tact, and leaves very little of what is taught on economics courses left in its wake.

P.S. Feel free to use the comments space to discuss any critiques of areas I have not covered/said I will cover.

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  1. #1 by Roman P. on December 3, 2012 - 6:04 pm

    Concerning demand, Prof. Keen left the best part of his critique out of the main book: namely, the practical impossibility of the calculation of utility for n goods and, thus, choosing amongst them. SMD theorems are kind of obscure in comparison.
    Supply: this critique would have been a killer one in, say, 1920’s, but right now the whole concept of the perfect competition is not very relevant for the science of economics. So I regard various Sraffa’s objections to the neoclassical theory, listed in the previous chapter of Debunking Economics, as more fundamental (and still ignored by the mainstream economists).

    • #2 by Unlearningecon on December 4, 2012 - 10:35 am

      Concerning demand, Prof. Keen left the best part of his critique out of the main book: namely, the practical impossibility of the calculation of utility for n goods and, thus, choosing amongst them. SMD theorems are kind of obscure in comparison.

      In my experience economists ignore this because people apparently act as if they are optimising. They frequently refer to analogies with biology where bacteria and other organisms are sometimes assumed to optimise. Difference being that we have large swathes of evidence on how humans actually make decisions, whereas the bacteria is just used because there is nothing better.

      Supply: this critique would have been a killer one in, say, 1920′s, but right now the whole concept of the perfect competition is not very relevant for the science of economics.

      It is relevant for what is currently taught, though not for modern models. However most people do not learn these, and still cling to the idea of perfect competition because it might be ‘useful’ or ‘elucidate certain principles.’ It’s difficult to persuade people who have spent years of their life learning it that it’s completely worthless.

  2. #3 by Min on December 3, 2012 - 6:54 pm

    I am involved in a related discussion on WCI and do not seem to be getting anywhere. Not that I am looking for someone to take my side, but I would appreciate some feedback. :)

    The claim is that the demand curve for the individual producer has the same slope as the market demand curve. That works in the special case that all other producers hold production constant. But if one producer is considering increasing production, then a lot of others probably are, as well. In that case the demand curve for the individual should normally be steeper than the market demand curve, no?

    (The discussion on WCI is still on the question of which assumptions are being made.)

    Thanks. :)

    • #4 by Unlearningecon on December 3, 2012 - 11:02 pm

      The theory of perfect competition assumes firms do not respond to other’s actions so their actions are considered independently.

      No, the demand *curve* will not be steeper. The curve itself only changes if something that is not on one of the axis is changing. In this case all that is changing is quantity, which is on the X axis. So what will happen will be that the firm will move down the demand curve, so the MR and demand curves will diverge.

      • #5 by Min on December 3, 2012 - 11:31 pm

        Thanks for the response. :)

        If I understand Nick Rowe correctly, he is saying (without calculus) that ΔP/ΔQ = ΔP/Δq, which means that ΔQ = Δq, or equivalently that ΔQ/Δq = 1. That is true when the other differences in quantity are 0. And that, as I pointed out, is not the same as independence. Independence does not require that condition.

        Anyway, if you grant that ΔQ > Δq, the individual slope will be steeper. :)

      • #6 by Unlearningecon on December 4, 2012 - 10:36 am

        Yeah, that’s the MR curve that will have double the slope – not the demand curve.

  3. #7 by Lord on December 3, 2012 - 6:55 pm

    One has to wonder how useful general equilibrium is if it can never be attained as circumstances change faster than the economy can and most of the economy is not about operating around it but exploiting the discrepancy from it and not about what circumstances are but about what they may or will be. Change, growth and decay are too large a part of the story. There are states and trends but never equilibrium.

    • #8 by Unlearningecon on December 4, 2012 - 10:30 am

      Yeah, absolutely. Few markets would exist were it not for the inefficiencies and disequilibrium of capitalism. I spoke about this in my post Assuming Away the Economy.

  4. #9 by Mathieu Dufresne on December 5, 2012 - 12:22 am

    “In fact, Mas-Collel is using this assumption to ensure that a welfare function, not a price relationship, will be satisfied.”

    In fact, Keen argues that Samuelson came up with the welfare function in order to get around the problem of aggregation and he suggest that Mas-Collel’s benevolent central authority is probably inspired from Samuelson’s paper, since he references it as a paper for further discussion.

    You think Keen is mistaken on that one?

    • #10 by Unlearningecon on December 5, 2012 - 9:43 am

      I have admittedly not read Samuelson on this but my guess is Samuelson used it to solve the same problem Mas-Collel did and Keen has misinterpreted both of them.

      • #11 by Mathieu Dufresne on December 5, 2012 - 12:03 pm

        Well, I don’t have Mas-Collel so I can’t see for myself but reading Samuelson’s paper, I don’t think there’s any doubt that he used the welfare function in order to get around the problem of aggregation.

        http://gatton.uky.edu/faculty/hoytw/751/articles/samuelsonsic.pdf

      • #12 by Unlearningecon on December 5, 2012 - 4:56 pm

        My take: it’s a similar assumption but not quite the same one. Mas-Collel’s is that a dictator redistributes resources prior to trade. Samuelson’s is that the community can be represented by a dictator.

        So Keen is half right, just a bit mixed up.

      • #13 by Oilfield Trash on December 5, 2012 - 6:49 pm

        I guess Keen’s main point on Samuelson was for market demand curves to behave just like individual ones, you have to assume that in a capitalist society, incomes are continuously adjusted so that an ethical distribution of income is achieved.

      • #14 by Unlearningecon on December 5, 2012 - 7:55 pm

        The point Mas-Collel makes is this, but for welfare functions of demand curves, not the shape of curves themselves.

  5. #15 by Jamie on December 5, 2012 - 8:10 pm

    I am not an economist but I have read most of Steve Keen’s book and a few of his articles, and I have watched several presentations by him. I have also followed your series with interest.

    When thinking about each topic, I try to ask myself several questions:

    • What problem is being addressed?
    • Is this problem important in the real world?
    • Who is correct? Steve Keen or the mainstream?
    • What is the most straightforward way of expressing both the problem and its solution?

    My perception is that both Steve Keen and you are primarily interested in the question of who is correct.

    In some areas, such as the role of banks and endogenous money, I agree with both Keen and you, and can answer all of my questions.

    However, in other areas, I get lost. Supply and demand curves are a good example.

    On the one hand, I can’t see why I should be interested in the shape of generic supply and demand curves. What problem are they addressing? Perhaps, I am showing my lack of economics knowledge but I can’t get past this question.

    On the other hand, I do think that the strategies used by real businesses to manage supply and demand can be very interesting. For example, supermarkets in the UK are currently using alcoholic products as a loss leader. By selling these products at a loss they stimulate demand for these products and attract new customers into their stores. This provides them with the opportunity to stimulate demand for many other full priced products. This strategy is obviously effective (otherwise they would discontinue the practice). However, it has unexpected side effects. By selling alcoholic products at a loss, they are encouraging drinking at home and cutting the throat of pubs.

    I could quote many other interesting examples from different industries. For example, some industries (e.g. retail, hotels) use pricing to reward customer loyalty while other industries (e.g. banking, insurance) use pricing to attract new customers but to punish customer loyalty. However, the main point is that pricing strategies are not generic across industries or even, in some cases, within industries. It’s the different strategies that are interesting.

    I’d be interested in your views both on the practical real world uses of theories about generic supply and demand curves, and also about the apparent lack of interest from economists in the practical pricing strategies observed in the real world. Why should I care about the first, and why do economists give the impression of not caring about the second?

    • #16 by Unlearningecon on December 5, 2012 - 10:43 pm

      Yeah, I think that’s a fair cop within the series. I tried to fill a gap: if you search for stuff on Keen, you will mostly find cheerleaders saying he’s right and economists saying he’s an idiot. I wanted to try and get his arguments out there and discuss them, so anyone looking would know. Personally, if I were to write a book critiquing economics, my approach would be far more similar to yours than Keen’s.

      You are right about how useful this all is. As I say in my post, who really cares about perfect competition and marginalist pricing? Let’s just use reality-based theories of the firm. Your approach sounds like the institutional perspective, which I find myself aligning more and more with. Every market is different and we need multiple theories to discern their behaviour and so know which policies are appropriate. Whether this takes the form of demand-supply or something else depends on the market itself.

      (I would recommend How Markets Work: Supply, Demand and the ‘Real World’ by Robert Prasch for a short, readable introduction to this. He provides perspectives on labour, asset and other markets, as well as general comments on how economics relates to politics and philosophy).

      • #17 by Jamie on December 6, 2012 - 3:54 pm

        Thanks. I’ll have a look at the book you suggest.

        Don’t get me wrong. Some of Keen’s Debunking Economics is very useful; you are right to publicise his material; and I admire your tenacity in promoting endogenous money.

        However, the real challenge is Rebooting Economics. The question is not what needs to be debunked but rather what is useful to society; what needs to be saved; what needs to be simplified/rationalised; and what needs to be modernised.

        For example, medical doctors start with a common pictorial description of the human body. All doctors have the same basic description. The rest of society also understands this same description. As a result, doctors can collaborate effectively, and the rest of us can communicate with doctors on problems and treatments.

        Compare that with economics. What does the macro-economy look like? What are its key components and their interactions? Earlier this year, there was a bad tempered and inconclusive debate between Steve Keen and Paul Krugman. Beneath the rudeness on both sides, they were arguing about the role of banks in the economy. This type of argument arises because economists don’t even share a basic description of the most important components of the economy.

        Somehow economists have lost the plot in much the same way that alchemists lost the plot. Economics needs its equivalent of chemistry. I think that the best starting point would be to go back to the quote from Keynes where he said that economists should aspire to providing a useful and reliable service like dentists.

      • #18 by Unlearningecon on December 7, 2012 - 1:02 pm

        I think the reason Keen does this is because economists dismiss people who disagree with them as people who don’t understand their theories. I think he is trying to show them- as well as persuade bystanders – that this is not the case, and there is good reason to doubt the theories.

        This type of argument arises because economists don’t even share a basic description of the most important components of the economy.

        Yep. Every textbook starts with a ‘rigorous’ theoretical description of a model or concept rather than actually investigating banks or other aspects of the economy. This has to change.

  6. #19 by Mathieu Dufresne on December 5, 2012 - 10:27 pm

    Regarding Gorman, I think Keen is right and that your mistaken. In his paper (entitled “community preference fields” BTW), Gorman shown that in order to aggregate individual indifferences curves into a community indifference curve, Engel Curves has to be paralel straight lines. So Gorman’s paper is about preferences and there’s no way anyone who actually read the paper could think otherwise (and when reading Samuelson’s paper, it seems pretty clear that’s what he’s talking about). As far as I understand the issue, Gorman polar form simply insure that those conditions are respected. The representative agent imply that the Engel Curves are paralel while the use of indirect utility functions imply that the Engel curves are linear. Keen actually mention that this is generally poorly understood and by looking at wikipedia, it seems to be true.

    • #20 by Unlearningecon on December 5, 2012 - 10:54 pm

      It seems they are very similar, but not the same. Gorman’s conditions are necessary and sufficient for there to be a representative consumer, whose demand can be represented by a standard demand function. SMD, on the other hand, simply states that aggregated demand curves will have no interesting properties unless certain conditions are satisfied.

      Keen is more right than his opponents make out, but the book gives the impression Gorman and SMD theorem are the same.

      • #21 by Mathieu Dufresne on December 5, 2012 - 11:32 pm

        I’m not saying that Gorman’s conditions and SMD conditions are the same (altough I would argue that beside some technical distinctions, they effectively mean the same thing). I’m only saying that Gorman’s conditions *are* about the aggregation of preferences required for demand curves.

      • #22 by Unlearningecon on December 6, 2012 - 2:32 pm

        Yeah I think you’re right there. Keen’s critics present this as something of a slam dunk when in reality it isn’t. Having said that, I think he does lose some nuance in the translation.

  7. #23 by Anonymous on December 14, 2012 - 11:00 pm

    Curious what you think about this theory, that debt is the cause of economic depressions.

    http://libertyloveandjusticeforall.com/2012/12/08/debt-reset-is-inevitable/

  1. Debunking Economics, Part XVIII: Response to Criticisms (2/2) « Unlearning Economics
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