Economists This Week: What is neoclassical economics? Glasner, Krugman, Vernengo, Knibbe and Pilkington
Keynes’s work was not neoclassical economics, and it has been an ongoing project ever since Keynes published the General Theory to determine whether, and to what extent, Keynes’s theory could be reconciled with neoclassical economic theory. Here is how Hayek summed up his essay.
It seems to me that signs can already be discerned of a revival of interest in the kind of theory that reached its first high point a generation ago – at the end of the period during which Menger’s influence had mainly been felt. His ideas had by then, of course, ceased to be the property of a distinct Austrian School but had become merged in a common body of theory which was taught in most parts of the world. But though there is no longer a distinct Austrian School, I believe there is still a distinct Austrian tradition form which we may hope for many further contributions to the future development of economic theory. The fertility of its approach is by no means exhausted and there are still a number of tasks to which it can profitably be applied.
So we are all (or almost all) neoclassical economists, and none more so than Hayek, who was steeped in the neoclassical tradition. But no tradition is static. When a tradition stops changing, when it stops evolving, it becomes a relic, not a tradition. And with change come differences of opinion and disagreements, even bitter disagreements, between practitioners operating within a single broad tradition. Many Austrians now view themselves as completely distinct and separate from the broader neoclassical tradition from which their own doctrines evolved, but that was never Hayek’s view. And for all the severe criticisms and complaints he voiced about the direction of economics since the 1930s, he never viewed himself as being cut off, or alienated, from the mainstream of neoclassical economic theory.
Paul Krugman http://krugman.blogs.nytimes.com/
So, what is neoclassical economics? There’s a historical definition, having to do with the “marginal revolution” of the late 19th century and all that, but what I think we mean in practice is economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal.
Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.
This is, not to put too fine a point on it, very much true of Keynesian economics as practiced (leave aside discussions of What Keynes Really Meant and whether we’re all apostates). New Keynesian models are intertemporal maximization modified with sticky prices and a few other deviations (such as balance-sheet constraints). Even IS-LM loosely appeals to maximization arguments to derive the slopes of the curves, while analyzing outcomes by comparing equilibria.
Why do things this way? Simplicity and clarity. In the real world, people are fairly rational and more or less self-interested; the qualifiers are complicated to model, so it makes sense to see what you can learn by dropping them. And dynamics are hard, whereas looking at the presumed end state of a dynamic process — an equilibrium — may tell you much of what you want to know.
These motives are the reason why other fields facing similar concerns adopt similar strategies. As I wrote long ago, evolutionary theory — the biological kind — looks remarkably like neoclassical economics.
What would truly non-neoclassical economics look like? It would involve rejecting both the simplification of maximizing behavior, going for full behavioral, and rejecting the simplification of equilibrium, going for a dynamic story with no end state.
And there is economics like this: agent-based economics. It’s a project that relies heavily on computing, to keep track of the complexities, and at this point makes simplifying assumptions that are in their own way as unrealistic — but in a different direction! — as those of neoclassical work. Still, it’s a good thing to pursue.
So what is neoclassical economics? According to Krugman it is basically maximization and equilibrium. In his words, neoclassical or marginalist analysis is:
“economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal.”
This is clearly incorrect. First, classical authors, meaning those that followed the surplus approach (from Petty to Marx, including Quesnay, Smith and Ricardo) did assume that economic agents were rational and self-interested and they also believed that the economy could be represented by equilibrium outcomes. And they clearly were not neoclassical, meaning they did not believe that supply and demand determined long term prices (natural prices as Smith and Ricardo referred to them, or prices of production in Marx’s terminology).
If profits were higher in a particular sector, capitalists would try to gain from those opportunities entering the industry, and in the process would lead to a uniform rate of profit. Market prices, determined by supply and demand, would gravitate around the long term equilibrium prices that were determined by the technical conditions of production, and the previously given real wage (by conflict), in modern parlance (on the issues raised by the Labor Theory of Value, and Sraffa’s solution just check other posts in this blog).
More importantly, there was no mechanism (even in the case of those classical authors, like Ricardo, that accepted Say’s Law) that implied full utilization of labor, capital or any particular means of production. Wage flexibility did not lead to full employment. The hallmark of marginalism is the notion that supply and demand determines simultaneously the equilibrium long term prices, and that price flexibility leads to full utilization of resources, something that the capital debates have demonstrated long ago it cannot be done. In this regard, Krugman decides (because it must be advantageous) to follow those that he criticizes, and remains oblivious to both logic and empirical evidence. If he wants to be coherent with his Keynesian ideas, he should get rid of the notion of a natural rate of unemployment (or and of interest).
In a blogpost, Paul Krugman asks, while defending the heuristic use of neo-classical economics : “What would truly non-neoclassical economics look like? It would involve rejecting both the simplification of maximizing behavior, going for full behavioral, and rejecting the simplification of equilibrium, going for a dynamic story with no end state.” Well, I personally do agree very much with the last part of the sentence – it’s also called ‘history’.
The influence that mathematics has had on neoclassical economics is obviously quite profound. However, when looked at in detail it appears that a certain type of modern mathematics was in fact highly suited to the direction many in the economics profession took after the work of Leon Walras – the Frenchman who founded modern neoclassical economics – appeared on the scene. So, it should not be thought that it was simply the formal tools of mathematics that transformed neoclassical economics into the obscurantist doctrine it is today. Instead it should be understood that its obscurantist skeleton was ready and waiting for its mathematical flesh.
It has been said before – and not just by the present writer – that neoclassical economics amounts to a sort of theological system that bears no resemblance to reality for the simple reason that it does not aim at reality.