Posts Tagged Piero Sraffa

A Unifying Principle for Economics?

Commenter Dan thinks economics has not yet found its watershed moment:

Think about Biology before DNA was discovered or Geology before plate tectonics was understood, both disciplines had learned a lot but they still lacked a comprehensive model that made everything fit into place.

I am sympathetic with this viewpoint. Heterodox criticisms come at economists thick and fast – personally, I think most of these criticisms are valid and very little of neoclassical economics should be left. Yet neoclassical economics persists.

However, in my opinion this isn’t because economics lacks a unifying theory; it’s the exact opposite. Economists already think they have found a unifying concept: namely, the optimising agent. Consumers maximise utility; producers maximise profits; politicians maximise their own interests/their ability to get reelected. Sure, there are a few constraints on this behaviour, but overall it is the best starting point. It all blends together into a coherent theory that can tell a plausible story about the economy. I find economists are resistant to any theory that doesn’t follow this methodology.

I have gone over my problems with this approach many times, so I shan’t repeat myself. The important question is what an alternative theory would look like.

The typical definition of economics is the study of how resources are allocated. Hence, a unifying theory should empirically and logically do a satisfactory job of explaining prices, production and distribution. Such a theory would be able to underlie virtually any economic model in some form, whether being the wider context of a microeconomic phenomenon, or the basis of macroeconomic phenomenon. No easy task, then, but luckily many approaches of this nature already exist.

Alternative Theories of Behaviour

If we want to stick with agent-based explanations of the economy, there are any number of alternatives to the ‘optimising’ agent. Among these are:

I consider all of these approaches useful, but none of them sufficient for the task at hand.

In the case of the first two, replacing ‘optimising’ agents with ‘satisficing’ agents isn’t exactly revolutionary. Maslow’s hierarchy can, in fact, work as a utility function. In both cases, we still run into similar problems of aggregation and of reductionism. And we end up trying to shoehorn every decision into a particular approach. The simple truth is that agents have a lot of different motivations for their actions and sometimes these aren’t always clear, even to them.

My main issue with these, and any agent based approach, is that they aren’t necessarily relevant for the wider question of resource allocation in society. Individualist-based neoclassical economics has to reduce things down to a  few agents with only a few goods in order to have any conclusions whatsoever; I can’t help but feel similar problems would emerge here. Class struggle may determine distribution but it doesn’t tell us much about what is produced and at what price it is sold. In order to understand how production takes place and prices are determined, we will have to look elsewhere.

A Theory of Value

The value approach has a lot of pluses. A theory of value underpins the explanation of relative prices, and also has normative implications that recognize the inevitable value judgments in economics. The only problem I have here is that I’ve yet to find a convincing theory of value – the two most widely known are the neoclassical/Austrian subjective theory of value and the Labour Theory of Value (LTV).

I object to the idea that prices merely reflect subjective valuations for the basic reason of circularity: prices must be calculated before subjective valuation takes place, so they cannot purely reflect subjective values.

I have more sympathy with the LTV (mostly because its proponents seem to have coherent responses to every criticism thrown at it), but I remain unconvinced. The defences of the labour theory of value tend to rest on appeals to ‘the long run’ and ‘averages” of socially necessary labour time. These may be useful, but, like the neoclassical ‘long run’ approach they seem to leave open the immediate question of what’s going on in the economy and what we can do about it.

In my opinion, these approaches both contain some validity, and are not mutually exclusive. I tend to agree with Richard Wolff, who asserts that suggesting one has refuted the other is like saying knives & forks have refuted chopsticks. Both are useful; neither are all-encompassing theories. I also believe both are compatible, to some degree, with my favoured approach:

The ‘Reproduction and Surplus’ Theory

This approach is the one emphasised by Sraffians and Classical Economists. It starts from the basic observation that society must reproduce itself to survive, and that generally society manages this, plus a surplus. The reproductive approach emphasises what I believe to be an important aspect of capitalism, and perhaps all systems: the collective nature of production. Industries are interdependent; people work in teams; various institutions, often state-backed or provided, underlie all of this. Hence, no special moral status is accorded to prices or the allocation of surplus, except that prices must be appropriate for the continued existence of industries and society as a whole.

On first inspection the ‘insight’ that society must reproduce itself might be considered trivial, but following through its implications can yield interesting and useful conclusions. The framework can be used to determine prices technically, independently of either preferences or values. It emphasises the interdependent nature of the economy: if one industry or input fails, it has severe knock on effects. For this reason, it would do a great job of explaining both the oil shocks and resultant stagflation of the 1970s and the 2008 financial crisis, something modern macroeconomics cannot manage.

On top of this, the model is versatile: it can interact with its institutional environment, which determines key variables exogenously (e.g. the monetary system determines interest rates, political power determines distribution). The classical approach is, for example, compatible with class theories of income distribution, post-Keynesian theories of endogenous money and mark-up pricing, and even neoclassical utility maximising individuals! Probably the most promising and complete framework out of them all – I look forward to further developments of this approach.

It is feasible that the task of finding a watershed moment is not possible in the fuzzy world of social sciences. Psychology and sociology are both characterised by competing approaches; psychology in particular has improved since the neoclassicals Freudians were dethroned. If neoclassical economics has taught us nothing else, it’s the importance of not being trapped by particular theories for want of elegance, which is why there is a lot to commend in the institutional school of economics.

Nevertheless, I think there is scope for exploring unifying principles. Progress in neurology may provide such a foundation for psychology; similarly, ideas such as societal reproduction could equally be applied to sociological concepts such as the role of beliefs, class, sports or what have you. As far as economics goes, such a substantial step forward could be what’s required to displace neoclassical economics, whose staying power, in my opinion, cannot be accorded to either its empirical relevance or its internal consistency. Perhaps neoclassical economics persists simply because its building blocks are so well defined that other approaches seem too incomplete to offer their opponents sure footing.

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Whichever Way You Paint It, The Supply Curve Is Flat

The conventional ‘upward sloping’ supply curve is known by everyone from an econ101 student to a professional economist. The curve posits a positive relationship between price and quantity supplied – in order to increase the quantity supplied, a higher price must be offered. What is less commonly known, however, is that an upward sloping supply curve is actually incredibly hard to justify, both in theory and in practice.

Behind the curve lies the proposition that production costs per unit increase as output increases. This makes the ‘upward slope’ a necessity: since an item costs more to produce, a higher price must be charged as production increases. Microeconomic theory posits that this relationship holds in both the short and long run. However, all signs say this can’t be true.

The Short Run

The neoclassical idea is that firms can only increase one factor in the short run, which gives birth to the increasing marginal cost argument – returns to production diminish as more and more is ‘squeezed’ out of the fixed input. Is this how production behaves?

I have previously commented on Piero Sraffa’s excellent critique of the idea of increasing marginal costs in the short run. Sraffa’s argument was two pronged, depending on how we define a ‘firm’ or ‘industry.’

Sraffa argued If we define an industry narrowly, such as a single firm, it turns out firms generally have a lot of spare capacity and can quickly employ previously idle resources to expand all inputs at once. This belies the traditional justification for decreasing returns – if we expand inputs simultaneously, we should expect roughly constant increases in output as a result.

Sraffa went on to argue that we could define an industry broadly enough that it’s reasonable to say a factor is fixed in the short run. This would be because, for a large industry, a new factor would have to be converted from other uses before it could be employed. Hence, diminishing returns may be possible. However, at this point it is no longer possible to neglect the collateral effects caused by changes in firm’s expenditure and output: the partial equilibrium method becomes contradictory, and the various curves – demand, supply, average cost – cannot move independently, which is a key assumption of the theory. So the theory as a whole is no longer appropriate.

So the idea doesn’t hold up in the short run, except in the extremely small number of cases that lie between the ‘narrow’ and ‘broad’ definitions. But what about the long run?

The Long Run

If you learn producer theory from the bottom up, one of the assumptions you start with is that inputs and outputs are infinitely divisible; in other words, they are like clay. They are also homogeneous, and available at a set price. Based on these assumptions, it is reasonable to assume that in a short run – when one factor is fixed – there may be increasing marginal costs. At this point I would defer to Sraffa’s above critique.

However, when we move to the long run, it’s incredibly hard to justify increasing MC even within the confines of the theory. Textbooks will generally assume the standard production function, which looks like this:

The downward sloping portion – for which costs fall as output rises – will generally be justified by ‘Economies of Scale (EoS).’ But what causes EoS? Bulk buying is one example, but this can’t apply because prices are taken as a given. Another is indivisibilities – if you buy a big machine it takes a while before you fully utilise it – but this quite clearly contradicts the assumption of perfectly divisible inputs. Yet another, the increasing returns to the division of labour, contradicts the assumption of homogeneous inputs.

Similarly, the upward sloping portion is then justified by ‘Diseconomies of Scale (DoS).’ Examples of this are generally few and far between – DoS is, after all, the strange proposition that firms simply become incompetent at some level – but again they tend to contradict our assumptions. One example is managerial difficulties – who is the manager if labour is homogeneous?

In fact, it turns out that few, if any, of the explanations for either EoS or DoS hold up under the available assumptions. If you increase a homogeneous  perfectly divisible mass of inputs a certain amount, there is no reason to expect anything other than a constant, proportional increase in put: in other words, constant returns to scale.

The Evidence

Unsurprisingly, it is true that the overwhelming majority of firms report constant or falling returns to scale. Walking down a high street in a capitalist country, it’s hard to deny that firms have the available goods to accommodate an increase in demand without a rise in cost; factories are designed in a similar fashion. Furthermore, in the long run a firm is likely to respond to an increase in demand by opening up more branches, rather than simply increasing prices.

So what’s the problem? The proposition that demand determines outputs and supply determines price is logically, intuitively and empirically reasonable in any time period and for most industries. Why can’t economists just tilt their supply curve 45 degrees to the right?

Well, at this point a few things become apparent. The theory of the firm becomes indeterminant: one of economist’s beloved negative feedback loops that allows the economy to self-equilibrate is gone, as firm size is not limited by production costs. Hence, the marginal theory of the firm goes from explaining everything – from firm size to income distribution – to explaining very little. This also makes explicit the idea that output in the economy is driven by demand, both in the short and long run, which contradicts conventional macro theory, where demand only matters because prices are sticky.

Overall, a flat supply curve turns the conventional story told in neoclassical economics, where the economy is self-equilibrating, bar a few frictions, to one where many key variables – wages, output, firm size – go from being at the equilibrium or ‘natural’ level, into one where they are largely arbitrary. It’s easy to see why economists would resist this.

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Debunking Economics, Part XVI: The Search for Alternatives

The final chapter Steve Keen’s Debunking Economics is a brief overview of the major competing alternative economic schools of thought. The question posed is whether these schools present a viable alternative to neoclassicism and marxism, both of which Keen has already dismissed. He now goes on to evaluate Austrian, Sraffian, post-Keynesian and evolutionary economics, as well as Econophysics. I will look at Keen’s evaluation of these schools of thought and discuss his conclusions.

Austrian Economics

Keen’s view on the Austrian school is similar to that of myself and other post-Keynesians:  it shares many characteristics  with neoclassicism. These include but are not limited to: an exogenous money supply (ex. Lachmann and Schumpeter), Say’s Law, a variant of marginal productivity theory, reductionism and a government versus markets perspective. Hence, many of his earlier critiques – Sraffa’s work on capital, the excessive focus microeconomics, and post-Keynesian views on banking and the money supply – could equally be applied to Austrians. Keen himself thinks that Austrians deal with uncertainty, but (again, ex. Schumpeter and Lachmann) I’m not even sure this is true – for example, Hayek completely misused the term. Hence, criticisms of neoclassical models based on irreducible uncertainty may also apply to some Austrian arguments.

While Keen applauds Austrians’ analysis of capitalism as more dynamic than that of neoclassical economics, he notes that they do seem to retain the belief that capitalism has a ‘natural’ state that should not be ‘interfered with,’ and they actually seem to take it much further than their neoclassical counterparts. This is particularly apparent – also something that I have noted – with Hayek’s ‘spontaneous order.’ Though it is an interesting concept, it has been misused as an ideological tool against government, without considering the ‘spontaneous order’ that may evolve inside government, or the possibility the dichotomy between governments and markets may be a false one.

All in all, it’s hard to deny Austrians are part of the marginalist tradition, something Mises explicitly said. Hence, I don’t consider the school a truly ‘alternative’ way of thinking about economics, even if it has something to offer.*

Sraffian Economics

Keen praises Sraffa’s work as “the most detailed and careful analysis of the mechanics of production in the history of economics,” and notes the importance of the interesting conclusions that it brought to light. Nevertheless, Sraffa’s analysis is a static one that seems to be dependent on the existence of a long run equilibrium (here Keen quotes the Sraffian Ian Steedman as evidence). Due to the lack of dynamism in Sraffian models, Keen’s previous comments about dynamics and equilibria could be applied to Sraffa. Keen ends by noting the subtitle of Sraffa’s magnum opus: “Prelude to a critique of economic theory.” He suggests Sraffa’s main aim was to provide a basis with which to critique other theories, rather than present a positive alternative. I’ve no doubt Sraffian readers will disagree.

Econophysics/Complexity theory

This school of thought is characterised by the application of modern chaotic modeling techniques to economics. Hence, the models produced are far better suited to generating the kind of instability we observe in capitalist economies than are those used in neoclassical economics. Keen comments that the school isn’t really a direct critique or challenge of neoclassical economics, instead dismissing it outright and presenting an alternative.

Bearing the lack of direct engagement with economists in mind, it’s not surprising that the physical scientists suffer somewhat from a curse of being a mirror image of economists. Keen says that they have been rediscovering old insights such as IS-LM, then using them with other, incompatible models such as rational expectations. They also seem to have an ‘everything looks like a nail when you have a hammer’ problem, and are applying inappropriate laws, such as conservation to the distribution of wealth, or electromagnetism to immigration.

Perhaps econophysicists should be more willing to read through the history of thought – as I noted in my post on mathematics, this type of imperialism/arrogance in physicists is no prettier than in economists (commenter Blue Aurora told me that some econophysicists have been more willing to engage with the discipline recently, which is a good development). Despite these flaws, the tools of modern chaotic modeling are surely a promising area for the future of economics.

Evolutionary Economics

Keen’s discussion of this field is the first time I have been properly introduced to it, so I’ll be brief. Keen seems to think that evolutionary science is an appropriate and promising field, but one that lacks maturity. Many evolutionary concepts, such as adaption and survival of the fittest, are surely applicable to capitalist firms and product evolution. Having said that, economics lacks the equivalent of the gene to ground the evolutionary approach, so many evolutionary models are often forced to rely on analogy. Perhaps – and hopefully – the evolutionary school will be able to establish a coherent grounding in the future, but for now it is not a strong enough alternative to neoclassicism.

Post-Keynesian Economics

As this is the school Keen and I both most closely align with, you’ll not be surprised to hear the many advantages we think it has to offer: dealing with uncertainty; the relative lack of ideological commitment to any particular system; paying sufficient attention to money, debt and banking; more reality based models of the firm; freedom from reductionist constraints, and much more.

The main problem with this school is the lack of coherency. It’s almost defined as ‘not neoclassical economics’ (and, Keen might add, not Marxism either). Post-Keynesiansism does not really have an agreed upon methodology, something that has worked against its status as a fully fleshed out alternative.

As a brief aside: personally I don’t see why class shouldn’t be adopted as the ‘official’ methodology of post-Keynesians. It is compatible with many of the core tenets of the school – for example, the idea that individual actions should be understood in their class context fits in with the post-Keynesian idea that microeconomics should have ‘macrofoundations.‘ Furthermore, there is also an element of ‘reclaiming classical economics’ to post-Keynesianism, and the classicals generally used class as a methodological starting point. Finally, many of the models – including Keen’s – already use classes as agents, so it seems like a natural progression.

Overall, it seems post-Keynesianism is simply less rigid and more reality-based than its neoclassical counterpart, and is more fleshed out than other alternatives, save a problem with a unified methodology.** Although I suggested that this methodology should be class, perhaps – and this something to which Keen alludes – the lack of a rigid methodology is a strength rather than a weakness. Viewed from this angle, post-Keynesian economics can accept and develop concepts from all of the alternative fields (as well as institutional economics, which Keen doesn’t mention). This also solves the ‘divide and conquer’ problem – part of the reason for neoclassicism’s dominance seems to be the splits between its rivals, which as you can see are many. Generally, I think cooperation between the alternative schools of thought may be the key to building a robust alternative to the curiously resilient school of neoclassicism.

*Obviously there are strong divides within the Austrian school. Rothbardianism is barely worth exploring, while Hayek and Mises have some insights but were fairly tainted by the government-market dichotomy. As I have noted above, Schumpeter and Lachmann seemed the most willing to abandon certain pretenses and come to interesting conclusions.

**Actually, judging from the constructive comments on my marxist economics post, I have more faith in marxist economics than does Keen. However, I will need to explore it more fully before I can come to a definitive conclusion.

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Why Prefer Preferences?

Nick Rowe offers a summary of the Cambridge Capital Controversies that, though it is tongue in cheek and should not be taken too seriously, substantively leaves a lot to be desired. He states that the debate started because “some economists in Cambridge UK wanted to explain prices without talking about preferences.” This is false – the debate started because Joan Robinson and Piero Sraffa took issue with a production function that used an aggregate capital stock k, measured in £, with a marginal productivity. However, despite the faulty summary of the controversies, and to Rowe’s credit, some good discussion followed in the comments.

Sraffa built up an entire model just to critique neoclassical theory. It followed neoclassical logic, but replaced the popular measure of capital with a more consistent one: summing up the labour required to produce it, and the profit made from it. His model of capitalism started with simplistic assumptions, but increased in complexity. Within the confines of his own model, he showed several things: the distribution between wages and profits must be known before prices can be calculated; demand and supply are not an adequate explanation of prices, and the rate of interest can have non-linear effects on the nature of production. I cover this in more detail here.

Rowe’s primary criticism of Sraffa is that his model did not use preferences, which is a criticism also made by others.  But eliminating preferences is a neglibility assumption: we ignore some element of the system we are studying, in the hope that we can either add it later, or it is empirically negligible. As Matias Vernengo notes in the comments, Sraffa was deliberately trying to escape the subjective utility base of neoclassical economics in favour of the classical tradition of social and institutional norms, so he assumed preferences were given. This is just a ceteris paribus assumption, which economists usually love! In any case it turns out that preferences can be added to a Sraffian model, with many of the key insights still remaining. Indeed Vienneau’s model (and, apparently, the work of Ian Steedman, with whom I am unfamiliar) invoke utility maximisation and come to many of the same Sraffian conclusions about demand-supply being unjustified.

Rowe also criticises Sraffa’s approach because it puts production first, over the consumer sovereignty upon which neoclassical economics is built. Should preferences provide an explanation of decisions? It appears Rowe does not take seriously the ‘chicken and egg’ problem with neoclassical models – surely, production must occur first, yet models such as Arrow-Debreu take prices as a given for firms, before anything is made.

In a modern capitalist economy, it seems illogical to say that the demand for a particular good comes first, then the supply follows as firms passively try to accommodate it. If it were true, advertising wouldn’t exist, or would be incredibly limited. It is fair to say that, independently, people have a ‘preference’ (though I’d say instinct) for food, shelter, clothing, security and other creature comforts. However, demand for most goods and services beyond this is certainly generated by advertising, marketing and other exogenous factors – advertising and marketing are one of the two primary expansion constraints experienced by real world firms (the other is financing, which, incidentally, neoclassical models often assume away too, but I digress).

An alternative way to model human behaviour would be an institutional/social norm perspective: while people instinctively want to subsist, what exactly they choose to subsist on is in large part dependent on their surroundings. There is the example of tea consumption in Britain, which started as a luxury and took decades to filter down to the lower classes. Similarly, if I had been born in India, I would probably have more of a taste for spicy foods. It’s hard to deny these things are largely dependent on social surroundings, rather than individualistic consumer preferences. Similarly, Rowe’s focus on the time-preference explanation of the interest rate seems to ignore that this will be largely dependent on institutional factors such as the state of the economy.

From an individual perspective, perhaps Maslow’s Hierarachy is a useful way of understanding purchasing decisions: after people have obtained basic needs such as food and security, things they buy are to do with identity and emotion. Don’t believe me? These concepts are exactly what firms use to try to expand their market base (for a longer treatment, see Adam Curtis’ documentary). If people don’t buy products because firms associate them with ‘self actualisation,’ then firms are systemically irrational.

Overall, I don’t think there are there any cases in which we can evaluate individual’s preferences outside a social and institutional context. Sraffa considers the economy as a whole, and leaves subsequent questions about consumers to be answered later – which they have been. Conversely, putting preferences first and having firms passively accommodate their demand runs into several logical problems, and does not corroborate with what we know about both firms and people in the real world.

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Debunking Economics, Part V: The Holy War Over Capital

There are probably few criticisms of neoclassical economics that have been both so universally acknowledged to be valid, and yet so completely ignored, as the Cambridge Capital Controversy (CCC). Chapter 7 of Steve Keen’s Debunking Economics provides an overview of this debate about the nature of capital.

Basic economic analysis teaches that capital, like other factors of production, is paid in proportion to its productivity – the so called ‘Marginal Product of Capital (MPC),’ which is presumed to be equal to the rate of profit. Keen gives two good criticisms before he delves fully into the CCC:

First, the MPC assumes that other factor inputs are fixed when capital is employed, which leads to our first problem: since capital is (rightly) assumed to be the least variable input, any time period in which you can employ more capital is surely one in which you can employ more labour, too? Once again we are forced to face the reality that firms tend to vary all inputs employed at once.

Second, in an industry as broadly defined as ‘the capital market’ we run into familiar Ceteris Paribus problems, where varying inputs will create effects on wages and the existing capital stock that alter the rate of profit. For small and medium sized firms these effects will be negligible, but when analysing the biggest firms and entire industries the feedback between them will create collateral effects that undermine partial equilibrium methodology.

However, even ignoring these criticisms, there are serious issues with the neoclassical treatment of capital.

Capital is often measured in units. There are obvious problems with this: capital includes brooms, blast furnaces, buckets, string and potentially any commodity you care to think of, so a single unit of measurement is difficult to justify. Generally economists either leave capital in undefined units or measure it by price. The former treatment does not deserve to be criticised formally – something that poorly defined is, like utility, Not Even Wrong. As for the latter, Keen notes that there is an “obvious circularity” to the definition. The value of capital is based on the expected profit from it, which is partly based on the price of capital. Thus the use of price as a unit of measurement is not particularly enlightening.

Piero Sraffa’s Devastating Critique of the Neoclassical Treatment of Capital

As always, Piero Sraffa offered the most fully fleshed out and devastating critique of the neoclassical theory.

Sraffa proposed that, instead of treating one factor of production as a mysterious substance called ‘capital,’ we instead supposed that goods produce other goods, when combined with labour (hence the title of his Magnum Opus, Production of Commodities by Means of Commodities). He rigorously derived an internally consistent model with the sole aim of invalidating neoclassical economics on its own terms. There is some debate about the empirical applicability of his conclusions, but logic is sufficient to invalidate the neoclassical theories, which are based on the same premises.

Sraffa builds up a complex model step by step, starting simple. In the first statement of the model, there are a few firms, whose only inputs are the goods produced by other firms and themselves.  So firm A needs a certain amount of commodities x, y and z to produce commodity x, whilst firm B needs a different combination to produce commodity y, and firm C a different combination to produce commodity z. Each firm produces just enough of their respective commodities for economy-wide production to continue at the same level in the next period. Sraffa’s next step is to alter the model so that each firm produces more than they need to in order to continue production – a profit.

The first conclusion he comes to is that the relative production of factor inputs,and the rate of profit, is not based on supply and demand, but on ‘the conditions of production’ – the amount of inputs required to keep a firm or industry going.

Sraffa then explicitly incorporates labour into his model. He notes that wages are obviously an inverse function of profit: the higher they are, the lower profit will have to be, and vice versa. He then proposes a new method of measuring capital: treat it as the dated value of the labour required to produce it (wages), plus the profit made from it since it was produced, plus the value of the commodity that was combined with the labour to produce it. This ‘residual commodity’ can then be further reduced to labour times profit, plus another commodity, and so forth:

commodity a = ((labour input at time x)*((1+rate of profit)^(time periods since time x))) + commodity b

As Sraffa himself points out, there will always be residual commodity left out if you break down a commodity into the labour and commodity required to create it. However, as you do this again and again, the resultant term becomes smaller and smaller until it can be negated. This type of reasoning is far more scientific than the neoclassical approach and actually closely resembles the perturbation methods used by mathematicians and engineers, where a function is split into an infinite amount of terms of decreasing value, but only the first few are used in calculations.

In the equation above, there are two competing effects: profits and wages. As one rises, the other must decrease. It is easy to see in this in equation that there is a peak value for capital somewhere in the middle; either side of this the reduction in one term will overwhelm the other and the measured value of capital will decrease.

This creates an interesting phenomenon known as capital reswitching. Consider two production techniques, A and B, which involve inputting different amounts of labour at different times – a common example is creating wine through ageing it (A) or through a chemical process (B). A requires more labour input in the distant past; B requires more labour input in the near past. At a zero rate of profit, both techniques are identical. As the rate of profit rises, technique A, which relies on more distant, fewer labour inputs, will remain cheaper and therefore more viable. However, as the effect of the rising rate of profit compounds due to the time delay, technique A will become more and more expensive, and technique B will take over.*

The point of this approach is to show a few things:

(1) The value of capital varies depending on the rate of profit, as the rate of profit is a variable in the equation for measuring capital. Since the measured amount of capital depends on the rate of profit, profit cannot simply be said to be the ‘Marginal Product of Capital.’

(2) There is no easy to discern relationship between profitability and the amount of capital employed. Generally, neoclassical economics teaches that output is simply a concave but increasing function of the amount of capital employed, much like any other demand/utility curve. Capital reswitching destroys this idea.

(3) We cannot calculate prices without first knowing the distribution between wages and profits. The measured price of inputs depends on income distribution, not the other way round.

Many might be struck by the sheer level of abstraction in Sraffa’s approach. It’s worth noting that in Commodities, he adds many more levels of realism past those that Keen explores. But, as I said before, the basic point was taking on neoclassicism with its own logic, rather than presenting an alternative. By the end of the debate, Samuelson and Solow had both conceded that the criticisms were valid, and their models were wrong or incomplete.

Discussions of the CCC since then have tended to assume the standard neoclassical tactic of asserting the objections have been incorporated. But this stuff was 50 years ago. Why do undergraduate and postgraduate programs still teach concepts like the MPC? The Solow-Swan growth model, which depends on an aggregated capital stock K, subject to diminishing returns? As Robert Vienneau says, if neoclassicism were really revising itself to the extent that’s needed, we’d expect some of the modifications to filter down over time. But the fact is that they haven’t.

In fact, what seems to have happened is that economists have done a fairly typical dance – weaving between ‘that is unimportant’ and ‘that has been incorporated:’

Aggregative models were deployed for the purposes of teaching and policymaking, while the Arrow-Debreu model became the retreat of neoclassical authors when questioned about the logical consistency of their models. In this response, a harsh tradeoff between logical consistency and relevance was cultivated in the very core of mainstream economics.

This sort of evasiveness is common – there will always be a paper written recently that attempts to shoehorn any objection one cares to think of into the neoclassical paradigm. But these objections are incorporated one at a time, rarely find their way into the core teachings, and never involve questioning the foundations of neoclassicism on any substantive level. The reality is that, when the problems are as deep as the ones highlighted in the CCC, we need a meaningful overhaul rather than mere ad-hoc modifications.

*For those interested, the linked Wikipedia article has a fairly simple numerical example where the most effective method goes from A to B and back to A again.

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Debunking Economics, Part III: “Uninformed and Inexperienced Armchair Theorisers”

Chapter 5 of Steve Keen’s Debunking Economics explores the marginalist theory of the firm. Keen first channels Piero Sraffa’s 1926 criticisms, then catalogues the neoclassical theory’s complete lack of real world corroboration – as noted in my title, a businessperson once referred to it as “the product of the itching imaginations of uninformed and inexperienced arm-chair theorisers.”

The neoclassical theory of the firm supposes that, in the short run, firms face increasing marginal costs – their costs per unit (average cost) increase as they produce more. This occurs because in the short run, the ‘amount’ of capital (and land) employed is fixed, so producing more involves squeezing more and more out of machines with more labour. The intersection of these increasing costs with how much they can gain from selling more, or their ‘marginal revenue’, constrains their size.

This homogeneous treatment of capital should strike many as silly. The neoclassical theory effectively supposes that, if we employ 9 people to dig a ditch with 9 spades, employment of the tenth will split the 9 spades into 10 slightly smaller, worse spades. However, if new labour is employed, new capital is – must be – employed simultaneously, whether it is bought or if it is taken from previously idle capacity. A taxi driver cannot do anything without his taxi; an office worker without a computer is also fairly useless.

So increasing marginal costs are unlikely to be the case with individual firms or narrowly defined industries. As Keen puts it, “engineers purposely design factories to avoid the problems economists believe force production costs to rise.” In reality, firms have excess inventories and tend to vary capital, labour and land all at once, even in the short run. They therefore face roughly constant, or falling, returns to scale.

Sraffa pointed out that it’s only really valid to treat some factor inputs as fixed if we define an industry so broadly that the factors would have to be converted from other uses. For example, if we take agriculture, and assume the country is well populated and at or close to full employment, then it’s reasonable to treat land and machinery as fixed in the short term. However, since the theory of the firm assumes that supply and demand are independent and that one ‘industry’ can be studied apart from all others, another problem appears: this situation does not lend itself well to ceteris paribus analysis. Changing wages, supply costs, and the displacement of labour from other areas will have notable impacts on the rest of the economy, such that tinkering with our curves individually cannot be deemed a proper representation of what will happen.

There are a few cases where firms or industries might fall between these two categories, but really they are the exception.

Keen cites 150 empirical surveys that found firms reporting constant or falling average costs of production. In particular he cites Eiteman and Guthrie, who found that 95% of firms out of 334 did this, whilst only 1 chose the curve that looks like the one found in textbooks. Most firms also use cost-plus pricing, rather than taking marginal considerations into account, and adopt a form of trial and error when pricing.

A flat(ish) supply curve leads us to the incredibly interesting proposition, supported by the classical economists, that supply determines price while demand determines quantity. This is, of course, a simplification ,but appears to corroborate far better with the real world than neoclassical ‘simplifications.’

In my opinion this is the strongest case against neoclassical micro as taught. Jonathan Catalan can find no objections to this section, either, and gives the story an Austrian slant. Keen says that this problem has never really been addressed by economists, but ignored, despite the clear superiority of Sraffa’s logic and the corroboration of the empirical evidence with his approach. I find it hard to believe neoclassical economists can wiggle their way out of this problem, should they ever address it.

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