More on neoclassical economics

 Matt Nolan at TVHE blogs:

I have recently seen an increasing number of attacks on “neo-classical” economics from every section of the political spectrum.

Last week, I heard a number of commentators at the sustainable economics conference claim that neo-classical economics was:

1. Based on falsified views of the individual,
2. Static,
3. Had no supply side.

Then I saw an attack on “neo-classical economics” from Roger Kerr at the Business Roundtable (and more) which seemed to imply:

1. It ignores institutions,
2. It ignores transaction costs,
3. It is static.

I was surprised by these attacks.  More than surprised, I felt like the attacks were based on a straw man version of neo-classical economics – one that in many ways never existed, and if it was floating around it was during the 1950′s-1970′s when a lot of the focus was on a narrow neo-classical synthesis in macro theory.

 He concludes:

The reason I am so defensive about the definition of neo-classical economics is because people see it as the current core – which according to my definition it is.  Setting up an alternative definition of neo-classical economics and knocking it down is either equivalent to setting up a straw man to attack, or directly misleading people to make it sound like modern economists are incompetent.

My advice would be to stop defending neoclassical economics as being the ‘core’ of economic theory Matt.  By redefining the term to include all the developments in economics that you identify (and there are more) you drain the term of any useful meaning.  You’re right to defend “modern mainstream economics” instead.

I wrote this passage in 1986 as a kind of valedictory to the Treasury:

“In the domain of macroeconomics we have probably all noticed that we have been relearning and reinterpreting much of what we were taught in the 1950s and 1960s, and rediscovering and developing the key ideas of the more established and orthodox tradition of economics that have been found to have a sound microeconomic basis and public policy rationale … What is probably less apparent is that we have been relearning a good deal of the microeconomics that was also shunted up the wrong track around the same time.

For 50 years after Marshall, the dominant model of market behaviour in most centres of learning outside the sphere of influence of the Austrian school was the perfectly competitive version, with its assumptions of full knowledge, zero transaction costs and no market power on the part of firms and individuals.  The central interest was in equilibrium properties, with marginal anything being equal to marginal everything else.  The vision of this ideal world was essentially a static one; real time did not enter into it.

As intellectual abstractions, the refined versions of the perfect competition model are a tour de force, and even illuminating up to a point.  The trouble for policy purposes is that the model leaves out much that is critical in the real world, extending far beyond features such as economies of scale, which were always recognised as qualifications.  Confronted with a host of situations in which its ‘nirvana’ properties do not hold, theorists initially devoted enormous intellectual effort to exploring the so-called economics of imperfect competition.  Much of this also originated in Cambridge, and focused in particular on monopoly and oligopoly.  The view that monopoly was a pervasive problem attained great influence, further undermining faith in the competitive economy and strengthening interest in anti-trust and planning.

As with the attack on Keynesian macroeconomics, the challenge to the regulatory wave of the 1930s that flowed from perceptions of ubiquitous ‘market failures’ took time to develop.  Initial critiques of intervention on market failure grounds involved two main propositions.  One was to draw attention to the ‘grass is always greener’ fallacy.  Critics pointed out that the fact that some market outcomes are not perfect (judged against some abstract ideal, in reality not attainable under any form of economic organisation) did not necessarily mean that governments can improve on them.  ‘Government failure’ came to be recognised as a problem often at least as severe as market failure – especially given human fallibility and the incentives involved in public decision making.  As one writer has put it, the fact that a fish can’t fly doesn’t mean that a rhinoceros can do any better.  The second critique recognised that most interventions involved costs as well as benefits.  When the test that the benefits would outweigh the costs was applied, many interventions failed, or should have failed, to pass.  Empirical studies also called into question the importance of earlier perspectives;  for example Stigler summarises the conclusions of a large amount of quantitative research in noting that ‘The evidence that monopoly is important is negligible, and the evidence that it is a quite minor influence on the workings of the economy is large’.

However, the development of microeconomic theory has gone far beyond these initial counterattacks on ideas of imperfect competition.  A large body of research has stressed the need to incorporate an understanding of incentive mechanisms, principal/agent problems, voting behaviour, uncertainty, and information, transaction and adjustment costs into any useful model of economic behaviour.  The ‘new’ economics of organisation – which goes back at least to Coase’s initial work on the theory of the firm – has pointed out that the long-standing preoccupation of economists with the allocation of resources in atomistic markets is an unsound and unbalanced view of social activity.  The insight that markets and organisations are alternative economic arrangements whose relative efficiency depends on transactions costs, broadly defined, has led to a long overdue interest in the systems of incentives that motivate behaviour in organisations, and to the development of modern agency theory.  The literature on ‘contestable’ markets has merged to supplement the competitive market model by showing that the openness of a market to potential competition may be more important than the structure of an industry – the number of firms in it – in determining production efficiency.  What contestability and transaction costs economics has shown is that competition and competitive outcomes are (a) complex, and (b) not dependent on the atomistic assumptions of perfect competition.  Finally, a renewed interest in entrepreneurship and the dynamic effects of competition in promoting the search for new knowledge and innovations has further exposed the limitations of static microeconomic theory.

The point to be stressed in surveying these developments in microeconomic thinking is not the problem of abstract models.  All models, including those that encompass costs of information, transactions and other complex aspects of business structure and conduct, are abstractions.  The problem has been the facts or behaviour that some economists have attempted to explain with over-simplified models, and the policy prescriptions they have adduced.  The traditional models have simply not provided us with enough microanalytic insights to help us understand individual transactions, which is what we must attempt to do if we want to improve outcomes in some way.

The most refined development of neoclassical Marshallian economics was the Arrow-Debreu model.  As one commentator has noted:

In its most elegant form neoclassical economics is epitomised by the idealised, frictionless, Arrow-Debreu model which provides necessary and sufficient conditions for a competitive equilibrium to be a Pareto optimum.  The dominant presumption in the profession was for a long time, and is still largely the case in the public sector today I suspect, that any departure from the idealised situation (eg of MC = P) is a market failure that will stop the Pareto conditions from holding.  Since this part of neoclassical economics implicitly assumed that government was perfect (eg property rights were perfectly well defined and contracts perfectly enforced and there were no deadweight costs of taxation) the bias towards intervention was strong. 

So my position is that neoclassical economics has a lot to offer, but that its application to policy by economists has a lot to answer for.  At the micro level, perhaps the bit I hate most is competition policy – premised as it is on the notion of static ‘perfect competition’.  The critical Schumpeterian notion of dynamic efficiency potentially undermines the entire static efficiency case – so in practice it is essentially confined to the ‘too hard’ basket. 

 For a fuller critique, see this article by Wolfgang Kasper, What’s Wrong with Neoclassical Orthodoxy?

I‘m not surprised by what you heard at the sustainable economics conference.  Some fair points may have been made (eg that neoclassical economics is static) but for many the term is just lumped in with other labels (like neoliberal, monetarist and Chicago economics) by anti-market critics who do not understand economics.

What’s Wrong with Neoclassical Economics?

A new Occasional Paper on the Business Roundtable website should be a useful resource for teachers of economics and participants in economic policy debates.

Written by Wolfgang Kasper, emeritus professor of economics at the University of New South Wales, Australia, an earlier version was delivered to the joint conference of the New Zealand Association of Economists and the Law and Economics Association of New Zealand in June this year.

For years I had urged Wolfgang to write a paper spelling out the limitations of neoclassical economics in understanding how the world works.

He resisted the idea (“nobody believes in neoclassical ideas any more”).  I told him he was wrong: various economics educators in New Zealand continue to teach on the basis of defunct human capital, and politicians attack free-market policies on the false assumption that they are grounded in neoclassical economics.

Finally Wolfgang relented and wrote the paper.

Neoclassical economics can be traced back to the work of British economist Alfred Marshall and to some extent even further back to ‘classical’ economists such as Adam Smith.  It is characterised by a focus on static equilibrium conditions in markets and the economy – like how supply and demand are matched and at what prices.  It does not explore the dynamics of the economic system, and in particular has little to say about entrepreneurship and economic growth.

As Wolfgang says in his paper:

The poverty of neoclassical economics becomes evident when one realises that key concepts – such as competition, enterprise, profit, the costs of transacting business, the need for law and other rules of coordination (institutions) – have simply been ‘assumed away for simplicity’s sake’. It is also imbued with a wrong-headed pessimism, derived from nineteenth-century agricultural reality (law of diminishing returns).

Almost as though on cue, a classic example of the persistence of neoclassical misunderstandings came to light just as Professor Kasper’s paper was being printed.  The New Zealand Herald, which features a constant diet of op eds by anti-market critics such as Jane Kelsey and Bryan Gould, printed this article by Auckland secondary school economics teacher Peter Lyons, whose articles also appear frequently in Herald columns.

It was entitled ‘Mantra of free market ideology wearing thin’ and contained a familiar theme: “In the past 25 years New Zealand has embraced the free market ideology of of neoclassical economics.”

As someone involved in some of the reforms, I can certify that none of the economic advisers of the governments concerned were slaves of neoclassical economics.  While recognising its insights they were well aware of its limitations as identified by Wolfgang Kasper, and drew on a far wider and richer body of economic literature.  A reading of relevant official documents would make this immediately apparent.

Similarly, governments in the United States, Britain, Australia and many other countries that embarked on liberal economic reforms around the same time as New Zealand were not driven by narrow neoclassical economics.  Again a reading of official documents would quickly confirm this.

Professor Kasper responded to Peter Lyons in this article.  Regrettably, the Herald declined to publish it.

I worry about bad economics teaching in our classrooms and lecture rooms.  I worry too about the effect of bad economics on public understanding when newspapers do not publish critical responses.

Professor Kasper’s paper should demonstrate that those who attack liberal economic policies on the grounds that they are based on neoclassical economics are attacking a straw man.