A fragile MPT

by Max Schröder

The neoclassical study of income distribution depends heavily on the notion of Marginal Productivity Theory (MPT). Apart from the (often admitted) practical (read measurement) problems with this account, the MPT also lacks a rigorous philosophical underpinning. The unwillingness to part with the account despite its evident theoretical and practical shortcomings is one of the many failures that can be witnessed in mainstream economics today.

The fundamental question of (in)equality is: “What is a fair or just distribution?” The answer to this question – drawing on some Calvinist-Protestant ethic – which can be found in most developed economies today is this: “A fair distribution is one where everyone receives a part of the general income that is (more or less) proportional to the contribution one has made to the general income.” And free markets (in theory) do just that. According to neoclassical economic theory free markets distribute income according to the marginal productivity principle – everyone labourer and capital(ist) is payed the exact contribution they have made to aggregate production.

The MP account has long been used to justify discrepancies in pay, but in the light of exploding executive salaries the MPT has been increasingly challenged. In the following I hope to show that MPT lacks a solid philosophical basis and is thus unable to perform its desired function. We will thus see that the distribution of income is far less “naturally determined” and therefore should be under more scrutiny from society.

The notion of MP is in essence a causal claim: Your marginal productivity is whatever change in the output that is caused by your actions. The problem that arises now is that causation as a philosophical concept is far less straightforward than is commonly understood. Even though philosophers are not agreed on the correct account of causation they understand that causation mostly works from multiple causes to effect rather than from a single cause. Failure to properly account for all the relevant causes might lead one to overestimate the impact that a single variable might have in bringing about a large effect. This is not to say that small causes cannot have impressive effects. A spark might still cause a forest fire, but only if there is dry scrub around, if it is not raining, and the if there is oxygen present, and so forth. In short a cause can only be effective in bringing about an effect if the right background conditions are prevailing. (In the lingo: The cause and the background conditions form a sequence of jointly sufficient conditions).

The main problem for MPT is that it discounts for these background conditions and proceeds from a situation where everything but one cause is fixed: ceteris paribus. To see the flaws of this system one only has to consider a simple example: Imagine that there are two workers, A & B, who operate a machine that produces 100 units of output. Now, given that the machine only works when operated by 2 people we can now show that B’s marginal productivity is 0 or 100 depending which background conditions we choose. If we assume that A is not operating the machine B’s MP will be 0 – which is the change in output from when no one is operating the machine (0) to after B has started working (also 0). Now let’s assume that A is already operating the machine. In this  case B’s MP will be 100, since that is the change from the output given that only A is working (0) to the output produced after B joins in as well (100). Clearly a focus on singular causes leaves us with a distorted (and wrong) estimation of the impact of B’s work. Please note that I have abstracted from the MP of the machine to illustrate my point – obviously this would complicate matters more.

In complex situations (such as production in a modern economy) the presence and exact position of the background conditions are important to evaluate the impact of a single cause. This can be seen by modifying the above example a little. Now assume that A is already working and the machine produces 30 units of output. After B joins output is up to 100 units. This seems to be a more straightforward (since less ridiculous) example – from a MPT perspective A’s MP is 30 and B’s 70. Again this is not enough since it might be the case that B´s productivity has been amended by A’s work. In order to distinguish between the productivity due to B’s work effort and the productivity due to the position of his or her work in the web of jointly sufficient conditions, we would have to swap A & B and compare the resulting outcome against the one observed. If it turns out that in the reverse example A’s MP is 70 and B’s productivity is 30 we would have evidence that the higher productivity of B is not so much due to his or her work effort and skill as to the particular position he or she occupies in the production process.

The results of these thought experiments bring bad news for MPT. Neither is it possible to evaluate the impact of a single worker whilst discounting for background conditions, nor is it possible to attribute an individual’s MP entirely to their work effort and skill.

The lessons we can draw, however, are powerful. First: background conditions matter. The success of some individuals and companies is largely enabled by the web of institutions (rule of law, public infrastructure, public education, work ethic, etc.) around them. Some of these – but by no means all – can reasonably be taken for granted (read held fixed): the existence of oxygen on earth might be necessary for the success of Microsoft, but I see no need to attribute any role to the big bang. Others have to be acknowledged (such as the existence of a school system that provides for an educated workforce) and deserve to be compensated for the role they play in the production process (e.g. trough taxes that help fund a public school system).

Second: The case of background conditions shows us that the relative position of a job within the production process might matter more than the individual who occupies it. This cuts through the traditional view that productivity is a sign of personal exertion and ability – some jobs just are naturally more productive than others simply due to the position they occupy in the web of jointly sufficient causes. The existence of these differently weighted positions requires a nuanced view of what a worker’s “real” contribution amounts to. Failure to do so might leave us with a gross overestimation of what certain individuals contribute to the general wellbeing.

The way ahead is long and riddled with complications. The excesses of income inequality witnessed in developed economies for the last 30 years have caused a lot of disturbance and are rightfully subject to increased criticism from politics, society and academia. Luckily MPT becomes increasingly untenable as a way to justify these discrepancies. With the breakdown of MPT we can see that reward in society is as much a matter of convention, social status and power as it is of productivity and it is important that we take account of these facts if we are interested to attain anything like a fair distribution of income. It is not enough to let the markets deal out their spoils. Society has to scrutinise market outcomes and reign in their worst excesses.

What is important now is to devise a nuanced account of just distribution that acknowledges the organic structure of society and takes account of background conditions whilst allowing room for reward of individual effort and skill. This task is cut out not for an individual, but can only be attempted by society as a whole – trough honest conversation to arrive at solution that is beneficial to all. The task is hard, but in all likelihood worth the effort.

Chessonomics – The Case for Formalism in Economics

By Max Schröder

I studied Metaphysics to understand Economics: After all, how can one make sense of the usual objects of Economic Theory if not via the route of the transcendental and strictly non-physical? Take for example one of the basic foundations of (neoclassical) Microeconomics: Consumers are supposed to optimise their decisions by picking – from a plethora of choices – the one basket of goods and services that maximises their personal well-being, given their preferences and budget constraint. Where, I was wondering, are all these baskets? Clearly not in any supermarket I have ever been to. Neither can they be located in the mind of the consumer, as some might claim. Personally, I can hardly fill my trolley with the few things I have put on my grocery list – too plentiful are the distractions provided by 2 for 1 offers and spontaneous advertisement-induced impulse purchases. In short: when I go to the shops I might have many things on my mind, but comparing baskets of goods at the margin is not one of them.

However, as W. V. O. Quine would insist: if the Science of Economics is to employ models containing millions and billions of baskets of goods, then Economists are committed to the existence of these mountains of baskets. They have to be somewhere – only where? Luckily philosophers (being notoriously non-commonsensical) have long pondered such questions and one might draw an analogy with the existence of numbers in the Philosophy of Mathematics. The similarity is striking – numbers, presumably do not exist in the real (read physical) world. No one has ever seen the number 3, or tripped over the decimal extension of pi. And yet most (if not all) of our technology depends crucially on these number-entities. Since Plato´s time philosophers had a neat explanation for the fact that numbers are clearly not physical and yet seem to be real: They are real and they do exist – specifically they are even more real than real stuff. Platonists believe that numbers (and other stuff that we cannot locate on earth yet need for our mental activities, such as “the good” and “the colour purple”) occupy some non-physical realm that can somehow be accessed by our minds. This opens an exciting possibility for the struggling economist: Instead of trying to defend the notion of rational economic man by searching (increasingly unsuccessfully) for earthly evidence of his existence one can relocate homo oeconomicus and his mountain of baskets to this fantastic land of ideas, where the former can compare the constituents of the latter at his leisure.

Unfortunately however, few will be satisfied with this solution. After all, which serious commonsensical person would readily believe in such a mythical realm? To most people with a scientific mind the physical universe is a closed economy. The world is constituted of material blips and blops (quarks and other mysterious particles) and that is it. And even if there were such a mysterious non-physical world it would be necessarily and utterly separated from ours to the extent that there could not be any interaction of any kind in any direction between here and there (after all this would violate certain laws of thermodynamics). But setting the epistemological issues aside: The belief in the existence of a platonic realm of perfect forms is – at least amongst the majority of the scientifically educated (read physicalists) – somewhat on par with believing in ghosts, or leprechauns. Thus, if economics and economists are to be taken serious by other scientists (something that is close to the heart of every member of an economics department), homo oeconomicus needs to be driven from this unearthly paradise. But where to go?

Again the solution can be found in the analogy with Mathematics and it is here that I want to present my proposal. At the beginning of the 20^th century some German mathematicians (Thomae, Heine & Hilbert) decided that it was time to do away with the ghosts in mathematics. They each devised theories that are broadly recognizable under the name “Formalism” and share an essential trait: That the expressions and symbols of mathematics are largely meaningless – they do not refer to anything, not in the real world and not in the heavens.

One of these theories, dubbed Game Formalism, is of particular interest to the economist. This theory holds that the manipulations of sequences of symbols in mathematics resembles a game – like chess – where set pieces (i.e. numbers) are manipulated according to the rules of the game.

In my view economists have a lot to gain by embracing some form of game formalism: No longer would one’s theoretical work be vulnerable on grounds that the assumptions of the model are “too simplified” or “nowhere near resembling reality”. It is up to anyone to choose the kind of game one wants to play, so don´t be a killjoy. Formalism would also justify a large chunk of what is already practised by (mainstream) academics today: Many players (academic economists) make moves in a game (write papers) using set pieces (models) following certain rules (mathematics) and sometimes someone wins (writes a very elegant/complicated model) – no reference to reality required.

By all means, I am not saying that playing the economics game is pointless (we are playful creatures after all). A lot can be learned by playing games, but it is important to distinguish between the game world and the real world. Crucially this mean that governments and other decision makers would have to take responsibility. Instead of blindly relying on the “truth” of economic theories and “expert advice” they would have to consider the nature of the theory game played in economics departments around the globe and appreciate that homo economicus resembles a rook more closely than any actual person. No one would think of handing over city planning to a reigning SimCity champion, so why do it with the economy?

The discipline of economics has a lot to gain if different variations of the game (different schools of economic thought) were allowed to be played on an equal footing. Instead of arguing about which game is better one should appreciate that some would rather play rugby than football. One could also understand that different games recommend different strategies for the same situation – depending on the specific rules of the game and the pieces that are available. From this standpoint a pluralist economics profession could once again emerge, where many different game strategies are acceptable for the same real world problems.

To sum up my case: Formalism could be a great asset to economists and the general public. It captures the nature of much of economic theory today – practised as a model-writing game with little reference to reality. It would serve as a wakeup call to all those who excessively rely on economic theory to make decisions that affect us all. And finally it would break the hegemony of a single school of economic thinking and promote pluralism in economics.

Lastly there is an advantage that a formalist economics would have – above and beyond its mathematical parent: A main criticism that is levelled against mathematical formalism goes as follows: “If it´s all just a game – then why do the models work so well?” It can be doubted that economics would encounter this problem anytime soon.

GURWES does research – Two papers by our members

Besides organising our various events and making the case for pluralism in economics, some of our members also actively pursue independent research in the areas they are interested in. Two of their papers have recently been published, so we thought it might be nice to share them with our followers.

Max Schröder, Honorary Secretary of GURWES and a fourth year student of Economics and Philosophy has been researching alternative measures of inequality. Some of the outcomes of this research have now been published as an article in Groundings, an undergraduate peer-reviewed journal in the arts, humanities, and social sciences, published annually by Glasgow University Dialectic Society:

Mythical Measures: The Problem of Objective Inequality Measurement in Economics and the Social Sciences

The Gini coefficient, one of the most widely used inequality measures in economics, is thought to report income disparity with a reliable degree of objectivity. However, a critical assessment of the Gini’s implicit normative assumptions reveals that this objectivity is overstated. Moreover, this critique can be extended to other indices as well, uncovering a more general worry that the perception of distributive justice, which determines the ideal level of inequality underlying such indices, is necessarily subjective. As a result, the prospect of a mutually intelligible and transparent discussion on inequality suffers – both at the scientific and policy level. The implication of this finding is that more work needs to be done in specifying the normative foundations of inequality measures.

The full issue of Groundings containing this article can be downloaded here.

Severin Reissl, President of GURWES and a fourth year student of Economics has used an analytical method he worked with during a summer internship to produce a paper intervening in the debate within the post-Keynesian school on the impact of debt on effective demand. This article has now been published as a working paper by the Macroeconomic Policy Institute (IMK) after being presented at the 2014 annual conference of the Research Network Macroeconomics and Macroeconomic Policies (fmm):

The return of black box economics – a critique of Keen on effective demand and changes in debt

In a paper for the Review of Keynesian Economics, Steve Keen recently provided a restatement of his claim that “effective demand equals income plus the change in debt”. The aim of the present article is to provide a detailed critique of Keen’s argument using an analytical framework pioneered by Wolfgang Stützel which has recently been developed further.Using this framework, it is shown that there is no strictly necessary relationship whatsoever between effective demand and changes in the level of gross debt. Keen’s proposed relation is shown not to hold under all circumstances, and it is demonstrated that where it does hold this is due to variations in the `velocity of debt’-variable he introduces. This variable, however, lacks theoretical underpinning. The article also comments on Keen’s proposal that trade in financial assets should be included in effective demand, arguing that this undermines the concept of effective demand itself. It is also shown that many weaknesses in Keen’s argument stem from a lack of terminological clarity which originates in his interpretation of the works of Hyman Minsky.

The full article can be downloaded here. A brief review of the paper on the popular blog The Case for Concerted Action can be found here.

An update on GURWES

 

This is just a quick update on what is going on with the society. Having held our elections before the examination period, we now have an enlarged board which will help us expand our activities during the next academic year. As is by now well known, we are involved in the highly successful International Student Initiative for Pluralist Economics, a collaboration which will hopefully continue far beyond the release of the open letter (which can be found at www.isipe.net) and become a worldwide network through which student groups in all countries can coordinate their efforts.

One pleasant side-effect of the work on the ISIPE-manifesto has been to give us a large number of contacts to academics around the world, which will prove invaluable in organising some interesting guest lectures next year. One thing that is definitely on our list is to invite Steve Keen, who will be based at Kingston University from September, to come to Glasgow for a guest lecture. Fingers crossed. For another event, Perry Mehrling has agreed in principle to hold a guest lecture via videolink. Since the release of the manifesto, we have also been contacted by the Scottish Economic Society who have expressed an interest in organising events with us.

Over the past year, we have built an excellent relationship with the Adam Smith Business School, who have been very helpful indeed. This means that there is a good chance we will be able to secure sufficient funding to invite speakers from far afield, including Steve Keen (and there are many others on our “wish list”).

Another thing that seems to be coming together now is a conference on economics at Glasgow University, organised by students. Of course, GURWES will be involved in this as well. Planning is in its earliest stages, but it sounds very exciting!

In addition, we are aiming to put on reading and discussion groups, as well as joint events with other societies on campus. The exam revision session we ran for second years at the end of the semester was a big success, judging by attendance, so we will definitely do our best to run sessions like this again next year.

On a final note, GURWES is now starting to create its own academic output. For example, Faheem Rokadiya and I are working on a paper entitled “The History, Philosophy and Economics of Full Employment” which has been accepted for presentation at the CPERN conference in Vienna this September. With the help of our newly created University Moodle page, we hope that many more collaborations such as this, incorporating many different fields, can come to fruition.

To conclude, it’s well worth staying updated on our activities. This academic year, the society’s very first year in existence, was overall a massive success. Next year will be even better. Enjoy your summer!

Getting to the CORE of curriculum reform

by Severin Reissl

*As always, the views expressed in this post are my own and do not necessarily represent those of either GURWES or ISIPE*

Over the past few weeks, the manifesto of the International Student Initiative for Pluralist Economics, of which GURWES is a member, has made quite an impressive impact. We have had considerable media coverage in a large number of countries, the size of the initiative has grown to 65 student groups from 30 countries, we have so far had 2400 individuals signing up in support (if you have not yet done so, please consider supporting the manifesto at www.isipe.net), and have had some reactions from academia, most of which were very positive.

Perhaps the most encouraging reaction has come from Steve Keen who, upon accepting a post as head of the School of Economics, History and Politics at Kingston University, explicitly vowed to react to the propositions for reform made by the movement. Kingston now, even more so than before, seems to be the place to go for a genuine education in economics in Europe.

A rather more questionable response was produced by John Kay, board member of INET, in the Financial Times. Kay, naturally, is a big fan of INET’s Curriculum in Open-access Resources in Economics (CORE) project, and for this reason rather dismissive of the more far-reaching reforms ISIPE has called for.

Before I deal with Kay’s article in particular, a few points on CORE in general:

• Before the existence of CORE, a committee, headed by Lord Robert Skidelsky and initiated by INET, had already broadly outlined a set of desirable changes any curriculum reform should make. The content of this outline was in fact much closer to the spirit of the ISIPE manifesto. What became of it, however, is unclear. CORE does not make any reference to it and what is available of CORE at the moment misses many of the vital points made by the Skidelsky-committee.
• CORE is headed by a group of economists with little discernable qualification to include diverse and alternative approaches to economics into a new curriculum. Some allowance has been made for the more palatable approaches such as behavioural economics and agent-based modelling and, laudably, some non-economists also seem to be included in the list of contributors. But as far as I can see, there is no one among the list of contributors who could reasonably be considered heterodox, in contrast with the earlier committee headed by Skidelsky. Why the sudden change of heart?
• The CORE people are quite happy to cite coverage of ISIPE on their website as supporting their particular efforts despite the fact that, as Neil Lancastle has noted, none of the CORE contributors have so far signed up to support ISIPE, which shouldn’t really come as a surprise at all.

 

The general attitude underlying CORE can perhaps best be described by commenting on its perception of itself, drawing on the CORE website. I have written the following previously in an internal document:

The CORE project specifically aims to remedy three perceived defects or “gaps”, as they put it:

(1) “The gap between what economists now know and what we teach undergraduates.”

(2) “The gap between the questions we are being pressed to answer by the public (including the questions that brought students into our classrooms) and the often-unrelated content of our curriculum.”

(3) “The gap between conventional text-and-lecture methods and available low-cost, individualised and interactive learning technologies.”

 

(1): To me, this sounds a lot like the “just wait until 2^nd/3^rd/4^th year. Everything will be much better then”, which you always get to hear from economics lecturers. Frankly, this sentence is a pretty dishonest cop-out. Think about what it really says: “We actually know better, we just never told you. There isn’t really any problem with the discipline at all. Curricula just haven’t caught up with the state of knowledge.” While it may in fact be true that some curricula lag behind some of the newer developments in mainstream economics, the suggestion that these new developments remedy all defects of current teaching is wrong. This statement also separates the problem of teaching from problems of the discipline itself, two issues which are in fact inherently intertwined and cannot be addressed separately.

 

(2): Yet again, this suggests that today’s orthodox economists actually have the single correct answers to all those questions, they just don’t bother to teach them. I disagree with this for two reasons. First, it is obviously not true that all those famous economists know the answer to all economic questions. They really don’t. Not even the ones with a Nobel Prize. Second, it also suggests that there is one correct answer to any economic problem, and the only problem is finding it and then teaching this one answer. While anyone is certainly entitled to believe this, I think it is a thoroughly bad basis for teaching a social science. What we really need is for economics to be taught like any other social science: Based on the presentation of contradictory and incompatible points of view, the encouragement of critical thinking and discussion, as well as self-reflection on the nature of the discipline itself and its methodology. Other social sciences seem to have enough confidence in their students’ ability to evaluate diverse perspectives to actually include them in their curricula.

 

(3): This is trying to address issues pertaining not to what is taught, but how it is taught. Funky learning gadgets are nice and all, but I would consider this issue to be at best of secondary importance. “Mainstream reformers”, if the term is allowed, seem to think that a major part of the problem is that academics who are employed by universities primarily for their research activity rather than as instructors are simply often bad teachers. Drawing from my own experience, I would disagree. The quality of the teaching I have received at university (regardless of my opinion on its content) has generally been of a very high quality, and has been so in all subjects I have studied. I consider this a pseudo-problem, serving to divert attention from the real issues at hand.

This last point makes a nice link to John Kay’s article, for he in fact makes the same argument saying that:

“One cause of the problem is not specific to economics. Modern universities prize research above teaching[…]. In reality, teaching ability plays a negligible role in university hiring, tenure and promotion decisions.”

I do not recall that any student initiative has ever complained about the quality of the teaching itself, rather than its specific content, making this a rather weak point. Kay goes on to say that:

“most economics professors are probably mildly to the left of the political spectrum”,

in defence against the claim that much of mainstream economics is ideologically motivated. Whilst I find this evaluation questionable in any case, I think it is also too simplistic to reduce the question of whether economics is ideological to the simple left-right dichotomy, rather than to understand the concept of an “ideology” more broadly. Whether they are “mildly to the left” or recognisably right, there is in fact a rather well defined set of ideas, ideals, and views of how the world works or should work which unites mainstream economists. It is in this light that Kay’s most dismissive point should be seen:

“Their demand for more pluralism in the economics curriculum is well made. Yet much of the “heterodox economics” the Manchester students suggest including is flaky, the creation of people with their own political agenda, whether Marxist or neoliberal; or of those who cannot do the mathematics the dominant rational choice paradigm requires. Their professors reject the introduction of these alternative schemes for the same good reasons their science colleagues would reject phlogiston theory or creationism.”

As I have written elsewhere, this generalisation not only reveals a shocking lack of knowledge about heterodox approaches, but also an equally blatant unawareness of the metaphysical and ideological foundations of the “dominant rational choice paradigm”. In addition, it is interesting to note that many of the most prominent economists who cautioned against the uncritical use of mathematical methods in fact themselves held degrees in mathematics (e.g. Keynes, Minsky, and we could also include Marshall in this category). Hence the claim that anyone who disagrees with these approaches must be too stupid to understand them looks very weak indeed. The mathematics used in “modern” macroeconomics in particular is not half as complicated, sophisticated, or in line with advances in mathematics itself as Kay seems to think it is. The last part of this statement is perhaps the most perfidious one in the whole article. The example of phlogiston theory is in fact a quite interesting one to look at. It would appear that this theory fell from favour after it repeatedly failed to be confirmed by empirical evidence. If this, as Kay thinks, is indeed the attitude professors take in evaluating which approaches to teach and which to disregard, why, for example, am I still being taught RBC theory? Why are concepts which are effectively incapable of being tested and hence falsified being taught as “scientific”? It would appear that the matter is not quite as simple as Professor Kay seems to believe. Limping analogies between the natural and social sciences cannot hide the fact that the labelling of alternatives as “unscientific” is often simply a knee-jerk reaction, and a hypocritical one at that.

Kay then goes on to instead recommend CORE as a potent alternative to the demands voiced by the student movement. The problems with CORE have been laid out above. In a letter to the FT, Alvin Birdi, argues that

“To suggest that there is only one way to “rethink economics” has the flavour of replacing one orthodoxy with another.”

While this may be true, there is certainly one way not to rethink economics, which is to put those who came up with the previous approaches in sole charge of devising the new ones. This is the direction CORE seems to be heading in, and contrary to Mr Birdi, I think that creating a new, only slightly altered orthodoxy is precisely what CORE will do. I hope I am wrong.

GURWES Guest Lecture: Professor Marc Lavoie – Essentials of Heterodox and Post-Keynesian Economics

A guest lecture delivered by Professor Marc Lavoie of Ottawa University via video-conferencing to Glasgow University Real World Economics Society on the 19th of March 2014.
This was the first time we tried video-conferencing and after some technical difficulties it was a great success, so we will try to make more use of this format in the future. I have put the slides into a Dropbox folder, which you should be able to access via this link:
https://www.dropbox.com/s/pde3hhj4v0wj4kd/E86%202014%20Introduction%20to%20Heterodox%20and%20Post-Keynesian%20Economics.ppt

Enjoy!

Loanable funds – 75 years later

by Severin Reissl

The recent discussion I had about Keynes’ article The Process of Capital Formation with Phil Pilkington (he wrote an excellent post about the paper) reminded me of a conversation I had with one of my lecturers some time ago. For a reason I cannot remember we were talking about saving and investment, and I voiced some criticism of the savings-cause/finance-investment view. She actually agreed with most of what I said (although she evidently believed that I was not saying anything new – a common attitude of the mainstream when confronted with criticism), and I ended up recommending a great working paper by Fabian Lindner of the Macroeconomic Policy Institute in Düsseldorf which debunks these notions quite skilfully.

Yet I remain puzzled about why, then, this same lecturer is prepared to keep teaching models that happily accept this erroneous view. Keynes, in the article mentioned above, is able to strike a quite critical blow to the loanable funds theory in the simplest terms possible. That was in 1939, and a lot has happened since then to complete the theory’s intellectual collapse (but, unfortunately, not its abandonment). 75 years later, I am confronted on my Macroeconomics module with the Solow model of economic growth. Now, there is a truckload of stuff that is wrong with this model and concepts related to it (reliance on the marginal productivity theory of income distribution; all the problems related to “growth accounting” and the “Solow residual” as analysed by Felipe & McCombie …), but what I want to focus on is that this model tells me that poor countries will become rich if they save more. The savings rate is a key determinant of an economy’s “steady state” level of income in this model, and the savings-investment identity is clearly presented to mean that a higher savings rate will cause more investment and hence growth. Yet this idea is just as false in the “long run” as it is in the “short run”. In fact, the distinction between short run and long run is particularly unhelpful in this context. The long run is itself just the result of a series of short runs and its character is determined by these. Therefore, if the paradox of thrift holds in the short run, there is no sense in saying that somehow, saving still magically causes investment and growth in the long run.  The trick is achieved by assuming that full employment prevails at any point in the Solow model, which amounts to assuming away the paradox of thrift altogether, at all points in (logical) time.

“[…] if households cut their consumption expenses by a certain amount because they plan to increase their financial net worth (believing in accordance with loanable funds theory that higher financial saving meant higher investment), corporations would immediately and mechanically see their revenues and profits from the sale of consumption goods fall by the same amount. […] As is rather obvious, there is no ex ante certainty that corporations, seeing their sales drop, will maintain their previous level of expenses – as loanable funds theory would like us to believe – or even increase their production of investment goods. Further, it is neither certain nor likely ex ante that firms would now borrow and increase their future debt service in the face of lower profits” (Lindner, 2012)

By assuming full employment at any point, we are assuming exactly this type of counterintuitive behaviour from agents in our model. It still does not mean that saving causes investment, but rather that we are imposing that there will always be sufficient outlays to maintain full employment at any desired rate of saving. Keynes reminds us in Chapter 21 of the General Theory that we use models “to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors amongst themselves. This is the nature of economic thinking “. And this is precisely what the Solow model does not do, by assuming away the complications pointed out through simply imposing full employment at all times.

I believe that this is an enormously important thing to point out. I am quite convinced that even many mainstream economists would agree with the analysis above, yet the Solow model is still being taught and, along with some other common culprits, contributes to forcing these erroneous views into students’ heads. The saving-causes/finances-investment view has a massive superficial appeal, because it is something we can metaphorically relate to our own lives. A big part of the problem is that, in my experience, the terms “investment” and particularly “saving” are notoriously liable to being ill-defined in economics courses. The crucial distinction between how they are used in everyday parlance and what they mean in an aggregate/national accounting sense is seldom pointed out. Indeed, the confusion is being encouraged, whether intentionally or not, by the way concepts such as the Solow model are presented. I would urge any student to read Lindner’s paper to get a grip on this distinction.

Since I am planning further posts on this blog, I should say that although I am an officer of Glasgow University Real World Economics Society, the views expressed in my posts do not necessarily represent the views of the society (although of course I hope that they do). Once this blog gets going properly (hopefully after our AGM), there will likely be posts from other members as well, and it will be used as a forum for expression of many different points of view.

GURWES PKE Tutorials – A Note On Constant Marginal Cost

At this week’s voluntary tutorial on Economics 2B run by GURWES, some points came up which may need further clarification.
It was asserted that firms generally (and particularly firms in manufacturing) produce with constant marginal/unit cost. This is in contrast with neoclassical microeconomic theory, which typically holds that firms will produce at rising MC.

The first thing to note is that this question is of highest importance when discussing perfect competition. In the first tutorial, the point was made that an independent supply curve can only be derived for perfect competition (an independent supply curve traces out a unique relationship between quantity and price, i.e. each quantity is only produced at one specific price and vice-versa). All mainstream micro textbooks make this point, and usually have a diagram to show why a supply curve which is independent from the demand curve cannot be derived for a monopoly, for instance (see e.g. Pindyck & Rubinfeld, 2012, p. 366 (still the 2A textbook?)). So, keep in mind that whenever you are shown a diagram (e.g. to analyse the welfare impact of a sales tax) where supply and demand are depicted as independent, it is implicitly assumed that the investigated industry is perfectly competitive, even if this is not mentioned explicitly. I know, in the first tutorial we showed how even under perfect competition, an independent supply curve cannot be derived, but let’s accept the neoclassical reasoning for the moment, i.e. assume that a perfectly competitive firm is facing a horizontal demand curve at the prevailing market price.

How does a perfectly competitive firm behave? It observes the prevailing market price and then produces output until its marginal cost has risen far enough to equal that price. What would happen if the marginal cost was constant? Well, the firm would produce an infinite amount of output, since MC would never equal P (Yes, even the Post Keynesian firm experiences rising unit cost beyond full capacity, but bear with me). So marginal cost can’t possibly be constant, right? Well, this is where the theory really runs into trouble because, unfortunately, studies conducted by Alan Blinder (not exactly a heterodox economist, incidentally), as cited by Keen (2011, p. 126) show that only around 11% of US GDP are produced under conditions of rising marginal cost. So 89% aren’t. The point here is that if marginal cost at the point of production is constant, the firm cannot possibly be a profit-maximising perfectly competitive firm as envisioned by neoclassical theory, see the diagrams below:

(Note: the second diagram is not the Post Keynesian production diagram but just a tool for illustration! The appropriate diagram can be found in Lavioe (2006) and in your lecture slides)
From the presentation in most micro textbooks, you could get the impression that at least 90% of the economy was perfectly competitive, by the relative weight given to the examination and application of that theory. A prime example is Mankiw (2012) who, in his treatment of income distribution, thinks it’s okay to model the entire economy as perfectly competitive. This is not the case (quite apart from the fact that the theory is unsound in the first place).

Studies like Blinder’s are also a good point of departure for discussing the Post Keynesian/Kaleckian theory of the firm. There are other studies also cited in Keen (2011, Ch. 5) showing that constant or falling marginal cost is appropriate to describe the vast majority of firms’ cost-conditions in industrialised countries. Then there is the data on excess capacity, also cited in that chapter as well as in Lavoie (2006), which we mentioned in the tutorial.

Observing this evidence, which are the most appropriate premises on which to construct a theory of production? The Post Keynesian theory of the firm, as presented to you in lectures and this week’s tutorial, would suggest itself since Leontief production functions result in constant or, under economies of scale, falling unit direct cost. In this sense, it is in accordance with the real world.

Leontief production functions also imply constant factor proportions, that is, labour and capital are used in a fixed ratio to produce output. Whether this always holds in practice I do not know, but keep in mind that the labour included in this ratio is only the labour physically required to produce the output, i.e. supervisors, managers, accountants, marketing and so forth are part of the overhead, the fixed cost! The Post Keynesian reasoning is that an existing plant embodies the technology prevailing when it was built. It was planned and constructed to be operated at maximum efficiency from the start by a specific number of workers, so that adding or removing a few does not make sense (one could add an additional shift though, if capacity permits, keeping the ratio constant). Similarly, if the plant can be divided into several assembly lines, it wouldn’t make sense to employ its entire capital at less than full efficiency by spreading workers evenly (which is what the neoclassical firm would do) but rather to operate one segment at full efficiency, leaving the rest idle (A point made by Sraffa and illustrated by an example in Keen (2011, p. 113)). As Lavoie (2006: 40) notes: “each firm usually has a number of physical plants, which are generally divided into a number of segments or assembly lines. The level of practical capacity is defined as the production capacity of a plant or a plant segment, as measured by engineers, the so-called engineer-rated capacity. Each segment is designed to operate with a given number of workers for a given number of hours. (…) Even if some flexibility is possible, bureaucratic rules and regulations, such as collective bargaining agreements, as well as customs and habits, dictate the number of workers on each machine.”

Is this a perfect description of reality? Probably not, but I would argue that it is a far more valid generalisation than neoclassical production functions given the empirical data.

Further (theoretical) underpinning comes from Piero Sraffa’s critique of diminishing returns, outlined in Keen (2011, Ch. 5). Sraffa observes that neoclassical economics makes two assumptions which are mutually contradictory:

–          Demand and supply curves are independent

–          There are factors of production which are fixed in the short run

Note that the “law” of diminishing returns has its origins in classical political economy. David Ricardo used it to derive a theory of aggregate rent on land. So it was originally conceived as a concept applying at the macro-level, connected to the distribution of income. Neoclassical economists picked up on the concept and applied it to the micro-level theory of production.

Sraffa goes on two make two critiques:

Sraffa’s broad arrow: If an industry is broadly defined (say, the agricultural sector), it is valid to treat one input as fixed. The industry utilises a large share (or, in extreme cases, all) of it and it will be costly and time-consuming to obtain additional doses of it. However, such a broadly defined industry can no longer be treated as a price-taker in input markets. If agriculture attempts to increase its output by employing more labour, the price of labour (the wage rate) will rise. This affects the distribution of income, and hence demand for the output of this broadly defined industry. Demand and supply are not independent, i.e. it is not possible to derive an independent supply curve. “Thus while diminishing returns do exist when industries are broadly defined, no industry can be considered in isolation from all others [which is what neoclassical theory of production does], as supply and demand curve analysis requires” (Keen, 2011, p. 111).

Sraffa’s narrow arrow: If an industry is narrowly defined, on the other hand, Sraffa argues that the assumption that some input is fixed is not reasonable. Sraffa argues that, if need be, such a narrowly defined industry will be able to draw marginal doses of this input from other industries, or to activate unutilised stocks of inputs, so that its unit-cost won’t increase appreciably. The former may, admittedly, not be the case with inputs such as specialised capital equipment, but the empirical observations on spare capital capacity in industry back up Sraffa’s point. This means that the ratio of inputs remains constant as output is increased.

The reasons firms have for keeping spare capacity were, I think, sufficiently discussed in the tutorial. An important point to note is that the output of a firm producing at constant marginal cost is constrained by demand. Sure, the firm would like to sell as much as it could possibly produce, but because in the real world firms aren’t perfectly competitive and products are differentiated, for a given demand there’s only so much output that can be sold. We could also add that a firm is constrained by available internal and external financing. Production takes time, and workers typically have to be paid before the output is sold.

I hope this makes the whole story a bit clearer, and if any questions remain please feel free to ask them next week! Also, I emphasise again that it’s really worth reading Keen’s book. If not all of it then at least those chapters with direct relevance to the course content. It covers not only the stuff you talk about in your tutorials, but also things you will be examined on (such as the Post Keynesian theory of the firm) and it really helped me get a better idea of the concepts, whilst at the same time it is quite entertaining.

Best,
Severin

References:

Keen, Steve (2011) Debunking Economics – The Naked Emperor Dethroned? Revised and Expanded Edition, London: Zed Books.

Lavoie, Marc (2009) Introduction to Post-Keynesian Economics, Basingstoke: Palgrave Macmillan.

Mankiw, Gregory (2012) Macroeconomics International Edition, 8^th edition, Basingstoke: Worth Publishers/Palgrave Macmillan.

Pindyck, Robert and Rubinfeld, Daniel (2012) Microeconomics – International Edition, 8^th edition, Boston: Pearson.