If you are a progressive, you've got to love neoclassical economics

Or so says Brad DeLong in an insightful contribution to the ongoing debate on economic heterodoxy. His point, I think, is not just that neoclassical economics provides the right (sorry!) way to think, but also that it gives you plenty of ammunition for tearing to shreds market fundamentalists. But then this raises an obvious question: why are the heterodox critics of "mainstream" economics mostly on the left of the political spectrum?

Every first-year graduate student learns the First Fundamental Theorem of Welfare Economics, which says essentially that provided a long list of conditions are satisfied, a market equilibrium is efficient in a particular way--that is, you cannot make someone better off without making someone else worse off. Now you can read the theorem in two, radically different ways. One is to say: "There you have it! We knew Adam Smith was right all along, but here it is stated in mathematically precise way and proved to everyone's satisfaction. Now let the government get out of the way and have the markets work their magic."  The other is to say: "Wow, hold on! You mean we need so many conditions for markets to produce efficient outcomes? No externalities, no returns to scale, no market power, markets for everything and for every point in time... I better get my theorems of the second-best straight!"

If you are the first kind of person... Well, I have never understood how you could be the first kind of person if you have also understood the First Fundamental Theorem of Welfare Economics. Which is what I think Brad is also saying (although you would not know it from some of his posts...)

      

Comments

[MIKE]

Just wondering if any one has read a book by Beinhocker (the origin of wealth), which outlines how new thinking on economics is based on the premise that old economic models are based on very shakey foundations - i.e. the classification of market economies being in equilibrium as opposed to a constant state of flux
interested in views on what he calls complexity economics

[Thorsten]

Just two points:

First, at least for Europe I think there is one more or less obvious reason why heterodox people reject neoclassical economics: If you belong to a social-democratic / socialist tradition you reject the notion that human beings are egoistic and just maximizing their own utility but you rather believe that people value solidarity (like Akerlof's "missing motivation" or "warm glow" of giving). Related to that is that a significant part of the predominantly left generation of students of 1968 is influenced by Marxian theories, which makes you think in social aggregates rather than using the methodological individualism/rational agent approach.

Second, in one of the later or the last chapters J.E. King points out that Post-Keynesian economics has some points in common with Austrian economics á la Hayek. But because these are usually on the other side of the political spectrum, there is not much co-operation between them. http://www.amazon.co.uk/History-Keynesian-Economics-Outstanding-Academic/dp/1843766507/ref=sr_1_1/026-3252082-0714008?ie=UTF8&s=books&qid=1180692440&sr=8-1

[potter]

Which raises the question, given how wildly ineffective markets are for improving our society, why do we continually rely on them? If path two is taken, then by capitalist economics own standards it is a failure & a better more humane system should be followed.

At the very least, we should continually be looking for ways to rid ourselves of market tyranny rather than opening up more and more daily life to "market forces" and "competition."

Yet that is exactly what we do not do. Western society is all part of the cult of capitalism regardless of class or whether a capitalist class exists. -

[kb]

Which raises the question, given how wildly ineffective markets are for improving our society, why do we continually rely on them?

Because so far nobody has found anything that works better. We really have only two systems -- the market or the state. The evidence can be read that market beats state. So far, all "third ways" have been really just a masked state solution.

[Ramon]

Most critics of neoclassical economics based their criticism on the confusion between these two propositions:

P1: Physicists claim that, in the vacuum, falling objects accelerate independently of weight.

P2: Physicist claim that falling objects accelerate independently of weight.

Which is basically Professor Rodrik's point.

[Bruce Webb]

"The evidence can be read that market beats state"

More revealing than kb might like. I had an enlightening discussion with Prof. Thoma. He explained that fundamentally Economics was a study of Efficiency and not of Equity. A light went on. Once you define Efficiency as your goal then of course there are ways to read evidence that markets beats states. But if you allow Equity to enter the equation everything becomes more difficult, particularly in a universal suffrage democracy.

My analogy is always Pie. Free Marketers insist that the proper measure of success is Pie Size and not Pie Slice. But they have no successful counterargument to why I shouldn't be more concerned about Slice than Size, after all they fully agree that it is fair to act in ways that maximize self-interest, logically why shouldn't democratic majorities act in ways that supply more Equity even at the cost of minor Inefficiency?

The problem as I see it is one of history. The foundations of modern economics were laid in a time and place where electoral suffrage was limited to property owners, i.e. holders of capital, from a practical point of view you could design an economic system that focused on maximizing returns on capital while holding the variable of worker interest steady. Your model could humanely suggest that worker compensation was being set at the level of his marginal productivity, or more brutally take a 'what the market can bear' approach where labor is just another cost to be reduced, but politically it really didn't matter, workers by and large had no say to start with. Absent armed rebellion they were helpless. Hence Marx.

But both Liberal Economics and Marxism proved vulnerable to Universal Suffrage, workers didn't have to accept the alternatives of passivity and violence, we can demand our Pie Slice at the ballot box.

Economics has been playing defence ever since, a science designed around Efficient returns to Capital faced demands to supply Equitable distributions of Production and really as yet is not supplying results satisfactory to the majority. Pretty much they are reduced to arguing that the Invisible Pie-Slicer is delivering perfect Pie Slices.

Well the evidence can be read that when you start from Equity that states beat markets. Marketeers need to start with a defence of Size vs Slice.

[gallagher]

On most days I too am Dani's second kind of person--who takes the theories I was taught seriously and juxtaposes them with policy questions and reality. Thus I use the "toolkit" Delong speaks of. Indeed, I have a new paper with the Indian economist Nagesh Kumar that demonstrates how current and proposed WTO rules make it difficult for developing nations to deploy "second best" policies for development.
http://www.ase.tufts.edu/gdae/Pubs/rp/RISDiscPaper120Apr07.pdf

However, on summer days when inspired to think bigger picture because of all this blogging about the discipline one has to acknowledge that some of the more sophisticated heterodox economists have a very fundamental point. The equilibrium conditions that both of the theorems of welfare economics rest are deeply flawed.

This is a consensus in the profession that is quietly acknowledged. A non-technical summary of the "proof" that general equilibrium is a bit of a nirvana (even according to Arrow and Debreu the "equilibrium" in general equilibrium is "non-stable," and not "unique.") see: http://ase.tufts.edu/gdae/publications/working_papers/stilldead.pdf

This is more a discussion for seminars and I guess blogs. Delong is right that the market-failure arguments have more "traction" in policy circles. But one has to acknowledge that when we do so we stand on flawed foundations.

[DRR]

My analogy is always Pie. Free Marketers insist that the proper measure of success is Pie Size and not Pie Slice. But they have no successful counterargument to why I shouldn't be more concerned about Slice than Size

Assuming you mean the size of the pie slice then the analogy is unneccessary as it becomes a question of distribution, but even if the sizes of the slices become more or less equitable, you're still back to paradigm 1, and success is determined by the size of your own slice.

Well the evidence can be read that when you start from Equity that states beat markets. Marketeers need to start with a defence of Size vs Slice.

Not really. Going back to "size vs. slice", it's the size of the slice that matters. And a microscopic pie, equally & equitably divided up amongst a whole group of people probably isn't too many people's idea of success. That's no to say a large pie wherein a small group of people get very large slices while the majority get very tiny ones is either. The "state" comes into play here as it is a vehicle for redistribution to make sure everyone gets a fair slized slice but it cannot generate the wealth to make the pie big enough to be worth eating in the first place.

I'm hungry.

[happyjuggler0]

I'd rather have 1/1000th of a pie which is 200 grams of pie, than have 1/10th of a pie which works out to 100 grams.

My problem with those on the Left is that they too often are fixated on how big the slice is of the biggest piece of pie as opposed to how how much the smallest size weighs. As a result we have poorly working socialism for the poor, e.g. the US's urban k-12 education system, when in fact the poor would be much better off with a more market based system of universal vouchers instead of taxing the rich more to give to the teachers unions without an improvement in the schools.

In other words, hurting the rich doesn't help the poor. Only helping the poor helps the poor, and the best way to help the poor is to increase the market demand for their labor. The best way to increase the market demand for their labor (aside from universal K-12 vouchers) really is to tax job creaters less, or not at all. But this is hard to see when your goal is to reduce inequality instead of reducing poverty.

[happyjuggler0]

For the sake of clarity, the two pies are 200,000 grams and 1000 grams big, with the weights listed being for the individual slices mentioned.

Also, not to be too pedantic, but "creaters" hurts my eyes. It ought to read "creators" of course, sorry for the eyesore. :o

[Bruce Webb]

DRR and happyjuggler

The reality seems to be that supply side and free trade deliver a pie 110% bigger but then take an additional 20% of the pie. Which is to say workers taking an objectively smaller slice of pie.

Certainly if you can deliver results that objectively show I am getting more grams of pie than otherwise I will be happy to smear pie filling across my face. But the pie slicers are not delivering.

DRR is assuming what needs to be demonstrated, where is the evidence that state intervention actually produces a microscopic pie?

And of course happyjuggler is introducing the same concept on a ludicrously precise scale. Exactly what would lead me to believe that the difference in Pie would be 200 to 1? Certainly if you could demonstrate differences at that scale my case loses all substance. But real world numbers would help here.

"Hurting the rich" builds a lot too many assumptions in, as does the belief that the road to job creation and income is to tax job creators (or creaters) less. Assertions are not arguments. Much of the discussion around the Econoblogs and TPMCafe over the last week has been about Reductionism passing itself off as Objectivism. I am seeing a lot of this same laziness in rigor here.

[ndd]

RE: the First Theorem of General Welfare Economics, isn't there a more fundamental theoretical failure?

Let's assume that there is an individual, I'll call him Donald Trump, whose preferences are such that he is always and everywhere happier the more wealth he owns, regardless of whether the rest of the human race starves to death and he is the last person living while the material world unwinds around him.
That is a Pareto optimal point, is it not?

Okay, the general theory proves that under certain conditions, if government gets out of the way, THERE EXISTS *A* Pareto superior point in a free market economy.

Cool. So this year I totally deregulate and get the market out of the way. Prove to me that the Pareto optimal free market result I actually get is the superior one outlined in the second paragraph, rather than the (for example) Donald Trump Pareto optimal point I described in the first paragraph.

To my knowledge, the General Theorem of Welfare Economics is incapable of proving that most important fact. It just tells me I can get a Pareto optimal point by deregulating, and that at least one of those points is Pareto superior, but to my knowledge it does not prove which Pareto optimal point I actually get.

It has been a long time since I studied economics, and I will certainly accept any correction on the above point if someone can point to the proof - heck, that's why I've mentioned it here - but I haven't seen it yet.

[DRR]

"DRR is assuming what needs to be demonstrated, where is the evidence that state intervention actually produces a microscopic pie?"

"State intervention" in what exactly? the economy? markets?

Exactly.

I'm not saying the state produces any size of pie, microscopic or otherwise. Unless we're talking about egalitarian command economies such as those in Cuba & N. Korea, then the "state" produces no pie at all, it is only a vehicle for redistribution of the content of the pie generated in the market economy.

[tt]

Two points.

1) I think it is improper to characterize the position of the "believers" in FWT as "let the markets work without the intrusion of the government" (it is also improper for such believers to characterize themselves that way!). Indeed, the FWT points out what it needs to be done for the mkt economy to deliver efficiency, e.g. crack down market power through antitrust laws. Protecting competition seems to be a concern that is sincerely shared by many free-marketers.
Moreover, the FWT relies on well-defined property rights and so the intervention of the government is needed for that too. Friedman was not against having police to defend property rights (even if he eventually abandoned support for antitrust laws).

2) It is interesting that you present the two differing views about the FWT as regarding its applicability to the real world.
I always thought that the main problem with the FWT, from a progressive point of view, was that it was silent about distribution.
Maybe you just wanted to point out another source of divergence in interpretations.
I just want to point out that the progressive economist can have a prima facie case in favor of government's intervention even if the FWT is applicable to the real world.

[Barkley Rosser]

MIKE,

Some of us were writing books about complexity and nonlineary dynamics in economics long before Beinhocker showed up. To a large degree that stuff came out of models done by Post Keynesians back in the 1940s.

I hear that Arrow continues to defend GE theory because it is so handy for telling stories to policymakers, even though he knows full well that it is not a very good way of describing the economy.

[inkathi]

kb | June 01, 2007 at 10:10 AM wrote "We really have only two systems -- the market or the state. The evidence can be read that market beats state."

Excuse me ?!

Can you give me just one example in the long history of mankind of a market without a state (that is, a central administration)?

First of all, what system are you talking about? The economic system? Which economy? So far, in economics, when we speak of an economy, we refer to a national economy. Hence a market-economy existing within a state. There is no example of a market free of government intervention, neither today nor in history. When we say that an economy performs well, this is seen as a compliment to its government. The general public also sees it like that. As Clinton said, "It's the economy stupid!". He wasn't then preparing to become a private entrepreneur (unless you consider the presidency to be just that).

If you consider capitalism on the one hand and communism on the other to be respectively a market without a state and a state without a market, then again I challenge you to find just one example of any such pure capitalist or communist system anytime anywhere.

All we have seen so far, both east and west of the iron curtain, are so many cases of "third ways" in which both state and market are working together. These systems (let's call them states, for sake of clarity) differ in the way power is attributed to both the market and the government in the economy, I admit, but they cannot be divided into just two clearly defined systems. States were and are on the contrary very diverse in their political (or if you prefer economical) organisation.

Thence, there can be no evidence that market beats the state. They are not competing! There never has, and indeed never can be a market left alone by the state, as all the elements that constitute the market and make its functioning possible depend directly on the state. The firm depends on the law that gives it a separate legal personality (without it it's just a group of individuals). Money is printed by the state (the central bank is part of it), making trade in a modern economy possible. Etc, etc. Even in "primitive" barter-communities there are chiefs of the clan who more often than not take the decisions that coordinate the other groupmembers' actions.

As pointed out by tt, even Friedman recognised this. He was aware of the complexity of the world, but advocated simplicity, as a sort of Occam's razor. If we stick to the theory, ok. But when you talk about evidence, real world evidence, you have to recognize that the real world is not just black or white but comes in different shades of grey.

The real question, then, cannot be whether the market or the state perform better independently. The question is: how to make the market and the state IN THEIR NATURAL SYMBIOSIS perform better. How can politicians AND businessmen TOGETHER produce both a bigger pie and bigger slices?