Political Economy: Critique of Neoclassical Economics

1
Political Economy Critique of Neoclassical
Economics

• Wrong answers to the wrong questions Demand

2
Why Political Economy?

• Reject questions asked by mainstream economics
• Neoclassical economics asks the wrong questions
• Assumptions of individual utility/profit
  maximisation omit social interaction, social
  conflict, gender issues, etc.
• Equilibrium hangup ignores dynamic processes
• Internally inconsistencies in mainstream
  economics
• Provides wrong answers to questions it does ask
• Demand theory cant derive downward sloping
  market curve
• Profit maximising firms dont produce where
  marginal revenue equals marginal cost
• General equilibrium cant be in equilibrium
• How do neoclassical economists cope?

3
Why Political Economy?

• Ignore the problem!
• Capital aggregation problem (Cambridge
  Controversies) ignored
• Income distribution adding up problem (Shaikh)
  ignored
• Assume the problem away
• Assume identical consumers to avoid demand curve
  aggregation problem (SMD conditions)
• In a nutshell assume a miracle

4
But it all looks so neat!

• Great appeal of neoclassical economics an
  apparently coherent picture of a complex system
• Individual preferences generate demand curves
• Profit maximising generates supply curves
• Intersection determines prices outputs
• Markets harmonise in general equilibrium
• Welfare maximised by free market
• Great weakness of neoclassical economics
• All steps in above process have logical flaws
• Firstly, a recap of the neoclassical vision
• With this bloke turning up whenever the theory
  glosses over a crucial problem

5
Consumer demand

• Consumers demand determined by preferences
• A rational consumer
• Does not let income affect tastes
• Always prefers more to less
• Gets less utility out of each additional unit
  (diminishing marginal utility)
• Can always tell which bundle he/she prefers
• End result
• Tastes can be represented by indifference map
• Prices incomes determine budget
• Interaction of these determines demand curve
• Fall in price necessarily increases consumers
  welfare

6
Consumer demand
Z

• Indifference curves show tastes

X
Biscuits

• Points on Z preferred to X

• Prices Income gives budget
• Budget line II banana price p1 cheaper than p2
  for line I

Y
W
q1
q2
q3
II
III
I
Bananas

• Hey presto
• downward sloping demand curve!
• consumer welfare ? as P ?

• Points of tangency give maximum utility at given
  relative prices

p1
p2
Price of Bananas
Consumer Surplus

• Price/quantity combos show the demand curve

p3
q1
Bananas
q2
q3
7
Consumer demand
Z

• A caveat income substitution effects
• Can get upward-sloping demand curve if (positive)
  income effect outweighs (negative) substitution
  effect
• Solution Hicksian compensated demand curve
• Notionally reduce income back to original
  indifference curve

X
Y
W
q1
q2
q3
II
III
I
Bananas

• Hicksian demand curve necessarily slopes down

p1
p2
Price of Bananas
p3
q1
Bananas
q2
q3
8
Consumer demand

• Now add lots of consumers together

• And we get a downward sloping demand curve where
  consumer welfare rises as price falls

Price of Bananas
The demand curve
Bananas

• Now stage two the upward-sloping supply curve

9
Supply

• Producers are short run profit maximisers
• Goods produced by combining factors of production

• In the short run, the quantity of one factor is
  fixed
• Output is increased by adding more of the
  variable factor (labour) to the fixed factor
  (capital)
• Production function therefore displays
  diminishing marginal productivity output
  eventually rises at diminishing rate
• Falling marginal product
• Rising marginal cost

10
Supply

• Marginal product can initially rise
• But ultimately it falls
• Falling marginal product mean rising marginal cost

Zero marginal product
Banana Output
Rising marginal product
Maximum marginal product
A
B
Labour Input

• Divide cost of input (constant wage) by
  additional amount produced (falling) and you have
  rising marginal cost

Marginal Product
Infinite marginal cost
Lowest marginal cost
A
B
Labour Input (capital fixed)
11
Supply

• Firms profit maximise by equating marginal
  revenue marginal cost because that identifies
  the biggest gap between total revenue and total
  cost

Slope of TRMR
Slope of TCMC

• Marginal revenue falls with rising output for a
  monopoly
• But a competitive firm is so small that, as a
  price taker, it doesnt affect market price. So
  its total revenue is a straight line

Maximum profitwhere MRMC
12
Supply

• Since price is constant for a competitive firm,
  marginal revenue equals price

• Competitive firm maximises profit by supplying on
  marginal cost curve
• Marginal cost curve becomes firms supply curve
• Sum of all firms MC curves is industry supply
  curve

13
Supply Demand

• Houston, we have equilibrium

• With maximum social welfare

P

• Unless theres a monopoly

S
PMgtMC
Consumer Surplus

• But assuming all markets are competitive, we can
  have general equilibrium

PCMC
Producer Surplus
D
MR
QM
Q
QC
14
General equilibrium

• All markets in instantaneous equilibrium
• Complete coordination of all markets without
  external intervention

Was equilibrium good for you too?

• Social welfare maximised by the free market
• But now lets check the fine print

15
Consumer Demand

• Adding lots of consumers together
• With one individual
• unambiguous link between preferences
  (indifference curves) demand curve
• Fall in price unambiguously benefits consumer

• With more than one individual

Biscuits

• Houston, we have a problem

Bananas
16
Consumer Demand

• Two different incomparable sets of indifference
  curves
• Point of tangency for one wont be for the other
• Income effect may work in opposite directions for
  two consumers (one might consume less as price
  falls, the other more)
• Income effects of changing prices
• Change in relative prices changes income/wealth
• One-person analysis assumes prices can be changed
  without affecting income
• Cant assume same for 2 or more persons
• Cant alter prices without affecting incomes

17
Consumer Demand
Z

• E.g., banana price rise increases wealth

• With one consumer, no problem keeping prices
  income/wealth separate

X
Biscuits

• With two consumers, even if their tastes are
  identical, can no longer separate prices from
  incomes/wealth

Y
W
q1
q2
q3
II
III
I
Bananas

• Any shape of market demand curve can result
• Two outcomes of these dilemmas

p1

• Demand rises as price rises

p2
Price of Bananas
p3
q1
Bananas
q2
q3
q3
q1
18
Consumer Demand

• (1) Standard individual law of demand (that
  demand rises as price falls) does not apply at
  market level
• Market demand curves can have any shape at all
• every polynomial is an excess demand function
  for a specified commodity in some n commodity
  economy every real-valued function is
  approximately an excess demand function.
  (Sonnenschein 1972 550)
• (2) To guarantee that a market demand curve
  slopes down like an individual demand curve,
  consumers effectively need to be identical and
  have tastes that dont change with income

19
Consumer Demand

• If
• (1) The marginal propensity to consume a good is
  the same for all consumers
• i.e., you have the same marginal propensity to
  buy Da Vincis original manuscripts as Bill
  Gates
• Bill Gates has the same marginal propensity to
  buy methylated spirits as a derelict AND
• (2) The marginal propensity to consume a good
  doesnt change with income
• When Bill Gates earned 100 a week, he spent the
  last 10 on pizza
• Now that he earns 100,000,000 a week, he spends
  10,000,000 on pizza
• Then the market demand curve will slope downwards

20
Consumer Demand

• Conditions in effect amount to
• All consumers are identical
• All commodities are identical
• i.e., model only works with one consumer one
  commodity
• When scaled to gt 1 consumer and gt 1 commodity,
  aggregation effects mean what applies at
  individual level doesnt apply at aggregate
• Result is general
• Doesnt depend on perverse utility functions
• Makes it impossible to derive meaningful
  aggregate (market) laws from principle of
  individual utility maximisation

21
Consumer Demand

• market demand functions need not satisfy in any
  way the classical restrictions which characterize
  consumer demand functions The importance of the
  above results is clear strong restrictions are
  needed in order to justify the hypothesis that a
  market demand function has the characteristics of
  a consumer demand function. Only in special cases
  can an economy be expected to act as an
  idealized consumer. The utility hypothesis
  tells us nothing about market demand unless it is
  augmented by additional requirements. (Shafer
  Sonnenschein 1982 671-2 emphasis added)

22
Consumer Demand

• Maybe class-based analysis is necessary?
• If we are to progress further we may well be
  forced to theorise in terms of groups who have
  collectively coherent behaviour. Thus demand and
  expenditure functions if they are to be set
  against reality must be defined at some
  reasonably high level of aggregation. The idea
  that we should start at the level of the isolated
  individual is one which we may well have to
  abandon. (Kirman 1989 138)
• Post Keynesians Marxists work in terms of
  groups (workers, capitalists, bankers) rather
  than individuals

23
Consumer Demand

• In general market demand curves (derived from
  neoclassical theory) look like this

• So rather than this

Price of Bananas
The demand curve
Bananas

• Even if consumers utility maximise!
• Which they dont

24
Indifference Curves

• Seen any good indifference curves lately?
• Dilemma indifference curves play crucial role in
  theory, but unobservable
• Samuelson suggested a solution revealed
  preference
• Induce consumers preference map from their
  purchasing decisions.
• What we want to find is

25
Indifference Curves

• What we can know is what a consumer actually buys
  at different prices

• Samuelson argued we can infer the indifference
  map from these

• Using revealed preference the axioms of
  rational behaviour
• Consumer can rank all bundles in terms of
  preference/indifference
• More preferred to less
• If A pref B B pref C then A pref C

Biscuits
Y
W
X
q1
q2
q3
P2
P3
P1
Bananas
26
Indifference Curves

• All points in box preferred to A (non-satiation)

• Can build up map of consumers tastes by
  offering different bundles of goods at different
  prices, seeing which bundles chosen
• reveal preferences

• If A preferred to B C at one price, must be
  preferred at any price (completeness
  transitivity tastes independent of income)
• A must be on higher curve than B or C

27
Indifference Curves

• Sippel (1997) attempted to do just this reveal
  preferences of experimental subjects
• 10 sets of Budget relative prices presented
• Budgets/prices chosen to test aspects of theory
  (e.g., Homogeneity degree zerodouble prices
  incomes, should be no change in consumption
• Choose from 8 goods at each budget/price combo
• Computer automatically calculated budget cost
• Consume choices in next hour from one of ten sets

28
Indifference Curves

• Goods on offer

• Unlimited amount of time to choose
• 60 minutes to consume one choice set

29
Indifference Curves

• Key propositions being tested
• Weak Axiom of Revealed Preference WARP
• If A ? B then never B ? A
• If consumer chooses bundle A once when B also
  affordable, then consumer will always choose A
  instead of B, regardless of relative prices
• Strong Axiom of Revealed Preference SARP
• If A ? B B ? C then never C ? A
• Formal definition of a utility maximiser
• Generalised Axiom of Revealed Preference GARP
• If A ? B B ? C then pC A ? pC C
• If A ? B B ? C then A more expensive than set C
  at prices when C declined in favour of B

30
Indifference Curves

• Results first experiment (12 subjects)
• 11 of 12 subjects violated SARP WARP
• 5 out of 12 violated weaker test GARP
• Results second experiment (30 subjects)
• 22 of 30 subjects violated SARP WARP
• 19 of 30 violated weaker test GARP

31
Indifference Curves

• Sippels interpretation of results
• In general not too favourable to the
  neoclassical theory of consumer behaviour (p.
  1438) but
• Low number of inconsistencies (median 2 out of
  45but average higher)
• Subjects did try to select a combination of
  goods that came as close as possible to what they
  really liked to consume given their respective
  budget constraints (1439)
• They spent a considerable amount of time on
  their decisions (typically 30-40 minutes)
• How serious are violations of axioms?

32
Indifference Curves

• Use waste of income from inconsistent choice as
  guide to how significant were deviations from
  rationality
• Afriat index ratio (pB A / pB B) when (from
  previous experimental round) A ? B
• Where consumer chooses A when B affordable, use
  formula A ? B if (e pA A) ? (pA B)
• Consumer deemed to prefer A over B if A (say)
  11 more expensive than B consumer still
  chooses A (here e0.9)
• Like having thicker indifference curves

33
Indifference Curves

• With thicker indifference curves, more
  combinations are shown as indifferent

Biscuits

• e1 C ? B ? A

C
A

• e.95 C ? B A but B ? A

B

• Choosing A or B appears rational for e.95 but
  not for e1

Bananas

• The good news number of apparent violations of
  GARP dropped significantly for elt1
• The bad news even throwing a darttotally
  random choiceappeared rational for elt0.95!
• For e.9, random choice appeared more rational
  than what human subjects did!

34
Indifference Curves
35
Indifference Curves

• Several other careful attempts to interpret
  results
• But overall judgment
• We conclude that the evidence for the utility
  maximisation hypothesis is at best mixed. While
  there are subjects who do appear to be
  optimising, the majority of them do not we
  call the universality of the maximising principle
  into question. (1442)
• So if people arent maximising their utility,
  what are they doing?
• Are they being irrational?

No!

• Its the neoclassical definition of rational
  behaviour that is irrational!

36
How rational is optimising?

• Neoclassical model a toy model of behavior
• Only 2 commodities, unspecified quantities
• Lets make it real
• Shopping in a supermarket with 1,000 different
  commodities
• Decide whether to or not to buy one unit of each
• How many bundles do you have to consider?
• For the textbook toy model, only 4
• (0 bananas, 0 biscuits 1 banana, 0 biscuits 0
  bananas, 1 biscuit 1 banana, 1 biscuit)
• In the supermarket?

37
How rational is optimising?

• Number of choices is
• Number of units being considered 1 (0 or 1)
• Raised to the power of how many goods
• 2 in textbook modelso only 4 combinations

• 2 goods, 22 4 combinations

• 3 goods, 23 8

• 4 24 16

• supermarket 1,000 goods
• How many combinations?

38
How rational is optimising?

• 21000, or roughly 10300.
• So is that big, or what?
• Spelling it out in full, its
• 10,720, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000, 000, 000, 000, 000, 000, 000, 000, 000, 000,
  000 combinations!

So is that big, or what?
39
How rational is optimising?

• How big a brain would you need to remember that
  many combinations?
• Pretend each neurone could remember the utility
  of 100,000,000,000 combinations
• Your grey matter weighs about a kilo
  100,000,000,000 neurones, each weighing
  1/100,000,000 grams
• Quick quiz a brain this big would weigh
• (1) More than your brain?
• (2) More than an elephant?
• (3) More than the planet?
• (4) More than the Sun?
• (5) More than the Galaxy?
• (6) More?

40
How rational is optimising?

• (6) 10224 times as much as the entire universe!
• If you could recall utility of each combination
  in 1/10,000,000,000,000,000,000,000,000,000,000,00
  0,000,000,000,000,000,000,000,000,000,000,000,000,
  000,000,000,000,000,000,000,000,000,000th of a
  second, how long would it take to remember the
  maximum?
• 10200 seconds 10180 times the age of the
  universe!
• Whats going on?
• The curse of dimensionality number of
  combinations grows exponentially as more options
  considered
• Impossible to consider even tiny fraction of
  options in effectively finite time
• Dimensionality overwhelmed Sippels subjects,
  even with just 8 commodities experimental setup
  replicating neoclassical theory

41
How rational is optimising?

• Rational behavior is not considering all options,
  but
• Reducing number you do consider in a way that
• Makes deciding in finite time possible
• Doesnt obviously rule out good combinations
• We use heuristics sensible rules of thumb
• We do consider our budgets when deciding tastes
• We use habit, convention, culture
• Buy much the same combination each week
• We segment our purchases x on food, y on
  clothing
• Tastes evolve over time (with marketing trying to
  manipulate development)

42
How rational is optimising?

• These non-optimising behaviors make choice
  possible
• E.g., segmentation rather than optimise over
  everything in supermarket, segment into fruit,
  meat, spices, hygiene, etc.
• Say 1000 products in supermarket, 100 in each
  segment
• Unsegmented optimising Buy/not buy 10300
  combinations
• Segmented optimising Buy/not buy 1031
  combinations10269 less could remember
  everything with a brain weighing only 1 million
  tonnes!
• More than segmentation needed! But optimising
  behaviour is clearly not rational

43
What should economists do instead?

• Abandon ambition to build coherent model of
  aggregate (market) behavior from isolated
  individuals
• Model at some reasonably high level of
  aggregation (Kirman)classes (capitalists,
  bankers, workers) or
• Model actual behavior at individual level
• Satisficing (Herbert Simons) rather than
  optimising multi-agent modelling
• Generate non-coherent model of aggregate
  behaviour (waves of demand, non-equilibrium
  dynamics, co-evolution of products and demand)
• These approaches being taken by Marxist, Post
  Keynesian, Evolutionary economists but not by
  neoclassicals (best offer game theory)

44
Political economy attitude

• Methodological individualism of neoclassical
  economics fails on own grounds
• Internally inconsistent
• Does not reach results they desire
• Socially coherent approach of Marxists, Post
  Keynesians, Evolutionary, Feminist economists
  superior
• Methodological individualism should be abandoned
  in favour of analysis of social groups/classes,
  income distribution between classes, etc.
• Next week, theory of the firm