Neoclassical economics: what is it good for?

Michael Leunig says the tough economic times will plant seeds of change and happiness.I sent the passage below to my friend Alex Coram noting “I like this post from Brad Delong – though you may not”. Alex, you see, has a deeper understanding than me of these things. I was right – he wasn’t that impressed – but for reasons that I also agreed with and might have offered if I were not a thirsty man in a desert.

I think that modern neoclassical economics is in fine shape, as long as it is understood as the ideological and substantive legitimating doctrine of the political theory of possessive individualism. As long as we have relatively self-interested liberal individuals who have relatively strong beliefs that things are theirs, the competitive market in equilibrium is an absolutely wonderful mechanism for achieving truly extraordinary degree of societal coordination and productivity. We need to understand that. We need to value that. And that is what neoclassical economics does, and does well.

Of course, there are all the caveats to Arrow-Debreu-Mackenzie:

  1. The market must be in equilibrium.
  2. The market must be competitive.
  3. The goods traded must be excludable.
  4. The goods traded must be non-rival.
  5. The quality of goods traded and of effort delivered must be known, or at least bonded, for adverse selection and moral hazard are poison.
  6. Externalities must be corrected by successful Pigovian taxes or successful Coaseian carving of property rights at the joints.
  7. People must be able to accurately calculate their own interests.
  8. People must not be sadistic–the market does not work well if participating agents are either the envious or the spiteful.
  9. The distribution of wealth must correspond to the societal consensus of need and desert.
  10. The structure of debt and credit must be sound, or if it is not sound we need a central bank or a social-credit agency to make it sound and so make Say’s Law true in practice even though we have no reason to believe Say’s Law is true in theory.

An adequate undergraduate economics major will spend due time not just on the excellences of the competitive market equilibrium, but on these 10 modes of market failure, and in so doing become, effectively, a history and moral philosophy major as well.

A first-rate undergraduate economic major will also spend due time on government failure and bureaucratic failure, and thus reach the very economic conclusion that there are substantial trade-offs, and we must pick our poison among inadequate and imperfect alternatives, even in institution design.

In any event Alex disagreed in terms that I completely agree with as below:

Still sort of misses the point – tends to confuse the model with the real world.

I think neo-classical economics is an answer to the question

Suppose we have a government that enforces the rules of property and every allowable contract between individuals and that all non-environmental property is privately owned. Under these circumstances would the actions of individuals with perfect knowledge pursuing their own interests produce one or more equilibria?

In order to answer this you will need a few additional assumptions about continuity and smoothness of utility and production functions, non-continuously increasing marginal products etc etc

It is in fine shape as a possible answer to this question and this is how I teach it.

It is then a different question altogether what, if anything, this tells us about real markets or economies.

A different way of putting it is that neo-classical economics tries to explore the mathematical model underlying Smith’s quote. “”It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.”

I think these guys are not prepared to accept that the model is not about reality.
Even the term market failure is a bit odd – it assumes that the market is somehow the natural mechanism and you need other things when it fails. In the hands of idiots it then leads to the default position that the solution to all problems is to privatize or create market . (sometimes yes: sometimes no)

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paul walter
paul walter
8 years ago

I always enjoy these sorts of posts, which relate to policy formation and the right sort of mind set for that.
I’m not required to envy bright people, but it generally helps to consider what they are saying and where they are coming from. What a beautiful thing context is.

Crocodile Chuck
Crocodile Chuck
8 years ago

“In the hands of idiots…”

We know.

God, do we know