Neoclassical Economists Being Wrong

by
Robert Vienneau
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What is neoclassical economics? (This post draws on something I wrote on Usenet more than a decade ago.) I believe I might have introduced this list of three key assumptions, as noted by Roy Weintraub, into the wikipedia article on the topic:

• People have rational preferences between outcomes that can be identified and associated with values.
• Individuals maximize utility and firms maximize profits.
• People act independently on the basis of full and relevant information.

One should recognize that neoclassical economics is associated with mathematical formalism. So neoclassical economists speaking among the clergy would prefer the language of topology and the algebra of relations for stating their assumptions.

The point of neoclassical economics is to build a theory on those assumptions which emphasizes equilibrium, characterizes economics as the allocation of scarce resources, and justifies supply and demand reasoning. Neoclassical economists wanted to argue:

• Equilibrium prices are scarcity indices
• Marshall's principle of substitution is generally applicable

Neoclassical economists are unable to state assumptions that justify such reasoning. Weintraub's assumptions, suitably formalized, don't succeed. They do not succeed because one can construct examples with these assumptions in which the negation of neoclassical claims hold. I and others have done this. This is a matter of logic.

Just to show you that others characterize neoclassical economics in the same way as I do:

"The [Demand-and-Supply-based Equilibrium] theory visualizes the economy as an aggregate of atomistic individuals (producers and consumers) making their decisions autonomously, with no interference from the influence of 'externalities'. Relative prices and quantities are determined simultaneously in equilibrium as an outcome of the interplay of 'forces of demand and supply', generated by the optimizing behavior of individuals subject to their resource constraints. A certain symmetry characterizes the behaviour of producers and consumers. Each producer, given the technological possibilities, chooses the profit-maximizing activities and outputs, at the going prices; each consumer, given his budget constraints and scales of preferences, maximizes satisfaction at the going prices. It is through the operation of the 'fundamental' and 'universal' principle of substitution that individuals adjust their chosen quantities in response to the parametrically given prices...

Further, the notion of 'change' in the DSE theory gets restrictively predetermined by the theory in the following ways. First, all changes in quantities within the system are seen as the outcome of the ever-active principle of substitution. Thus the changes are primarily in relative quantities involving allocational variations. The role of prices as a scarce-resource allocator, given the resources, dominates the theory as contrasted with the resource-creational role of prices in classical theory... Secondly, all changes are explained as induced by changes in relative prices and operate through the decisions of individuals who are only 'quantity adjusters'; that is, all influences affecting quantities have to be necessarily mediated through relative prices or changes on the market and are outcomes of the atomistic responses of individuals. The relative prices acquire the all-powerful role of resource-allocation and the 'market' becomes the 'arena' of action." -- Krishna Bharadwaj (1989).

Here are a couple of examples of the incorrect reasoning to which I object:

"It is indeed the great contribution of the Pure Logic of Choice that it has demonstrated conclusively that even such a single mind could solve this kind of problem only by constructing and constantly using rates of equivalence (or 'values' or 'marginal rates of substitution'), that is, by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure...

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual to co-ordinate the parts of a plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin has arisen, or that one of the sources of tin has been eliminated. It does not matter for our purpose and it is significant that it does not matter which of these two causes has made tin more scarce. All that the users of tin now need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply... The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity ­ or rather the local prices are connected in a manner determined by the cost of transport, etc. - brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process." -- F. A. Hayek (1945).

"Let us then suppose that... there is a strike on the part of one group of workers, say the plasterers, or that there is some other disturbance to the supply of plasterers' labour... The rise in plasterers' wages would be checked if it were possible either to avoid the use of plaster, or to get the work done tolerably well and at a moderate price by people outside the plasterers' trade: the tyranny, which one factor of production of a commodity might in some cases exercise over the other factors through the action of derived demand, is tempered by the principle of substitution." -- Alfred Marshall (1920).

Hayek and Marshall were writing before it was known that the assumptions of neoclassical economics could not justify their reasoning.

Here is an ignorant or dishonest neoclassical economist perpetuating ignorance to another generation:

"Suppose the number of carpenters suddenly increases, due to the immigration of thousands of new carpenters from Mexico. Both before and after the change, carpenters receive their marginal revenue product... But the wage after the migration is lower than the wage before. Since the supply of carpenters is higher than before, the equilibrium wage is lower.

...an increase in the supply of an input I own drives down its price (and marginal revenue product) and so decreases my income. The same is true for an increase in the supply of an input that is a close substitute for an input I own. If I happen to own an oil well, I will regard someone else's discovery of a new field of natural gas--or a process for producing power by thermonuclear fusion--as bad news." -- David D. Friedman (1990).

David cannot state his assumptions. Here is a quote from a refereed paper:

"This note considers a linear programming (LP) formulation of the theory of the firm. A neoclassical non-increasing labour demand function is derived from the solution of the LP. It is argued that only a small number of points on this curve, one or two in the examples provided, are equilibria of the firm. Equilibria are characterized by decisions of the managers of the firms that allow the same decisions to be made in successive periods. Hence, one can explain the quantity of labour that firms desire to hire either by a traditional neoclassical labour demand function or by an analysis of equilibria of the firm, but generally not both. Explaining wages and employment by well-behaved supply and demand functions for labour is of doubtful logic." -- R. L. Vienneau (2005).

• Krishna Bharadwaj. 1989. Themes in Value and Distribution: Classical Theory Reappraised London: Unwin-Hyman.
• David D. Friedman. 1990. Price Theory: An Intermediate Text 2nd Edition.
• F. A. Hayek. 1945. "The use of knowledge in society. American Economic Review 35 (5): 519-530.
• Alfred Marshall. 1920. Principles of Economics: An Introductory Volume 8th edition.
• E. Roy Weintraub. 2007. Neoclassical economics. The Concise Encyclopedia of Economics.
• Robert L. Vienneau. 2005. On labour demand and equilibria of the Firm. Manchester School 73 (5): 612-619.