Quote of the day #3

from Peter Radford

Ronald Coase asks the big question in his 1937 paper “The Nature of the Firm”:

“Within a firm, … market transactions are eliminated and in place of … exchange transactions is substituted the entrepreneur-co-ordinator who directs production. It is clear that these are alternative methods of co-ordinating production, Yet, having regard to the fact that if production is regulated by price movements, production could be carried on without any organization at all, well might we ask, why is there any organization?”

To which, or at least in part answer to, G.B. Richardson responded with this in his 1960 book “Information and Investment”:

“there is, in fact, a genuine gap in our theoretical presentation of the working of the competitive economy. The theory of the maintenance or attainment of equilibrium under perfectly competitive conditions fails to account for the process for the adjustment in terms of investment decisions by individual entrepreneurs, who have expectations which they could reasonably be presumed to form, on the basis of information which can be reasonably be presumed to be available”

What both Coase and Richardson are trying to get at is the implausibility, or perhaps the impossibility of, the very heart of what is now called orthodox economic theory.

The problem is this: orthodox theory assumes that people react instantaneously, rationally, and completely to information they receive in the marketplace. This reaction takes the form of instantaneous adjustments in resource use and so on, and the vehicle transmitting the necessary information is the price structure of the political economy in question. I hope you can see how fraught this is. Not only do prices convert all the information needed for instant adjustment, but they change simultaneously to reflect said adjustment. This, to put it bluntly, requires nothing short of an immaculate and omniscient ability on the part of everyone involved.

To make this work we need to suspend our critical faculties and allow the information being acted upon to include an aspect that reflects its own refection of the information being acted upon. For everyone. All at the same time.

Don’t think about it too hard, your head will explode. Only economists are equipped to think in such contorted and unreal ways.

Now, the relevance of this is that such lunacy sits at the core of orthodox theories that purport to tell us how the economy works. Upon such sand are the foundations of modern economics built. Worse: economists who theorize along these lines dominate the articulation of policy. So our public discourse, as it relates to such things as  employment problems or getting the economy growing again, is itself rooted in the fairy tales economists tell each other.

I hope you feel queasy. You ought to.

Economists obsess over equilibrium, but to make up theories to study it they have to wander off the reservation. Here is a short list of the basic elements of what is called general equilibrium theory:

  1. People are perfectly rational. They both know everything – literally – and know how to react to what they know. They react as an economist would. Omnisciently.
  2. People are perfectly independent. They don’t collude, ever. They don’t cheat. They don’t exchange any information at all until they bump into each other in the marketplace. At which point they happily exchange every shred on information they possess. [This is weird: I thought they knew everything about everything before they went to market. In which case why go to market?]
  3. Everything takes place in a special dimension called logical time. That is to say everything happens all at once. This includes the future which is reduced to a kind of compressed instant that reflects everything that will ever happen. Ever.
  4. Everyone can enter the market as either a buyer or a producer or both. Always. Without cost, special knowledge, or prohibition. You can make cars. I can raise cows. Or vice versa. For ever.
  5. Which is helpful because: all products, goods, and services are the same. My cow is your car. Vice versa etc.

This is, naturally, ridiculous. But it is grand economics. These kind of things undergird Nobel prize winning thoughts.

Which brings me to another quote. This time from John Hicks in his 1939 master work “Value and Capital”:

“What we mainly need is a technique for studying the interrelations of markets. When looking for such a technique we are naturally impelled to turn to the works of those writers who have specially studied such interrelations – that is to say, the economists of the Lausanne School … The method of General Equilibrium, which these writers elaborated, was specially designed to exhibit the economic system as a whole, in the form of a complex pattern of interrelations of markets. Our own work is bound to be in their tradition, and to be a continuation of theirs.”

Umm. No. Our own work ought not be in their tradition because, as Coase and Richardson point out: it is impossible to construct a credible system that way.

For one thing, Hicks misses the boat entirely. General Equilibrium theories, and their modern cousins, are designed precisely to eliminate the complex interrelations Hicks says we need to study. Why else deploy such unreal assumptions? There is nothing complex about the world of General Equilibrium other than the mounds of math needed to distort reality and get rid of any pesky vestiges of the actual world.

Economics is littered with examples of instances where assumptions are carefully chosen to assist in producing a tractable – and elegant – model of the economy rather than reflect its messy detail. Such efforts are usually hidden by the call for the simplification necessary to elicit clarity around one or two objects of study. But, as I think Coase and Richardson both contest, the truth is that economists do not simplify reality and then study it. They get rid of it and replace it with make believe.

Upon which their advice to presidents and prime ministers everywhere hangs.

I hope this makes you uncomfortable. It sure as heck upsets me.

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  1. Podargus
    December 22, 2013 at 6:54 pm | #1

    The problem goes a lot further than a bunch of economists with cognitive dissonance playing at being scientists. That amuses me.It doesn’t make me uncomfortable.

    There is a fundamental problem – our economic system is not sustainable for a number of reasons all of which should be familiar with the erudite people who populate this blog.Do you detect a touch of irony there? – if so,good thinking 99,you can go to 100. If not then you need to spend this current silly season doing something more than contemplating your navel.

    Maybe we all need to do a lot more systems thinking instead of just picking and examining strands of wool out of the cats cradle we have made.

  2. December 23, 2013 at 6:12 pm | #2

    Economists present markets as governors of scalar quantities: Price, quantity, maybe derivatives thereof. But markets are a very expensive and unreliable way of setting prices. It takes great effort to set up the market and keep it running within stable limits, and a good bureaucrat could compute the long run clearing price with less effort.

    What markets excel at is connecting multiple needs with multiple supply potentials and arbitrating between these alternatives. Should we produce more steel or more cola-flavored drinks? The US did better than the Soviet Union because it was better able to connect potential consumers and suppliers. Bureaucrats can’t do that.

    Markets aren’t scalar governors. They’re networks. Price signals are interesting when they arbitrate between many potential products and buyers, not one or a few. The stock market is interesting because there are many stocks. The bazaar because there are many different goods.

    Like a neural network, markets work when the connections are stable. Yes, price signals fire constantly and prices go up and down relative to other prices, but new kinds of goods don’t appear and disappear as often. It takes time for the market to integrate new goods, by forming links, and for price signals to stabilise. The idea that markets resolve novel products instantly is nonsense.

    I would guess that firms choose to work as non-market value networks because by and large each firm or business unit has to produce one product, or just a few. It doesn’t need the market as in bazaar to connect the various needs of customers and suppliers, and can govern its simple, scalar production using bureaucrats.

  3. December 24, 2013 at 2:51 pm | #3

    Reblogged this on Employment Relations and commented:
    Hier ist ein interessanter Beitrag über die nach wie vor aktuellen Probleme der dominanten ökonomischen Theorie. Der Verfasser kommt zu dem Schluss: “… the truth is that economists do not simplify reality and then study it. They get rid of it and replace it with make believe.” Ganz genau so ist es – jedenfalls für die Mainstream der Wirtschaftswissenschaften. Wer an dieser Aussage zweifelt, möge einen Blick in die akutell verwendeten Lehrbücher werfen. (Thanks to Peter Radford for the interesting post.)

  4. December 26, 2013 at 9:55 pm | #4

    The passage from Coase above alludes to a subtle truth about how the world works, which is that the concept of perfect competition can’t exist without plenty of cooperation among economic actors along the way.

    I once heard a speaker discuss the notion of cooperation and competition not being mutually exclusive with the metaphor of kids playing soccer. At the heart of the match is a competition. But within that competition there are countless examples of cooperation and order that allow it to happen: passing and teamwork within the team, obeying the referees’ orders, lining up to shake hands afterwards, etc. You can draw plenty of parallels to markets.

    Why do some people, economists and others, resist this reality? I’m convinced that it’s not just that modern macro has become obsessed with micro foundations and complicated math, drifting further and further away from observed reality. I also think it’s because of our obsession as Westerners with individualism. We love to celebrate self interest and insist on ignoring the other many elements that constitute a working market system.

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