Monday, November 5, 2012

Confusion and the Failure of Marginalism

In my last post I briefly discussed the Austrian approach. One interesting point, discussed in more detail in the comments, is that several Austrians do not understand that they are neoclassical. Note that the core of neoclassical economics is the determination of prices, initially at least it was long-term prices, by the interaction of supply and demand.

I find a bit surprised that several neoclassical or marginalist economists do not understand the basics of their own theory. This confusion is compounded by the fact that several heterodox economists do not understand it either, and tend to be confused, as a result, on how they depart (when they do) from the mainstream.

I'll give you an example. If you think that prices (long-term normal prices, for those that think that these are analytically important) are determined by supply and demand, then you basically must believe that (with the exception of rigidities and other imperfections) full employment is the natural tendency of the system. Note that if prices are determined by supply and demand, the real wage in the long run would be determined by the supply and demand in that market, and given productivity and preferences you get full employment at the equilibrium real wage.

The failure of some mainstream and heterodox economists to understand the neoclassical approach, in my view, stems from the collapse of the marginalist project after the capital debates (not of its dominance, but the ability to provide coherent responses to the critics). Robert Vienneau has a very good post on the failure of neoclassical economics. Worth reading.


  1. Note, supply and demand is not how Austrians explain price determination. Austrian price theory mostly comes straight out of Böhm-Bawerk. According to Austrians, prices are determined by the valuation of the marginal product. Specifically, by "marginal pairs:" the first buyer that would drop out of the price were to rise, the first buyer who's excluded at the present price, the first excluded seller, and the first seller who'd drop out if the price were to fall.

    And, this only explains certain prices. Most capital goods, according to Böhm-Bawerk, are basically determined by cost plus mark-up. I talk about it briefly here: (skip past the first paragraph). Essentially, assuming that the values of capital goods are imputed from the final product, it's the least valuable marginal product that impacts the price of the capital good. So, there's a huge margin between the buyer's valuation and seller's, such that the buyer's valuation doesn't determine the price of the product (although it does still determine the range of possible prices).

    None of this, of course, isn't to deny that Austrians aren't in the marginalist tradition. But, either Austrians have a different theory of prices (stemming from the same foundations), or the Neoclassical theory of prices isn't about supply and demand either (or both)

    1. Hi Jonathan:
      Here is a quote from Böhm-Bawerk's Book V, Chapter 4 of the Positive Theory of Capital (named the Law of Supply and Demand):

      "The zone within the limits of which the struggle of competition forces the formation of price is, as we have seen, characterised as lying between the subjective valuations of the marginal pairs, and on this characteristic feature we have formulated our law of price. But this zone has a second characteristic feature: it is that in which exactly as many commodities are offered for sale as are wanted to purchase;*19 or, to use the common expressions, in which supply and demand are quantitatively in equilibrium."

      Link here,Ch.V.
      Note that obviously he thought that prices are determined by cost, since the fluctuations of market prices would lead to cost minimization (as in all neoclassical models). the pairs that you refer exactly involve the marginal productivities on the supply side and the marginal utilities (or the preferences) on the demand side. It is essentially a theory that suggests that prices are determined by supply and demand, i.e. market forces. Note that his point was that Marx was wrong, since workers too received according to supply and demand.

    2. He was a student of Menger, and also there is no doubt that Menger, like Jevons and Walras (Bharadwaj would include, I think correctly, Marshall among the pioneers), had a supply and demand theory of long term prices. By the way, that is logically impossible to do. Böhm-Bawerk's theory does not survive the capital debates. That's part of what Robert suggests about all neoclassical theories in his post.

    3. That an equilibrium price is where supply and demand intersect doesn't necessarily imply that supply plays a role in determining the price. Couldn't it be that the price determines supply (i.e. demand determines supply)?

    4. Jonathan,

      In the Austrian version of theory market exchange is not price-mediated, while in the Walrasian or Marshallian versions market exchange is price-mediated. In non-price-mediated processes, buyers and sellers face each other, as do the horse traders in Böhm-Bawerk's marginal pairs example. But, in Austrian theory, price still emerges from the independent interactions of buyers and sellers, and supply and demand are representations of these individual valuations. That is Böhm-Bawerk's point (duplicated in Vernon Smith's experimental markets): competition on the market is determinant of price. This is also clearly expressed in Mises and Rothbard's work. Mises, for example, speaks of the "laws of the market," and writes: "There prevails on the market a permanent tendency to eliminate all discrepancies in prices for the same commodity or service." And Rothbard writes, "the greater the number of people with differing valuations, the more negligible will zones of [price] indeterminacy become."

      So, no, demand cannot determine supply. If it did you would not be able to derive a stable market. It is a fundamental rule of supply and demand theory that supply decisions must be independent of demand decisions.

    5. Hi Jonathan

      "According to Austrians, prices are determined by the valuation of the marginal product. Specifically, by 'marginal pairs': the first buyer that would drop out of the price were to rise, the first buyer who's excluded at the present price, the first excluded seller, and the first seller who'd drop out if the price were to fall."

      Correct me if I am wrong, but when one says that "were the price to rise", one is speaking of a positive change in price; when one talks about "the first buyer that would drop out", one is indirectly speaking about a negative change in the quantity demanded of a given good.

      In other words, what one is saying is that the demand curve has a negative slope (negative change in quantity divided by a positive change in price).

      Similarly in your quote you are indirectly speaking of a positively sloped supply curve.

      Like I said, I may be wrong, but to me you seem to be speaking about supply and demand, if not directly, at least in a roundabout way.

  2. Notice that when you add a mark up over costs, what you're saying is not a mark up over wage costs but over all costs, including, of course, the means of production. Yes: means of production are produced by means of production. That would go like this:
    (wL+P1k*K1)(1+r)=P2k. Now, under perfect competition theory, the markup r must be equal to all branches of production: you are, indeed, in botkiewicz model of determination of "natural prices".
    Now, for marginalist theory to be true, you want that for a given set of preferences, and then for any set of demanded quantities, you have a set of relative prices between wages and markup that uses all labour and savings available. Well, that's what you don't get, because you can't prove substitution between capital (I think you like to call it "time") and labour.

  3. The modern Austrian view is that the cost of making a product actually has nothing to do with the ultimate sale price which is based upon the subjective value of the buyer.

    The fact that he would not have engaged in the labor at all if he had known in advance of the present price might indicate a deplorable instance of poor judgment, but it does not affect the present situation. At present, with all the labor already exerted and the product finished, the original—subjective—cost has already been incurred and vanished with the original making of the decision. At present, there is no alternative to the sale of the good at the market price, and therefore the sale is costless. It is evident, therefore, that once the product has been made, “cost” has no influence on the price of the product. Past costs, being ephemeral, are irrelevant to present determination of prices. Rothbard “Man Economy and State pp. 341-342.

    1. No, modern Austrians are divided between the marginalist view and the profit markup view.

      Ludwig Lachmann took the costs of production plus profit markup view of prices.

      As said above, Böhm-Bawerk - an early Austrian - apparently had a theory of costs of production pricing.

      Catalan also cites Reisman’s "Capitalism" as another source for “cost plus markup” pricing.

    2. Hi Bob:
      Note that beyond the subjective value of buyer, for a product to be produced, not just sold, meaning that there must be an incentive for a producer to bring to the market on a regular basis, it has to cover cost and a normal profit. Even if you, like Böhm believe that this depends on the subjective valuation of the supplier (because he wants to buy other goods, for example). Note that this subjective valuation implies that the supplier thinks that the price is enough to make him demand the factors of production, pay the other costs and still have enough to make a gain. So inescapably a coherent theory based on subjective valuations has to deal with objective forces too. Lord Keynes I would argue that the Austrians that think that they follow a cost of production theory are just confused. As I said, it is always the case that prices are at cost of production, because of cost minimization.

  4. How is this any different from the Marshallian 'market period'? (Note that Rothbard admits in the next breath that costs will impact the the level of production in the long-period.)

  5. Further, this post is deceptive in that it omits mentioning the central Austrian view of how fiat money loans created out of nothing artificially increase or distort prices to an unsustainable level thereby drawing labor and investments into lines of production that in the long run are not sustainable due to price dis-coordination.

    Hayek uses the term “equilibrium structure” to refer to the price structure that would have existed but for GOVERNMENT intervention, especially granting banks the right to create fiat funny money loans out of thin air, thereby distorting the price, investment and capital structure. Hayek stated:

    These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due to some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, somewhat misleadingly, we call an equilibrium structure, and second, that labor is reallocated according to these new prices. ****

    The primary cause of the appearance of extensive unemployment, however, is a deviation of the actual structure of prices and wages from its equilibrium structure. Remember, please: that is the crucial concept. The point I want to make is that this equilibrium structure of prices is something which we cannot know beforehand because the only way to discover it is to give the market free play; by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured. ****

    In contrast, the modern fashion demands that a theoretical assertion which cannot be statistically tested must not be taken seriously and has to be discarded. As a result of this belief, a theory which, in my opinion, is the true explanation has been discarded as not adequately confirmed, and a false theory has been generally accepted merely because it happens to be the only one for which statistical evidence, even though very inadequate evidence, is available.”

    1. Bob roddis illustrates beautifully how ignorant internet Austrians have no idea that they are just parroting mainstream neoclassical ideas.

      An "equilibrium structure of prices and wages" is nothing but mainstream neoclassicism.

  6. "If you think that prices are determined by supply and demand, then you basically must believe that (with the exception of rigidities and other imperfections) full employment is the natural tendency of the system."

    I'm not an austrian so I don't really care whether austrian economics is based on neoclassical reasoning. Instead I wonder what's controversial about this statement, or more precisely, how it shows the failure of marginalism? Yes, everybody knows that the basic neoclassical model leaves no space for involuntary unemployment, which is exactly why many economists spend their time studying "rigidities and other imperfections".

    1. Hi Ivan, that does not prove the failure of marginalism, nor was intended as such. Read my post on the capital debates and you'll see what I mean. Neoclassical economics only gets full employment because of a thing called the principle of substitution. You buy the cheap factor, labor for exmaple, because its abundant. It turns out that one cannot make a connection, as admited by Samuelson, between relative scarcity and price. Hence, supply and demand are not guides for resource allocation. That, the capital debates, show the intellectual failure of the mainstream.

  7. That IS funny, and funnier is the fact that he talks about "the modern Austrian view" while quoting from "Man, Economy and State", a book from 1962.


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