Week Ten - Amazon S3

Week Ten - Amazon S3

Lecture Eleven Critiques of Economics Dogma versus Debate Economics differs from hard sciences Normally at least two rival schools In classical period Smith, Ricardo, Malthus: objective theory of value Say (and others): subjective theory In neoclassical period Neoclassical Austrian (anti-equilibrium analysis) Post Keynesian, Evolutionary, Institutionalist, Marxian, Econophysics One dominant, others marginalised but still professional i.e., represented by academic economists rather than cranks Dogma versus Debate

Physical sciences normally have just one school of thought Fundamental concepts agreed upon Physicists differ by their specialisations only Except during periods of paradigm change E.g., today, all physicists accept Quantum mechanics, Relativity, & Thermodynamics as fundamental Then specialise in different aspects But Quantum mechanics & Relativity are in conflict Different schools compete here to try to resolve conflict String theory was dominant Failure to produce refutable experiment causing other approaches to arise Competing Scientific Research Programs arising, as Lakatos argued But agreement on fundamental concepts, and different schools read each others papers Dogma versus Debate Different schools of thought in economics Dont agree of fundamentals Generally dont read each others papers But asymmetric:

members of some non-mainstream schools do read mainstream papers to critique them; most mainstream economists dont read (or even know about) non-mainstream theories So there is critique, but rarely debate Many disputes really contests over theory of value One school disputes hard core of the other Critique really is re-phrasing of one schools core beliefs in terms of the others Necessarily incompatible Dogma versus Debate E.g., Diamond-Water paradox Diamonds comparatively useless, but high price Water very useful, but low price: The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase

scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. (Smith, Wealth of Nations, Book I) Dogma versus Debate Neoclassical/subjective theory of value explanation Marginal utility of diamonds much higher than water Alleged classical/objective theory had no explanation But classical school did have a labour-value solution: Diamonds much scarcer than water More effort needed to produce them Effort to mine diamonds vs effort to draw water explains relative prices Both sides rejected each others explanation At issue is incompatibility of hard core beliefs Significant disputes are about internal consistency

Most prominent early critique: Neoclassical/Austrian critiques of labour theory of value Bohm-Bawerk & the transformation problem Labour theory of value asserts Surplus Value comes from labour only Surplus Value is the only source of profit Assumes rate of surplus value constant across industries No real explanation as to why Assumes tendency for rates of profit to equalise across industries Desire for maximum return will cause capitalists to move capital from low to high return industries But ratio of constant capital (commodity input) to variable capital (labour) differs between industries So rates of profit should differ

Bohm-Bawerk & the transformation problem How to make values consistent with equalised rates of profit? Engels promised Marx would provide solution in Volume III of Capital (edited by Engels & published after his death) Marxs solution was a pair of tables One with values, different amounts of surplus and differing rates of profit Other with values, same amounts of surplus and same rate of profit Sum of rows and columns the same. Just arithmetic, not analysis First major evaluation made by Austrian economist Eugene von Bhm-Bawerk: Bohm-Bawerk & the transformation problem

I cannot help myself: I see here no explanation and the reconciliation of a contradiction, but the bare contradiction itself. Marx's third Volume contradicts the first. (Karl Marx and the Close of His System, p. 30.) Transformation problem still debated today By remaining groups trying to preserve labour theory of value (mainly TSS School: Temporal Single System) Failure of Marx & successors to solve problem assisted decline of Classical School, rise of Neoclassical in late 19th century And it had its critics Veblen & evolutionary science Neoclassical theorists had ambitions to be dynamic & evolutionary: The main concern of economics is thus with human beings who are impelled, for good and evil, to change and progress. progress

Fragmentary statical hypotheses are used as temporary auxiliaries to dynamicalor rather biologicalconceptions: biologicalconceptions but the central idea of economics, economics even when its Foundations alone are under discussion, must be that of living force and movement. movement (Marshall, Principles, p. 22) But in practice, never moved beyond static analysis Thorstein Veblen posed question Why not?: Why is economics not an evolutionary science? Veblen father of institutional economic thought Co-developer of evolutionary economics (Schumpeter) In 1898, scathing critique of neoclassical economics: Why is economics not an evolutionary science? Argued that

True sciences seek explanation of actual phenomena in terms of cause and effect Neoclassical theory instead based on ideal ideas of what behaviour should be Therefore unable to explain what is observed except as exceptions to what should be observed Rather than explaining what is observed proposes idealised interpretations of what should be observed Why is economics not an evolutionary science? E.g., Money: should be only a medium of exchange Actual role of money in society not really analysed; just figure of speech medium of exchange asserted: it is this facile recourse to inscrutable figures of speech as the ultimate terms of theory that has saved the economists from being dragooned into the ranks of modern science By their use the theorist is enabled serenely to enjoin himself from following out an elusive train of causal sequence. He is also enabled, without misgivings, to construct a theory

of such an institution as money without descending to a consideration of the living items concerned, except for convenient corroboration of his normalised scheme of symptoms. (p. 383) Veblens opinion of theory of individual as a utility-maximiser: Why is economics not an evolutionary science? The hedonistic conception of man is that of a lightning calculator of pleasures and pains who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact. He has neither antecedent nor consequent. He is an isolated definitive human datum, in stable equilibrium except for the buffets of the impinging forces that displace him in one direction or another. Self-imposed in elemental space, he spins symmetrically about his own spiritual axis until the parallelogram of forces bears down upon him, whereupon he follows the line of the resultant. When the force of the impact is spent, he comes to rest,

a self-contained globule of desire as before (p. 389) Why is economics not an evolutionary science? Veblen on equilibrium reasoning: Professor Marshalls work remains an inquiry directed to the determination of the conditions of an equilibrium It is not an inquiry into institutional development it is the movement of a consummately conceived and self-balanced mechanism, not that of a cumulatively unfolding process or an institutional adaptation to cumulatively unfolding exigencies. (1919: 173) The neoclassical view of dynamics is that The more dynamic the society, the nearer it is to the static model; until in an ideally dynamic society, with a frictionless competitive system the static state would be attained (1919: 190) Why is economics not an evolutionary science?

What should economics really be? the theory of a process of cultural growth as determined by the economic interest, a theory of a cumulative sequence of economic institutions stated in terms of the process itself. It would attempt to trace the cumulative working out of the economic interest in the cultural sequence. It must be a theory of the economic life process Neoclassical economics cant do this because: a hedonistic psychology does not afford material for a theory of the development of human nature nature It is therefore not readily apprehended or appreciated in terms of a cumulative growth of habits of thought (p. 163-64) Why is economics not an evolutionary science? Reception of Veblen by neoclassical economists set

standard for later debate between opposing schools: deny that opponents are economists As to the merits of his work, opinions differ more widely and more fervently than on any other writer of equal prominence. He is rated among the great economists of history, or as no economist at all; as a great original pioneer or as a critic and satirist without constructive talent or achievement. And he was, one might almost say, all of these things; from different standpoints and by different criteria, each of which it is possible to understand and even to appreciate. (John Maurice Clark, AER obituary for Veblen, 1929, p. 747) Sraffa and discarding Marshalls theory Veblen dismissive of entire neoclassical vision Next major critic back on logical soundness of one neoclassical argument: the upward-sloping supply curve: I am trying to find what are the assumptions implicit in Marshalls theory; if Mr. Robertson regards them as

extremely unreal, I sympathise with him. We seem to be agreed that the theory cannot be interpreted in a way which makes it logically selfconsistent and, at the same time, reconciles it with the facts it sets out to explain. Mr. Robertsons remedy is to discard mathematics in the circumstances, I think it is Marshalls theory that should be discarded. (Sraffa 1930, p. 93) Sraffa and discarding Marshalls theory Sraffas argument Basis for rising supply curve is rising marginal cost of production Rising marginal cost occurs because of diminishing marginal productivity Marginal productivity falls because One input to production fixed in short run One input variable in short run Adding more of variable input causes less output per additional unit of input Sraffa disputed assumption of fixed input in short run

Sraffa and discarding Marshalls theory 2 cases broadly defined industry e.g., Manufacturing Similarly broad definition for fixed input needed E.g., Land or Capital Narrowly defined industry e.g., Cardboard boxes Similarly narrow definition for fixed input needed E.g., glue guns Sraffa asserted that in either case, assumption undermined concepts of supply & demand analysis Recap of basic neoclassical idea: Sraffa and discarding Marshalls theory Supply curve derived from production function combining (at least) one fixed input with variable inputs result: diminishing marginal productivity

A Diminishing marginal productivity sole basis for rising marginal cost (variable input cost assumed constant) Labor cost Wheat Output productivity may rise as initial variable inputs added but eventually diminishing productivity sets in B C

A C B Labor Input Flip axes & multiply by wage rate: Wheat Output Sraffas Broad critique Wheat Diminishing marginal productivity means rising marginal cost, & hence upward-sloping demand curve (a) PF

(c) MPF Fertiliser Fixed Land (b) Fertiliser PW (d) SW P2 D2 P1 Fertiliser

D1 Wheat Sraffas Broad critique If broadly define factor/industry, then can regard factor as fixed since attracting additional units difficult But increasing output of industry will affect incomes of all other industries/factors: If in the production of a particular commodity a considerable part of a factor is employed, the total amount of which is fixed or can be increased only at a more than proportional cost, a small increase in the production of the commodity will necessitate a more intense utilisation of that factor, and this will affect in the same manner the cost of the commodity in question Sraffas Broad critique

and the cost of the other commodities into the production of which that factor enters; and since commodities into the production of which a common special factor enters are frequently, to a certain extent, substitutes for one another ... the modification in their price will not be without appreciable effects upon demand in the industry concerned. (Sraffa 1926) So demand shifts for each movement along supply curve Cant have independent supply and demand curves Sraffas Broad critique Increased usage of fixed resource increases price and changes income distribution not all land used by agriculture (e.g., fallow, housing) increased demand for agriculture partly met by switching resources from fallow/housing prices of land, fertiliser will rise Supply and demand curves therefore not

independent If not independent, can have indeterminate outcome No unique equilibrium price because demand and supply interdependent Sraffas Broad critique Fertiliser Fixed Land (b) F PF, PL (a) Different demand curve for every point

on supply curve since change in supply changes incomes Price/bushel MPF Agriculture Income effects with Broad Definition of Industry Price? PL (c) Dq3

PF Dq2 Supply ? Dq1 ? ? q1 q2 Quantity? Demand q3 Wheat Sraffas Narrow critique If use narrow definition of industry (e.g., wheat industry rather than agriculture)

Sraffa argued assumption of fixed input much less justifiable Instead, extra fixed input can normally be found if increase supply needed Increased demand for wheat will mean conversion of land from (e.g.) barley to wheat Negligible change in cost of land Fertiliser to land ratio remains constant Marginal product & thus marginal cost remains constant Constant cost with narrow definition Sraffas Narrow critique If we next take an industry which employs only a small part of the constant factor (which appears more appropriate for the study of the particular equilibrium of a single industry), we find that a (small) increase in its production is generally met much more by drawing marginal doses of the constant factor from other industries than by intensifying its own utilisation of it;

thus the increase in cost will be practically negligible (Sraffa 1926) Sraffas Narrow critique Wheat Constant cost with narrow definition PF (a) (c) Fertiliser/land ratio held constant at ideal ratio Fertiliser Land MPF

Price of fertiliser unaffected by increased use in wheat production F Horizontal wheat supply curve with constant MPF PW (d) (b) Marginal productivity of fertiliser therefore constant F D1

P D2 SW Wheat Supply sets price, demand sets quantity: position of classical school Sraffa and discarding Marshalls theory Sraffas views debated by profession, but then ignored From Lakatos perspective Diminishing marginal productivity too much a hard core belief to allow challenge Next major critique empirical Interviews with businessmen found marginal costs

constant or falling for most firms Accidental critique Originated in Oxford Study Group in UK Intended to help economists & businessmen communicate Businessmen couldnt accept economists concept of diminishing marginal productivity Economists surveyed business to find out why The empirical critique In USA, similar critique arose from WWII rationing Economists put in charge of price-setting Key people Gardiner-Means, J.K. Galbraith Found two different price regimes Agriculture, raw materials had volatile prices Manufacturing, services had stable prices Developed concepts of administered prices Prices not set by supply & demand but by markup on relatively constant average costs of production Engineering explanation for costs

Manufacturing cost structure reflects design of factories to achieve maximum efficiency at maximum output: The empirical critique E.g., Eiteman & Guthrie 1952 showed managers 8 hypothetical average cost curves: 3-5 neoclassical: 3 most like textbook drawing 6-8 had constant or falling MC: Text description given to managers as well:

6 high at minimum output, decline gradually to a least-cost point near capacity, after which they rise slightly; 7 high at minimum output, decline gradually to capacity at which point they are lowest (Eiteman & Guthrie 1952: 835) The empirical critique Curve Indicated

Number of companies 1 0 2 0 3 1 4 3 5 14

6 113 7 203 8 0 Total 334 Only 18 out of 336 fit neoclassical vision of diminishing marginal productivity, rising cost unit costs at Almost 2/3rdsmarginal have lowest maximum output

The empirical critique Eitemans explanation for these & similar results: Factories are designed by engineers so as to cause the variable factor to be used most efficiently when the plant is operated close to capacity. Under such conditions an average variable cost curve declines steadily until the point of capacity output is reached. A marginal cost curve derived from such an average cost curve lies below the average cost curve at all scales of operation short of capacity, a fact that makes it physically impossible for an enterprise to determine a scale of operations by equating marginal cost and marginal revenues. (Eiteman 1947) The empirical critique Neoclassical response to this critique: Friedmans Methodology paper: The lengthy discussion on marginal analysis in the American Economic Review some years ago is an

even clearer, though much less important, example. The articles on both sides of the controversy concentrate on the largely irrelevant question whether businessmen do or do not in fact reach their decisions by consulting schedules, showing marginal cost and marginal revenue. Friedman advised economists to ignore this literature After making the analogy that billiard players dont actually use Newtons mathematics to sink balls The empirical critique Excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas , could make lightning calculations from the formulas, and could then make the balls travel in the direction indicated by the formulas. Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that,

unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players. (Friedman 1953: 21) This evidence is in part similar to that adduced on behalf of the billiard-player hypothesis--unless the behavior of businessmen in some way or other approximated behavior consistent with the maximization of returns, it seems unlikely that they would remain in business for long. The empirical critique Let the apparent immediate determinant of business behavior be anything at all--habitual reaction, random chance, or whatnot. Whenever this determinant happens to lead to behavior consistent with rational and informed maximization of returns, the business will prosper and acquire resources with which to expand; whenever it does not, the business will tend to lose resources and can be kept in existence only by the addition of resources from outside. The process of "natural selection" thus helps to validate the hypothesis--or, rather, given natural selection, acceptance of the hypothesis can be based

largely on the judgment that it summarizes appropriately the conditions for survival The empirical critique It is only a short step to the economic hypothesis that individual firms behave as if they calculated marginal cost and marginal revenue and pushed to the point at which marginal cost and marginal revenue were equal. Now, of course, businessmen do not actually and literally solve the system of simultaneous equations in terms of which the mathematical economist finds it convenient to express this hypothesis the businessman may well say that he prices at average cost, with of course some minor deviations when the market makes it necessary. The one statement is about as helpful as the other, and neither is a relevant test of the associated hypothesis. The empirical critique Neoclassical economists behaved as if they took

Friedmans advice and ignored this empirical research Other schools took it seriouslye.g., Post Keynesians Kalecki, Eichner, Lee-Downward Developed cost plus pricing models Kornai Developed demand-constrained models to explain why diminishing marginal productivity does not apply Another sub-school has developed Experimental Economics Neoclassical economists continue to be surprised when this empirical information is re-discovered Blinder 1998 Next critique after this: Sraffa round two Sraffa and input-output In debate over Marshall, Sraffas noted interdependence of markets: and this will affect in the same manner the cost of the commodity in question and the cost of the

other commodities into the production of which that factor enters After 1930, Sraffa (based in Cambridge University UK) attempted to state this problem rigorously Published Production of Commodities by Means of Commodities: Prelude to a Critique of Political Economy in 1960 Argued marginal productivity theory of income distribution invalid Position disputed by neoclassical economists in Cambridge University, USA: the Cambridge Controversies The Cambridge Controversies Neoclassical theory argues that increasing supply of factor of production will reduce its price reducing its price will increase its use in production Factors price equals its marginal product Direct relationship between supply of factor and

its price Models production as involving factors of production (Land, Labour, Capital) as inputs and goods as outputs versus classical position: goods produced using goods and labour as inputs The neoclassical position of profit and capital is Marginal Product Labour Output The Cambridge Controversies Increasing supply Decreasing price... Capital Diminishing

marginal product Capital Capital Increasing use of factor relative to others... Rate of profit is the marginal product of capital The Cambridge Controversies Sraffa, 1960 Take economy in full general equilibrium All marginal changes complete What determines prices in full equilibrium if all marginal changes are over? Self-reproducing system of commodity production inputs commodities & labour output commodities

equilibrium prices of outputs must enable their purchase as inputs in next period System (1): Simple reproduction, commodity inputs only: The Cambridge Controversies 240 qr wheat + 12 t iron + 18 pigs --> 450 qr wheat 90 qr wheat + 6 t iron + 12 pigs --> 21 t iron 120 qr wheat + 3 t iron + 30 pigs --> 60 pigs 450 qr wheat | 21 t iron | 60 pigs (sum of inputs=sum of outputs) Regardless of demand, prices must allow system to reproduce itself: 450 qr wheat must buy 240 qr wheat, 12 t iron, 18 pigs 21 t iron must buy 90 qr wheat, 6 t iron, 12 pigs

60 pigs must buy 120 qr wheat, 3 t iron, 30 pigs The Cambridge Controversies 240 pw 12 pi 18 p p 450 pw System of production: 90 pw 6 pi 12 p p 21 pi 120 pw 3 pi 30 p p 60 p p As a matrix 240 450 equation: 90 21 120 60 Has the solution:

12 450 6 21 3 60 18 450 pw pw 12 p p 21 i i 30 p p p p 60 1 pw 10 pi 1 $ 1

pp 2 i.e., price system for simple reproduction independent of demand, marginal utility, etc.; depends instead on system of production The Cambridge Controversies System (2): Expanded reproduction surplus produced, split between capitalists and workers in equilibrium, uniform rate of profit r, wages w A A a pa Ba pb ... Ka pk 1 r La w A pa b pa Bb pb ... Kb pk 1 r Lb w B pb

Amount of ... Amount of B A used to produced Ak pa Bk pb ... Kk pk 1 r Lk w K pk produce B La Lb ... Lk 1 Labor fully employed Aa Ab ... Ak A, Ba Bb ... Bk B... +ive net output The Cambridge Controversies r & w values determine split of surplus between capitalists, workers. To determine prices, must therefore know either r or w beforehand Distribution therefore not determined by market Instead, different pattern of prices for every pattern of distribution: marginal productivity theory of income distribution incorrect in general

equilibrium But what about validity of production function, isoquants, when marginal changes still relevant? The Cambridge Controversies Neoclassical position (by Samuelson): Concedes Classical position more factual output produced by heterogeneous commodities and labour, aggregate capital an abstraction But neoclassical position still defensible as an abstraction Samuelson (for neoclassicals) argues isoquants just a parable we use to teach students reality is different technologies, each with fixed ratio of capital to labour increase in price of capital will lead to less capital intensive technology being chosen: Labour The Cambridge Controversies

Technology 1: low K/L ratio, used when K expensive Envelope is isoquant Technology 5: high K/L ratio, used when K cheap Capital Decreasing price of capital means more capital intensive methods used, akin to simple parable that decreased price means more capital used The Cambridge Controversies As an aside, Samuelson ridicules classical theorys problems with labour theory of value, that capitallabour ratios must be the same in all industries. Problem: Samuelson assumes each technology can be represented by a straight line relationship between capital and labour Garegnani shows that straight line relationship only applies if capital to labour ratio is the same in all industries

If K/L ratios differ, each technology will be represented by a curve, not a straight line Curves can cut each other in more than one place: Labour The Cambridge Controversies Technology 1: low K/L ratio, used when K expensive Envelope is isoquant Technology 2: only used in intermediate K/L price range Technology 1: could also be used when K cheap Capital Problem known as reswitching: simple neoclassical parable does not work when multiple industries considered. The Cambridge Controversies

Why a curved relationship? The definition of capital What is capital? Money? Machine? Both, obviously; but how to add machines together? Money value only common feature but money value reflects expected profit rate of return and value of capital thus linked Sraffas solution: reduce all machines to dated labour Machine today produced with labour last year, plus machinery inputs last year The Cambridge Controversies If economy in long run equilibrium for indefinite past then all goods produced earned normal rate of profit r therefore value of machine now equals value of previous years inputs (labour and capital) multiplied by 1+r

Do it again: replace last years machine inputs with labour and capital used to produce those machines multiplied by 1+r Get a whole series of terms for the labor input each year multiplied by 1+r, (1+r)2, (1+r)3 Machine/commodity component reducible to almost (but not quite) zero. The Cambridge Controversies Next: the standard commodity Earlier, Sraffa shows how to devise a measure of value unaffected by the distribution of income: the standard commodity When measured using this, there is a simple linear relationship between the real wage w, the rate of profit r, and the maximum possible rate of profit R: r R 1 w This can be reworked to give an expression for the wage in terms of the rate of profit:

r w 1 R The Cambridge Controversies Each years labor input to producing a machine today is thus broken down into the number of units of labor performed (say 1 unit) times the wage rate w (now expressed in terms of r & R) times 1+r raised to the power of n, for how many years ago the labor was applied: Number of years Wage in r n ago that terms of rate 1 1 r

machine was R of profit made Rate of profit Expression gives an unambiguous value for todays capital input in terms of dated labor, but the measured value of capital depends on the rate of profit: The Cambridge Controversies So rather than the rate of profit depending on the amount of capital (marginal product theory of income distribution), the amount of capital depends on the rate of profit Second problem: this relationship is very nonlinear First part falls uniformly as rate of profit rises

Second part rises slowly as r rises rises rapidly as n (number of years ago rises) Two parts interact very unevenly For small change in r, second effect outweighs first as n rises For large change in r, first effect outweighs second for small n In between, cant pick whether increasing r will increase or decrease measured amount of capital: The Cambridge Controversies Value of machine produced with one unit of labor applied n years ago at a rate of profit r between zero and 25% when R=25%: 1 1 Made this year

(n=0) w( r 0) 0.5 Made 5 years ago (n=5) w( r 1) 0.5 r=0 r=25% 0 0 0.05 0.1 0.15

0.2 0.25 0 0 0.05 0.1 r w ( r 10) 20 1.5 15

Made 10 years ago (n=10) 0.5 0 0 0.05 0.1 0.15 r 0.2 0.25 r

2 1 0.15 0.2 Made 25 years ago (n=25) w( r 25) 10 5 0.25 0 0

0.05 0.1 0.15 r 0.2 Measured value rises & then falls as rate of profit rises 0.25 The Cambridge Controversies Cant apply marginal productivity theory to capital:

return to capital cant reflect marginal product of capital Output measured amount of capital depends on rate of profit numerator/y-axis (r) and denominator/x-axis (amount of capital) are interdependent relationship is messy rises as r rises for a while then falls as r rises Rate of profit therefore cant be marginal Diminishing productivity of capital marginal product Capital The Cambridge Controversies

Numerous other facets to Cambridge Controversies Minority of neoclassicals who got involved in debate (Samuelson, Solow, Hahn, etc.) had 2 eventual responses Grudgingly conceded critique had validity and started to develop alternative approaches to neoclassicism themselves (Samuelson, Solow) Abandoned attempt to make neoclassical economics relevant to real world and developed general equilibrium models as abstract thought experiments only (Hahn, etc.) Majority of neoclassicals assumed (wrongly) that debate won by neoclassicals and continued on as always. Next major critique an own goal Sonnenschein-Mantel-Debreu conditions Individual demand curve derived by Holding consumers income constant Varying relative prices Working out points of tangency between budget line and indifference curves

Normally results in downward sloping demand curve Except for Giffen goods Always does for compensated demand curves Market demand curves derived by? Neoclassical economists posed question: does market demand curve necessarily have same properties as individual demand curve? Answer? No! Sonnenschein-Mantel-Debreu conditions Problem Valid to hold income constant when considering one isolated consumer But when considering a market, changing relative prices changes distribution of income Under what conditions will this not affect the shape of market demand curve? i.e., under what conditions can market demand curve be guaranteed to Be downward sloping Obey axioms of rational choice (Axioms of

revealed preference WARP, SARP & GARP) When conditions dont apply, what shape will market demand curve have? Sonnenschein-Mantel-Debreu conditions First, when preferences are homothetic and the distribution of income (value of wealth) is independent of prices, then the market demand function (market excess demand function) has all the properties of a consumer demand function... Second, with general (in particular non-homothetic) preferences, even if the distribution of income is fixed, 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, Handbook of Mathematical Economics, 1982) Sonnenschein-Mantel-Debreu conditions Neoclassical economics response has been to invent the representative consumer Sounds like representative firm, but much more restrictive Suppose that all individual consumers indirect utility functions take the Gorman form... [where] ... the marginal propensity to consume good j is independent of the level of income of any consumer and also constant across consumers... This demand function can in fact be rationalized by a representative consumer (Varian 1984) What does this mean in terms of consumer theory? All Engel curves are straight lines Engels curves of different consumers are parallel Sonnenschein-Mantel-Debreu conditions Remember Engels curves? Show how consumption on different commodities

change as income rises Four possibilities Luxury: consumption rises proportionately as income rises Necessities: consumption falls proportionately as income rises Giffen: consumption falls absolutely as income rises Neutral: consumption proportion remains constant Sonnenschein-Mantel-Debreu conditions a. Necessity All other goods Bananas c. Luxury Bananas b. Inferior Bananas

d. Neutral Bananas All goods likely to fit 1st 3 cases: few if any likely to fit 4th Sonnenschein-Mantel-Debreu conditions a. Banana hater All other goods Engels curves will differ between individuals because indifference curves differ between individuals Engels curves could only be identical if people were all clones of each other Most neoclassical economists Either accept conditions Or dont know they exist

Some neoclassical economists Take conditions seriously Realise theory must change Bananas b. Banana lover Bananas Sonnenschein-Mantel-Debreu conditions E.g. of first camp: the original discoverer of problem The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given. (Gorman 1953) E.g. of second: developer of heterogenous agent models 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) Dispute and Debate today Past history of debates makes critics wary about worth of criticism If critique will be ignored, why bother critiquing? Less communication now between schools of economic thought than ever Some debate within schools E.g., some neoclassicals involved in debate over representative agent macroeconomics Post Keynesians debate theory of endogenous money Some cross-school critiques E.g., my critique of profit-maximisation mathematics See Debunking Economics website for papers Econophysicist McCauleys critique of Efficient Markets Hypothesis

But largely, schools of thought dont communicate with each other Back to Billiards My critique of the theory of the firm Rejected by neoclassical journals (AER, EJ) Published in non-neoclassical ones One element addresses Friedmans billiard players analogy Set up artificial market Have trial and error profit maximising firms Does what they do conform to MR=MC?

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