Tuesday, August 28, 2012

Krugman on the meaning of neoclassical economics

So what is neoclassical economics? According to Krugman it is basically maximization and equilibrium. In his words, neoclassical or marginalist analysis is:
"economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal."
This is clearly incorrect. First, classical authors, meaning those that followed the surplus approach (from Petty to Marx, including Quesnay, Smith and Ricardo) did assume that economic agents were rational and self-interested and they also believed that the economy could be represented by equilibrium outcomes. And they clearly were not neoclassical, meaning they did not believe that supply and demand determined long term prices (natural prices as Smith and Ricardo referred to them, or prices of production in Marx's terminology).

If profits were higher in a particular sector, capitalists would try to gain from those opportunities entering the industry, and in the process would lead to a uniform rate of profit. Market prices, determined by supply and demand, would gravitate around the long term equilibrium prices that were determined by the technical conditions of production, and the previously given real wage (by conflict), in modern parlance (on the issues raised by the Labor Theory of Value, and Sraffa’s solution just check other posts in this blog).

More importantly, there was no mechanism (even in the case of those classical authors, like Ricardo, that accepted Say’s Law) that implied full utilization of labor, capital or any particular means of production. Wage flexibility did not lead to full employment. The hallmark of marginalism is the notion that supply and demand determines simultaneously the equilibrium long term prices, and that price flexibility leads to full utilization of resources, something that the capital debates have demonstrated long ago it cannot be done. In this regard, Krugman decides (because it must be advantageous) to follow those that he criticizes, and remains oblivious to both logic and empirical evidence. If he wants to be coherent with his Keynesian ideas, he should get rid of the notion of a natural rate of unemployment (or and of interest).

29 comments:

  1. Krugman: "...evolutionary theory — the biological kind — looks remarkably like neoclassical economics."

    That's going to ruffle a few institutionalist feathers!

    ReplyDelete
  2. Oh yes. I saw that one too, but decided that I had to aim at the definition of neoclassical economics. But that one is clearly off the mark too.

    ReplyDelete
  3. I wrote this on Krugman's blog, if he decides to post it:

    "Dr. Krugman, guess how often the other social sciences cite something from economics (neoclassical mainstream stuff)(lets say, per year)? Now guess how much economics cites stuff from the other social sciences? If you guessed 0 for both, you would have been very close to the right answer. That is the state of neoclassical economics, divorced from social reality and the social sciences, and people in the other social sciences completely recognize it. but congratulations on continuing to support it despite, deep down, you know it should be trashed and thrown away. There is a growing heterodox field of economics out there (and no, I'm not talking about MMT and all of the e-fans it has generated, though admittedly MMT is just one aspect of a larger heterodox tradition that rejects reductionism). I'm talking about stuff like what Dr. Fred Lee has written, or many other institutionalits/post-keynesians(ie the real followers of Keynes), sraffians, marxians, ecological, etc etc. "

    Anyway, Dr. Vernengo, I find it interesting that you in the past of accusing Keynes of using terminology that invites neoclassical analysis in the "back window" but you consistently refer to long period natural prices and don't assume your analysis does the same? Regardless, I don't like the long period approach, it has no agency in the model. I much prefer Fred Lee's input-output approach to the typical sraffian one.

    ReplyDelete
    Replies
    1. Long term prices have nothing to do with neoclassical economics (meaning determined by supply and demand). They are directly related to the surplus approach of the old classical authors. Sraffian are compatible with some PK pricing theories. But without the long period method there is no serious economics.

      Delete
    2. You're suggesting that Fred lee's models aren't serious? I would say that without agency that the surplus approach is without conceptual meaning.

      neoclassical economics was obviously helped along in developing their market clearing models from the classical natural price approach. No one could dispute that neoclassical economics twisted the natural price approach. And the only thing you could say about Keynes is that they co-opted his approach.

      Delete
    3. Nope. Fred's models are perfectly compatible with Sraffian analysis.

      Delete
    4. From Investopedia,

      'An approach to economics that relates supply and demand to an individual's rationality and his or her ability to maximize utility or profit.'

      Sounds a lot like Krugman's definition... 'maximization and equilibrium'.

      Forgive me if I misunderstand your post but how is his definition incorrect?

      Delete
    5. Hi Realpolitic00. Adam Smith, for example, thought that: "It is not from the benevolence of the butcher the brewer, or the baker that we expect our dinner, but from their regard to their own interest" (WN, book1, ch. 2, 2nd paragraph available here http://www.marxists.org/reference/archive/smith-adam/works/wealth-of-nations/book01/ch02.htm). Hence, self-interest was part of the theory. He was not neoclassical, since in no place he thought that supply and demand determined the long term equilibrium or natural price, or that the optimal level of employment (full utilization of labor) would take place. As with all classical authors wages were exogenous, and in his case the level of activity seemed to be connected to demand (the division of labor, which determined the Wealth of Nations, was after all determined by the size of the market). The point is that neoclassical economics is about the substitution principle, which guarantees that prices change according to relative scarcities and provide efficient outcomes. Maximiation and equilirbium are necessary, but not sufficient, and other theories have egoistical behavior and equilibrium without neoclassical results.

      Delete
    6. Doesnt Krugman address this when he says...

      "There’s a historical definition, having to do with the “marginal revolution” of the late 19th century and all that"

      I understand the explanation he gives may appear simplistic, but it is the same definition you will find in most other sources, the top results when you google 'neoclassical economics definition' all agree with Krugman.

      Now you could argue that they are all wrong too, but to ascribe this definition to Krugman soley is unfair. It just looks like you have an axe to grind with him.

      Delete
    7. Nope. He just says that the neoclassical view started with the marginalist revolution, which happened around the 1870s. But he misses the point about the definition of what changed in the 1870s. I just showed you that the two things, rational maximizing behavior and equilibrium, that he said started with marginalism, actually where present in Smith, a whole century before neoclassical economics. I highly recommend the little book by Krishna Bharadwaj on "Political Economy and the Rise of Dominance of Supply and Demand Theories."

      Delete
    8. Fair enough, but like I said his charactisation no different from most other sources.

      Well Smith's self interested baker is quite different from the homo economicus that people usually associate with neoclassical economics, especially as it pertains to models.

      Self interest does not imply rationality.

      Cheers for the link Ill check it out!

      Delete
    9. Dr. Vernengo, Fred Lee explicitly says that there is no long period pricing in his models, and says why that is so. You said that models without long period pricing is not serious economics.

      Delete
    10. I know that DaRkJaWs, but that doesn't mean that there couldn't be compatibility between the Post keynesian pricing theories based on full cost pricing and Sraffian prices. That would be my view. Note that if you don't have the long run equilibrium with a tendency (not necessarily something that is achieved in the real world) to a uniform rate of profit, the very notion of comptetition is difficult to defend. Further, then one can always fall into the argument that interventions are necessary because of imperfections. Finally, note that it is the modern neoclassical economics, Arrow-Debreu, which was forced to rely on a short run solution because of the defeat in the capital debates.

      Delete
    11. I'm sorry dr. Vernengo but that is completely wrong. His pricing theories and long period prices have a completely different methodology at play, which comes to fundamentally different meanings and results. I recommend you read stuff on market governance, like Granovetter 1985, Richardson 1967?, Campbell et al. 1991, Fligstein 1996 and 2001 (architecture of markets is name of his book) to understand why Lee comes to the conclusions he does. His pricing theory can say nothing about the economy without a theory of market governance, which as you stated without one you can't defend the notion of competition!

      Delete
    12. Sorry to butt in, but aren't cost-plus pricing and Sraffian theory going in different directions? Cost-plus pricing is coming at the problem from a Kalackian approach that largely rejects competition in favour of "degrees of monopoly". So, when Matias says:

      "Note that if you don't have the long run equilibrium with a tendency (not necessarily something that is achieved in the real world) to a uniform rate of profit, the very notion of competition is difficult to defend. "

      When Matias says this he's entirely right. Post-Keynesians -- from the Kaleckian tradition -- generally regard competition as an exception and monopoly to be the general rule. But Sraffians, it seems, continue to aim at the uniform rate of profit and hence competition (free entry).

      Perhaps this is where we can reconcile them to some extent. But it would have to be based on price leadership, not competition. Firms would have to "get in line" with price leaders in the market and this would lead them to gravitate toward a long-term price. The price leader's price could then be seen to rely on Sraffian pricing.

      (However, I'd also point out the the price leader's price would rely on the degree of advertising monopoly etc. that it had built up too...)

      Delete
    13. No need to be sorry, you have the right to your opinion. Mind you I'm not talking about methodology. I'm talking about concrete things. Prices of production (long term) do reflect the way the world actually works. Of course there are imperfections (barriers to entry that imply that free entry, competition) does not work completely. And there is evidence. But from a methodological point of view, if you say that you only believe in the short run, then, like Krugman and New Keynesians, you are an imperfectionist.

      Delete
    14. Okay, but if there are long-run prices, do these really have to be due to competition? Could they not be due to price leadership instead, as I suggested above?

      Take a Japanese car. Will the long-run prices for a Nissan, Toyota and a Honda (of a given "class") converge? To some extent, I expect they would. However would this be due to "competition"? I doubt it. More likely it would have to do with price leadership.

      This doesn't, in my opinion, rule out either approach. After all, if Honda is the price leader, it's leadership must still be based on Sraffian input costs (together with market share, advertising etc. Sraffa leaves these very important aspects out). But it suggests that long-run prices exist, but they generally rely on price leadership and not on competitive dynamics.

      Delete
    15. Dr. Vernengo, if one follows Lee's model and what Lee says specifically, then he does away with the short run/long run dichotomy altogether, which is why the long period approach has no conceptual meaning whatsoever (for Lee).

      Delete
    16. The relation of Sraffian prices and full costs and the barriers to entry tradition can be thought in this way, irrespective of what Fred says. Classical prices of production are the centre of gravitation for market prices and are determined by the costs of the dominant techniques and the state of distribution. They provide a general theory of the structural determinants and limits for the trend of market prices in all types of markets. Normal cost or full cost pricing which is a generalization of the descriptions given by some firms as to how they actually calculate their own prices based on their own costs starting with the work of hall and Hitch and the Oxford Economist's Research Group. The normal costs of the firms, do not in general, as noted by Franklin Serrano in a post in this blog, take into consideration the dominant technique or the potential entrants. However, prices of production can still explain the structural or trend element in the determination of firm prices. That was the sort of thing that John Eatwell taught back in the 1990s at the New School. Mind you, I have great respect for Fred's work, and I'm fine with not agreeing 100% with him on this. If your point is that he doesn't agree with my interpretation, that's a given. My point is that Eatwell's interpretation is also possible. We can certainly discuss then the merits of both views.

      Delete
    17. "...prices of production can still explain the structural or trend element in the determination of firm prices."

      That sounds right to me. Although again, I stress the importance of advertising which is a whole different sphere and not dealt with by the Sraffians.

      Delete
    18. There is some work on that, but you're right that not enough given its relevance.

      Delete
  4. Link to Bharadwaj's book here http://books.google.com/books/about/Classical_political_economy_and_rise_to.html?id=tM_rAAAAMAAJ&redir_esc=y

    ReplyDelete
  5. - If profits were higher in a particular sector, capitalists would try to gain from those opportunities entering the industry, -

    Land rents are higher every year, but there is no land industry.

    ReplyDelete
    Replies
    1. Not sure what you mean by land industry. Land is not a produced means of production, though. For prices of non-reproducible means of production there are a few Sraffian models. There is a chapter in Kurz and Salvadori's "Theory of Production."

      Delete
    2. What do you mean then by "entering the industry?" Or do you mean that land owner is not a "capitalist?"

      You don't have to go to Straffa to understand land rents. People from Aristoteles to "institutionalists" told us everything there is to know.

      Delete
    3. Entering the industry means exactly that. A firm enters an industry in search of profits above normal. Still not sure what a land industry is?

      Regarding rent theory, which is a necessary part of the theory of price and distribution, only with Sraffa you find a coherent solution to the problems with the surplus approach. So you need to read Sraffa. By the way, Marco Piccioni and Fabio Ravagnani have a great paper in the Centro Sraffa Qauderni di Ricerca on "Absolute Rent and the Normal Price of Exhaustible Resources."

      Delete
    4. Sraffa favours land value tax?

      Delete
  6. This comment has been removed by the author.

    ReplyDelete