Chapter 11 - Critique of Basic Economic Theory
Chapter 11
Critique of Basic Economic Theory
Assumptions
Economic theory starts with a set of assumptions about behavior. The most basic is the assumption of rationality in the limited sense that individuals can calculate and compare the marginal costs and marginal benefits of decisions. They then pick that decision that maximizes net benefit.
Economists and psychologists have attacked this assumption. Some have won Nobel Prizes in Economics. It is refuted by virtually everything that has been learned in cognitive psychology and neuroscience. Yet it remains the foundation of economic theory.
This assumption is not even supported by one of economists’ favorite tool, game theory. One famous experiment, the “ultimatum game,” demonstrates that moral considerations can overcome maximizing income. This outcome seems to hold over many different social groups and many different cultures.
Profit Maximization
Maybe the most defensible assumption is profit maximization. While it is doubtful that consumer behavior is rational, it does seem plausible that a business owner or manager might aim at maximizing profit. Even this assumption has been attacked by a Nobel Prize-winning economist. We will see in a later post that the meansof maximizing profit are assumed away in basic models.
The profit maximization assumption can be modified to profit maximization subject to risk. Companies will invest in new equipment or change procedures if they are highly confident that the change will increase the profits of their existing businesses. But increasing profit by expansion or entering a new business or market is risker, less certain. There is also the increased investment and expense which might jeopardize the existing business. The vast majority of business owners in the United States decide to remain small. Their goal is to make an adequate level of income with minimum risk.
Perfect Competition
Perfect competition is based on a highly restrictive set of assumptions. The model assumes away the dominant market structures of a capitalist economy, all of the strategies that managers use to increase sales and profits, and the long-run dynamics of innovation.
The usual approach is to describe perfect competition as the ideal model and then describe all the ways competition can deviate from the ideal. In the real world, the dynamics usually work the other way over time. A new industry or market is formed because of innovation. A variety of different products or services are developed and sold. A few survive and become the basis of large companies. Markets and market niches are oligopolies. The dominant companies become mature and use all the tools available to defend and maintain their market share and profits. Eventually, however, new competitors enter the market with a similar product or the same product. Customers and consumers view the competing products as commodities and make decisions solely or primarily on the basis of price. Perfect competition is the end result when marketing strategies no longer work and there is no longer any product innovation in the industry.
At some time during this process, other companies enter the market to supply the market or a part of the market with new products or services based on new technology or using new marketing techniques. Older companies lose market share. Some exit. In the end, there is a new dominant set of products supplied by the newer companies. But the market structure remains oligopolistic.
Demand Curves
A demand curve illustrates the relationship between the price and the total (market) demand of a product or service. It is “downward-sloping,” meaning that the lower the price, the greater the demand for the product.
It is assumed that each firm in a perfectly competitive industry faces a perfectly horizontal demand curve but the sum of these demand curves is somehow downward-sloping. Maximum production of any one company is a tiny percent of total production, limited by the existing production technology. There is no increasing return to scale. No company supplies new technology that supports new ways to produce the product that could lead to exponential growth, economies during the growth spurt, and a new industry structure. Even if available, no company with the industry or outside the industry buys the new technology.
Although plausible for some commodities, there is virtually no evidence that demand curves exist. Even if the general relationship exists, it is impossible to estimate the shape of a demand curve for a particular product or service at a particular moment of time. Elasticities of demand around the current market price are subject to wide statistical error and are unstable.
The smooth shape of demand curves is based on a restrictive set of mathematical assumptions, not behavioral assumptions. The smooth shape is necessary to illustrate that the market can reach a unique equilibrium.
When estimating demand curves for a particular product, which is theoretically suspect, the most important explanatory variable is usually total real income. Yet, in theory, this variable shiftsthe demand curve. Other important variables, such as consumer interest rates, wealth effects, and exchange rates, also shift demand curves. Relative prices of substitutes tend not to be important influences (statistically significant variables). This is consistent with the view of the economy as made up of market niches of differentiated products.
The period of adjustment, from one demand curve to another, is a period of disequilibrium. Since these and other variables that shift demand curves are always changing, the demand side of a market is usually in disequilibrium.
What you see from the data are not shifting demand curves but a series of shifting points. Variables estimating the price or relative price of the product tend to be insignificant or unstable over time.
Variables like total income and interest rates that shift demand curves are mostly macroeconomic variables. The division of economic theory into microeconomics and macroeconomics hinders fuller explanations of economic changes.
Supply Curves
Rising total short-run supply curves are based on the assumption that the amount of at least one input is fixed for some indeterminate period of time. The result is rising marginal cost per unit of output. All strategies to reduce or keep constant the cost per unit of output are assumed away. But outside forces, such as the change in the price of an input, may be due to changes in exchange rates. Innovation by input suppliers can shift a supply curve but it is implicitly assumed that the innovation will not change the structure of any industry. Yet continuous innovation by capital goods and IT suppliers has been a major source of “creative disruption” change.
The assumption that the industry supply curve is smooth (no kinks or discontinuities) is not very plausible. Laws and regulations about wages, such as overtime pay, indicate discontinuities or a step function of labor costs and unit costs.
Equilibrium
The objective of the supply/demand model with smooth curves is to demonstrate that a unique short-run equilibrium exists for one market and, by extension, for all markets simultaneously (general equilibrium). It is only possible to show this if smooth supply and demand curves exist and all business strategies except a change in the level of output are excluded.
Long-Run Equilibrium
It is difficult to reach any general theoretical conclusions about what happens in any market in the long run. It is generally assumed that demand becomes more elastic, usually because more “substitutes” (new products or services) are created. While entrepreneurs are allowed to create new products, managers in existing companies are not allowed to create new versions of existing products or services (extend product line) or attempt to differentiate their product to increase sales or profits.
Implicitly, the proprietary knowledge behind any innovation quickly becomes public information and many new firms are formed.
Imperfect Competition
Models of imperfect competition, like perfect competition, usually exist to find a short-run equilibrium. They are either not very plausible or have most of the restrictive assumptions of the perfect competition model.
There is no general model of how an industry becomes imperfectly competitive. The theory of monopoly assumes a monopoly and then describes the resulting price and output level, usually in comparison with a theoretical price and output of a perfectly competitive industry. But there is little theory on how a company becomes a monopoly. Historically, monopolies were created through governments creating a monopoly or granting a private company monopoly rights. But why does not a dominant company become a monopoly? Or why is it that most industries became dominated by a few large firms rather than being perfectly competitive or a monopolistic. Whatever dynamics created this common industry structure (oligopoly) somehow ceases to exist when analyzing market behavior.
Even in the short run, there is a serious theoretical problem. If an industry is imperfectly competitive, no unique supply curve exists. Therefore, no unique equilibrium exists. The main goal of economic theory cannot be reached.
Financial Markets
Milton Friedman argued that unrealistic assumptions can be ignored as long as the resulting model was good at prediction. When economic theory is applied to financial markets, some very strange things happen. The dominant model, mostly developed at the University of Chicago, says that changes in the prices of stocks, bonds, currencies, and other financial instruments are not related to anyeconomic variables. Price changes are random. Prices of financial products are impossible to forecast.
Conclusion
The paradigmatic economic theory (general equilibrium based on perfect competition) assumes away almost all of the structure and dynamics of the capitalist economy it attempts to model. What is left is a theoretical construct mostly useful as political ideology. There is no alternative general theory describing or explaining the structure or the dynamics of change of a modern economy.
Towards a More Realistic Model
Many years ago The Economist surveyed graduate students in Economics in England. The questionnaire asked them to choose from a list of the most important factors they thought would advance their careers. The most important factor was an ability to develop mathematical models. Only 3% said that “understanding the economy” was important. It is not surprising that economic theory is irrelevant in understanding a modern economy.
When academic economists enter public life or influence policy, they seldom rely on economic models. Economic theory is simplified or distorted when used as the basis for econometric modeling or forecasting. Even these models are not very useful (statistically significant with narrow confidence internals) in predicting changes from long-term trend lines. This is not too surprising since they are predicting change in behavior (decisions) based on changes in expectations about the future.
Why is economic theory irrelevant to understanding the real world?
Modern microeconomic theory was being developed in the late 19thcentury and early 20thcentury just as mass production was starting in new industries and being applied to old industries. New technologies of mass production and assembly created large economies of scale. Electricity revolutionized manufacturing and productivity. Steel skyscrapers created the modern, centralized office building. Combined with innovations in data creation, storage, and analysis, modern techniques of operational and financial control were developed. Advertising, branding and marketing were beginning, utilizing mass media. Mass distribution and mass merchandizing (department stores like Macy’s, catalogs, and chain stores like A&P) were spreading rapidly. Industries were being consolidated through mergers and acquisitions, creating dominant corporations. New management techniques and information technologies were developed to manage much larger, more complicated companies. “Network” industries like the telegraph, the telephone and railroads facilitated the creation of national markets and rapid transmission of market and financial data. Small producers selling similar products in local markets were becoming relatively less important in many industries; the long-term process towards industrial concentration was underway.
Economic theorists then and now ignored all this. Economists avoided asking the following set of related questions:
Why do large corporations exist?
And a paradox. Some research suggests that modern economies dominated by large companies are about as efficient as an idealized perfectly competitive economy. How is this possible? What are the constraints on market power and economic profit (profit beyond the cost of capital) of large corporations?
A large part of the answer is due to the structure of the economy. Again, most industries and markets are oligopolies. Large corporations do not face an undifferentiated mass of customers or consumers or a large number of small suppliers. On both sides of markets – buying inputs from suppliers and selling output – they face other large corporations. Both sides of most markets are oligopolies. It may be the “countervailing power” of large companies facing other large companies across markets leads to price and production outcomes similar to the theoretical outcomes of perfect competition.
Most large companies do not sell to final consumers. They sell to other companies along the supply chain, often other large companies. They sell to wholesalers, distributors and retailers. They buy information technology and other capital inputs from large corporations. Economic theory is largely irrelevant in markets like this and in an economy dominated by markets like this.
The next tutorial describes an economic structure dominated by large corporations on both sides of markets. The structure is labeled “bilateral oligopoly.”
Assumptions
Economic theory starts with a set of assumptions about behavior. The most basic is the assumption of rationality in the limited sense that individuals can calculate and compare the marginal costs and marginal benefits of decisions. They then pick that decision that maximizes net benefit.
Economists and psychologists have attacked this assumption. Some have won Nobel Prizes in Economics. It is refuted by virtually everything that has been learned in cognitive psychology and neuroscience. Yet it remains the foundation of economic theory.
This assumption is not even supported by one of economists’ favorite tool, game theory. One famous experiment, the “ultimatum game,” demonstrates that moral considerations can overcome maximizing income. This outcome seems to hold over many different social groups and many different cultures.
Profit Maximization
Maybe the most defensible assumption is profit maximization. While it is doubtful that consumer behavior is rational, it does seem plausible that a business owner or manager might aim at maximizing profit. Even this assumption has been attacked by a Nobel Prize-winning economist. We will see in a later post that the meansof maximizing profit are assumed away in basic models.
The profit maximization assumption can be modified to profit maximization subject to risk. Companies will invest in new equipment or change procedures if they are highly confident that the change will increase the profits of their existing businesses. But increasing profit by expansion or entering a new business or market is risker, less certain. There is also the increased investment and expense which might jeopardize the existing business. The vast majority of business owners in the United States decide to remain small. Their goal is to make an adequate level of income with minimum risk.
Perfect Competition
Perfect competition is based on a highly restrictive set of assumptions. The model assumes away the dominant market structures of a capitalist economy, all of the strategies that managers use to increase sales and profits, and the long-run dynamics of innovation.
The usual approach is to describe perfect competition as the ideal model and then describe all the ways competition can deviate from the ideal. In the real world, the dynamics usually work the other way over time. A new industry or market is formed because of innovation. A variety of different products or services are developed and sold. A few survive and become the basis of large companies. Markets and market niches are oligopolies. The dominant companies become mature and use all the tools available to defend and maintain their market share and profits. Eventually, however, new competitors enter the market with a similar product or the same product. Customers and consumers view the competing products as commodities and make decisions solely or primarily on the basis of price. Perfect competition is the end result when marketing strategies no longer work and there is no longer any product innovation in the industry.
At some time during this process, other companies enter the market to supply the market or a part of the market with new products or services based on new technology or using new marketing techniques. Older companies lose market share. Some exit. In the end, there is a new dominant set of products supplied by the newer companies. But the market structure remains oligopolistic.
Demand Curves
A demand curve illustrates the relationship between the price and the total (market) demand of a product or service. It is “downward-sloping,” meaning that the lower the price, the greater the demand for the product.
It is assumed that each firm in a perfectly competitive industry faces a perfectly horizontal demand curve but the sum of these demand curves is somehow downward-sloping. Maximum production of any one company is a tiny percent of total production, limited by the existing production technology. There is no increasing return to scale. No company supplies new technology that supports new ways to produce the product that could lead to exponential growth, economies during the growth spurt, and a new industry structure. Even if available, no company with the industry or outside the industry buys the new technology.
Although plausible for some commodities, there is virtually no evidence that demand curves exist. Even if the general relationship exists, it is impossible to estimate the shape of a demand curve for a particular product or service at a particular moment of time. Elasticities of demand around the current market price are subject to wide statistical error and are unstable.
The smooth shape of demand curves is based on a restrictive set of mathematical assumptions, not behavioral assumptions. The smooth shape is necessary to illustrate that the market can reach a unique equilibrium.
When estimating demand curves for a particular product, which is theoretically suspect, the most important explanatory variable is usually total real income. Yet, in theory, this variable shiftsthe demand curve. Other important variables, such as consumer interest rates, wealth effects, and exchange rates, also shift demand curves. Relative prices of substitutes tend not to be important influences (statistically significant variables). This is consistent with the view of the economy as made up of market niches of differentiated products.
The period of adjustment, from one demand curve to another, is a period of disequilibrium. Since these and other variables that shift demand curves are always changing, the demand side of a market is usually in disequilibrium.
What you see from the data are not shifting demand curves but a series of shifting points. Variables estimating the price or relative price of the product tend to be insignificant or unstable over time.
Variables like total income and interest rates that shift demand curves are mostly macroeconomic variables. The division of economic theory into microeconomics and macroeconomics hinders fuller explanations of economic changes.
Supply Curves
Rising total short-run supply curves are based on the assumption that the amount of at least one input is fixed for some indeterminate period of time. The result is rising marginal cost per unit of output. All strategies to reduce or keep constant the cost per unit of output are assumed away. But outside forces, such as the change in the price of an input, may be due to changes in exchange rates. Innovation by input suppliers can shift a supply curve but it is implicitly assumed that the innovation will not change the structure of any industry. Yet continuous innovation by capital goods and IT suppliers has been a major source of “creative disruption” change.
The assumption that the industry supply curve is smooth (no kinks or discontinuities) is not very plausible. Laws and regulations about wages, such as overtime pay, indicate discontinuities or a step function of labor costs and unit costs.
Equilibrium
The objective of the supply/demand model with smooth curves is to demonstrate that a unique short-run equilibrium exists for one market and, by extension, for all markets simultaneously (general equilibrium). It is only possible to show this if smooth supply and demand curves exist and all business strategies except a change in the level of output are excluded.
Long-Run Equilibrium
It is difficult to reach any general theoretical conclusions about what happens in any market in the long run. It is generally assumed that demand becomes more elastic, usually because more “substitutes” (new products or services) are created. While entrepreneurs are allowed to create new products, managers in existing companies are not allowed to create new versions of existing products or services (extend product line) or attempt to differentiate their product to increase sales or profits.
Implicitly, the proprietary knowledge behind any innovation quickly becomes public information and many new firms are formed.
Imperfect Competition
Models of imperfect competition, like perfect competition, usually exist to find a short-run equilibrium. They are either not very plausible or have most of the restrictive assumptions of the perfect competition model.
There is no general model of how an industry becomes imperfectly competitive. The theory of monopoly assumes a monopoly and then describes the resulting price and output level, usually in comparison with a theoretical price and output of a perfectly competitive industry. But there is little theory on how a company becomes a monopoly. Historically, monopolies were created through governments creating a monopoly or granting a private company monopoly rights. But why does not a dominant company become a monopoly? Or why is it that most industries became dominated by a few large firms rather than being perfectly competitive or a monopolistic. Whatever dynamics created this common industry structure (oligopoly) somehow ceases to exist when analyzing market behavior.
Even in the short run, there is a serious theoretical problem. If an industry is imperfectly competitive, no unique supply curve exists. Therefore, no unique equilibrium exists. The main goal of economic theory cannot be reached.
Financial Markets
Milton Friedman argued that unrealistic assumptions can be ignored as long as the resulting model was good at prediction. When economic theory is applied to financial markets, some very strange things happen. The dominant model, mostly developed at the University of Chicago, says that changes in the prices of stocks, bonds, currencies, and other financial instruments are not related to anyeconomic variables. Price changes are random. Prices of financial products are impossible to forecast.
Conclusion
The paradigmatic economic theory (general equilibrium based on perfect competition) assumes away almost all of the structure and dynamics of the capitalist economy it attempts to model. What is left is a theoretical construct mostly useful as political ideology. There is no alternative general theory describing or explaining the structure or the dynamics of change of a modern economy.
Towards a More Realistic Model
Many years ago The Economist surveyed graduate students in Economics in England. The questionnaire asked them to choose from a list of the most important factors they thought would advance their careers. The most important factor was an ability to develop mathematical models. Only 3% said that “understanding the economy” was important. It is not surprising that economic theory is irrelevant in understanding a modern economy.
When academic economists enter public life or influence policy, they seldom rely on economic models. Economic theory is simplified or distorted when used as the basis for econometric modeling or forecasting. Even these models are not very useful (statistically significant with narrow confidence internals) in predicting changes from long-term trend lines. This is not too surprising since they are predicting change in behavior (decisions) based on changes in expectations about the future.
Why is economic theory irrelevant to understanding the real world?
Modern microeconomic theory was being developed in the late 19thcentury and early 20thcentury just as mass production was starting in new industries and being applied to old industries. New technologies of mass production and assembly created large economies of scale. Electricity revolutionized manufacturing and productivity. Steel skyscrapers created the modern, centralized office building. Combined with innovations in data creation, storage, and analysis, modern techniques of operational and financial control were developed. Advertising, branding and marketing were beginning, utilizing mass media. Mass distribution and mass merchandizing (department stores like Macy’s, catalogs, and chain stores like A&P) were spreading rapidly. Industries were being consolidated through mergers and acquisitions, creating dominant corporations. New management techniques and information technologies were developed to manage much larger, more complicated companies. “Network” industries like the telegraph, the telephone and railroads facilitated the creation of national markets and rapid transmission of market and financial data. Small producers selling similar products in local markets were becoming relatively less important in many industries; the long-term process towards industrial concentration was underway.
Economic theorists then and now ignored all this. Economists avoided asking the following set of related questions:
Why do large corporations exist?
Why are most industries oligopolies?
Why does the process of concentration stop at oligopoly and not continue to monopoly?
And a paradox. Some research suggests that modern economies dominated by large companies are about as efficient as an idealized perfectly competitive economy. How is this possible? What are the constraints on market power and economic profit (profit beyond the cost of capital) of large corporations?
A large part of the answer is due to the structure of the economy. Again, most industries and markets are oligopolies. Large corporations do not face an undifferentiated mass of customers or consumers or a large number of small suppliers. On both sides of markets – buying inputs from suppliers and selling output – they face other large corporations. Both sides of most markets are oligopolies. It may be the “countervailing power” of large companies facing other large companies across markets leads to price and production outcomes similar to the theoretical outcomes of perfect competition.
Most large companies do not sell to final consumers. They sell to other companies along the supply chain, often other large companies. They sell to wholesalers, distributors and retailers. They buy information technology and other capital inputs from large corporations. Economic theory is largely irrelevant in markets like this and in an economy dominated by markets like this.
The next tutorial describes an economic structure dominated by large corporations on both sides of markets. The structure is labeled “bilateral oligopoly.”
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