The marginalist revolution
From 1870s, classical economics has been slowly declining. During the last three decades of 19th century a new set of economic techniques had been developed that helped transform classical economics into new current of economic thought – the so-called neoclassical economics.
As you can deduce from the name of the new current ‘neo-classical economics’ is to some extent an extension of classical economics, it is in many aspects similar to classical economics, but since it is “neo-classical” it is also in many respects different.
The most important new economic technique that helped to create neo-classical economics was marginal analysis – that is the analysis of marginal economic variables, such as MU, MP, MC, marginal revenue and the like.
Beside its obvious usefulness in economic theory, marginal analysis is an important development in the history of economics, since it initiated a significant increase in the use of mathematics in economics.
Since 1870s, economics began to be slowly, but continuously, transformed into mathematical science.
The acceptance of marginal analysis in economics and the realization of its all implications did not occur fast; it took about 30 years from about 1870 to 1900.
The first application of marginal analysis was to the theory of demand.
In the early 1870s, three economists independently applied marginal analysis to demand theory and developed the concept of MU. Later they and their followers applied marginal concepts to other parts of economic theory.
So from 1870 to nineteen hundred almost all economic theory was transformed, and many postulates of classical economics were rejected or highly modified. What is equally important, marginal or neoclassical economics has focused almost exclusively on microeconomic problems. And since it had the dominant position in economics from 1870s to 1930s, macroeconomic questions of economic growth, distribution of income and the like, were largely ignored, not discussed in economics in this period.
So the whole body of economic theory was more or less transformed and that’s why we say that the year 1870 is the end of classical economics period and the beginning of a quite new era of economic thinking – neoclassical economics.
In fact, marginal analysis had many precursors, who used the notion of MU in their writings before 1870s. Some English, German and French economists earlier in 19th century explicitly used marginal concepts, especially the concept of MU, but they did not discover all implications of this concept and what’s more important they did not influence subsequent writers.
So, it is generally accepted that the introduction of marginal analysis into economics has been the effect of three works published between 1871 and 1874. In those works, the concept of MU was developed and applied to the theory of demand.
The authors of these works were:
William Stanley Jevons (1835-82), Theory of Political Economy, 1871 (English economist)
Carl Menger (1840-1921), Principles of Economics, 1871 (Austrian economist)
Leon Walras (1834-1910), Elements of Pure Economics, 1874 (French economist)
As you can see those economists were of different nationality and it is accepted that they did not know about their respective works, so the introduction of marginal analysis to economics was done by them independently.
Walras, Menger and Jevons agreed that marginal analysis is a very important tool of economic analysis; they differ however on many economic issues, for example, the proper methodology of economic science – Walras advocated that economics should be a mathematical science; Jevons wanted more empirical work in economics, while Menger suggested abstract and deductive, but not mathematical, approach.
Moreover, Menger had contributed to the establishment of the so-called Austrian school of economics, a heterodox approach to economics, which was quite important in the development of economics in 19th and 20th century, we will discuss it shortly later.
And Walras, who is definitely the most important thinker all of three of them, created also general equilibrium theory, the most important tool of economic analysis in 20th century, so he was the greatest theoretician among them and his influence on subsequent economic thought is tremendous. We will discuss his contribution to the GET in one of the following lectures.
However, ignoring all those differences, we call them all – marginalists, since their views on the demand theory were very similar.
All three of these economists, working independently, were convinced that they had developed a unique, revolutionary analysis of the forces explaining the determination of relative prices; that is they thought that they had produced new, revolutionary theories of value, theories of relative prices.
They claimed that value (or price) of a unit of any given good depends entirely on marginal utility from the consumption of this unit.
As you know MU is the increase in utility as a result of consuming one more unit of the good.
Notice here the difference with classical theory of value, which is value theory of classical economists. In general, (beside Ricardo who held labor theory of value) they claimed that value is determined by the cost of production of a good.
In general price equals the sum of wage, profit and land rent paid during the process of production of the good (P=w+pi+r).
According to marginalists, it is a wrong explanation. Price and value do not come from the past, from the costs of production advanced in past to produce goods, price comes from the future; from the utility consumers expect to receive from consuming the good.
Therefore, it does not matter whether the good was costly to produce or not, high production costs may not result in high price – it all depends on how consumers estimate the utility from consuming the good.
Therefore, the marginalists theory of value claims that value (price) depends solely on the marginal utility received from the consumption of the good.
It explains prices from the demand, consumer side of the market (utility of consumers determines prices), while classical theory of value explains prices from the supply side of market (price is determined by the cost of production, costs made by suppliers, producers).
The difference between those two theories of value should be now clear to you. It is revolutionary, as their inventors thought, in that it finds completely different factors explaining prices, than any previous theory of value.
Marginalists claimed that classical theory of value, cost of production theory of value is not sufficiently general because it fails to explain prices of some goods.
As you should remember, classical theory of prices (cost of production theory) does not explain prices of goods, which have a fixed supply (the case of perfectly inelastic, vertical, supply curve). In this case, price is determined by demand, and does not depend on the cost of production (that is supply curve) – you cannot change the supply of these goods.
Examples of this kind of goods include: land, rare coins, paintings or wines.
Therefore, they claimed classical theory of value lacks generality and therefore should be replaced by their theory of value based on the concept of MU. According to them MU determines the demand curve for goods, and therefore marginal theory of value can explain prices of goods, if the supply of goods is fixed.
Hence, it is more general, better theory of value.
All of them thought that utility can be measured without problems and assumed that the principle of diminishing marginal utility is working – which states that as the consumption of a good increases its marginal utility decreased.
To formulate a new theory of value, marginalists applied the concept of MU to the demand theory, to discover the relation between utility and demand.
They assumed that the utility an individual receives from consuming a good depends exclusively on the quantity of that good consumed – it does not depend on the quantities of other goods consumed.
Using modern language of economics they assumed that there are no relations of complementarity or substitution between goods – goods do not have complementary or substitute goods.
It is a very restrictive assumption, but you have to remember that we are talking about the beginnings of modern microeconomic theory; the analysis had to be simple.
Using the abovementioned assumptions (utility can be measured, there is diminishing marginal utility and there are no complementary or substitute goods) they were able to formulate verbally and mathematically (especially Walras), the condition that must be fulfilled if a consumer maximizes his or her utility.
That is the income must be spent in such a way that the last unit of money spent for any particular good yields the same marginal utility as the last unit of money spent on every other good, which may be formally stated as:
MUa/Pa=MUb/Pb=…MUc/Pc.
Moreover, Walras was able to show mathematically, what is the relationship between MU and the exchange of goods in the market and also to prove that the MU is the main force determining demand, and that the demand curve, for most of goods is negatively sloped.
Therefore, these are the most important contributions of marginalists to the demand and exchange theory, but you should notice that those developments were made under restrictive assumptions (for example there are no complementary and substitute goods).
Evaluation of the value theory of marinalists or marginal theory of value.
In the case of goods with fixed supply, we have stated that marginal theory of value is correct MU and demand solely determine the value of goods.
In the case of perfectly elastic supply, demand does not play any role in determining the price, which is explained solely by the supply side, the cost of production.
Therefore, as you can see the theory of value suggested by marginalists is incorrect, and it cannot be said that it is a more general theory of value than classical theory.
Therefore, against the claim of marginalists, value or price does not depend entirely upon utility or demand. In different cases, value depends on demand or supply, and in general case it depends on both demand and supply.
Marginalists’ theory was incorrect, because marginalists wanted to find a single factor determining prices, while as it was settled later there is no such a factor.
In fact cost of production, supply, demand, MU and price are interdependent and mutually determine each other. However, only Alfred Marshall in works published later in 19th century gained this understanding of interdependence of all those economic variables.
It was Marshall, who formulated another theory of value - neoclassical theory of value, which builds up, which is synthesis of classical and marginal theory of value, and which correctly stresses the interdependence of price, supply and demand. We will get back to this issue.
The summary of the contribution of marginalists.
They influenced heavily views on the proper subject and method of economics. They were concerned mainly with microeconmics and the following generations of economists accepted this as the most important subject of economics and during the period from 1870 to 1930s economists turned from the long-term and macroeconomic issues that Smith, Ricardo, Mill or even Marx, were interested in and focused on microeconomic issue of how price system works to allocate resources in market economy.
They have provided a new theory of value and demand, which was incorrect as we have seen but the theory have turned the attention of later economists to the neglected demand side in explaining prices – and this remains the important contribution of marginalists.
Finally, they applied the marginal analysis in economics and thanks to this marginal analysis had been extended to cover almost all areas of economic theory. In this way, the mathematization of economics has started, and marginalists are the persons responsible for the beginnings of the 20th century process of mathematization of economics.
The so-called second generation of marginalists.
The first generation of marignalists, Jevons, Menger and Walras introduced marginal analysis to economics and applied it to the theory of value and demand.
The second generation of marginalists consisted of the followers of Jevons, Menger and Walras, who from late 1870s to 1890s have applied marginal analysis to other parts of economic theory, notably to the theory of production, production costs theory, prices of factors of production and the distribution theory. The second generation of maginalists consists of various writers from Austria, England, Sweden and the United States; we do not have to present their names.
Some of the achievements of the second generation of marginalists.
First, in the theory of production and the theory of the prices of factors of production they have established that the firm optimally will hire the factors of production up to the point at which its marginal product multiplied by the price of output (good produced by firm) equals the price of the factor.
For example: w=MPL*p (w – wage rate, price of labor)
The same optimum condition holds for other factors of production.
Notice, this is not only a condition explaining the prices of factors of production, but also a condition determining the functional distribution of income in the society, because it specifies the prices of factors of production, and knowing the amount of aggregate labor and capital, we can calculate how much income goes to the labor (wL), how much to the capital (piK) and the like.
Therefore, this condition and similar conditions for other factors describe also the marginal productivity theory of distribution. In the theory, the prices of factors of production are proportional to the marginal productivity of these factors.
Moreover, they proved that the general rule for employing several factors of production is that
MPA/PA=MPB/PB=… = MPN/PN.
These developments allowed also marginalists to derive formally the demands functions for factors of production.
One of the most important marginalists, American economics John Bates Clark, (he was the first American economist to make an important contribution to the economic theory), gave an interesting interpretation of marginal productivity distribution theory, that is the theory in which the prices of factors of production are proportional to the marginal products of the factors of production.
In 1899, he published a book under the title, Distribution of Wealth, which contains an extensive analysis of ethical implications of marginal productivity theory of distribution.
According to Bates Clark, under perfectly competitive markets, each factor of production would receive a return equal to the value of its marginal product [let’s see that (w=MPL*p) – MP – it’s the quantity of marginal product, multiplied by the price of the final good, it gives us the value of MP].
Then the return to factors of production measures the contribution (value of marginal product) of a factor both to the particular product being produced in the firm and to society and its wealth.
The return to capital is justified ethically by the fact that capital is productive (its MP is greater then zero), the return to capital is not robbery or theft, but honest, fair and just.
The same applied to land and labor.
Clark’s conclusion is that the distribution of income in capitalism (with competitive markets) is an ethically correct distribution in that it rewards the factors of production according to their economic contribution to the social product.
His interpretation was explicitly aimed at Marx’s theory of exploitation, Marx as we have learned tried to prove that in capitalism, workers are exploited by capitalists, he thought that capital is not productive it itself.
Clark was interested in marginal productivity theory mainly because he wanted to give an answer to Marx’s charge of exploitation under capitalism.
In John Bates Clark’s vision, capitalism is non-exploitative and just economic system. He thought that Marx’s theory of exploitation was incorrect, because Marx could not understand how market forces work, especially in distributing product in proportion to the marginal productivity of the factors of production.
How can we treat Clark’s claim that competitive markets result in ethically desirable distribution of income from modern perspective?
First, his claim violate scientific premise that we should not draw ethical conclusion from non-ethical analysis. According to modern standards, you cannot prove any ethical statement (just distribution of income) from purely scientific (economic) analysis. Therefore, Clark’s thesis is not scientific from this point of view.
Second, the thesis concerns only functional distribution of income. It is silent on the more important question whether capitalism results in just distribution of personal income.
Third, Clark assumed perfectly competitive markets, while in real economies we have to deal with monopolies, firms with market power, labor unions and the like, so his conclusions have little relevance for real societies.
Marginal productivity theory was also used by second generation of marginalists as a theory of employment of labor.
Many economists, especially American economists, in the beginning of the 20th century, used this theory to describe labor market in competitive setting.
Those economists concluded that unemployment (exceeding frictional unemployment, that is excluding people who change their jobs) was caused by wages being higher than the equilibrium level. If the wages are flexible, than market system will automatically correct the unemployment, as wages will fall to the equilibrium level.
From this analysis a number of policy conclusions have been drawn:
the wages should be kept flexible and that obstacles to flexible wages such as union contracts, long-term wage contracts, minimum wages legislation are not desirable.
Unions and minimum wage legislation cause unemployment
The best policy to reduce unemployment is to keep government out of the economy and let the market work the way to the full employment by lowering wages.
This was the most popular view on the problem of unemployment in the first three decades of 20th century in mainstream economics. There is no long-term, involuntary (to use later phrase) unemployment of labor in capitalism, the main reason for unemployment are labor unions and minimum wage legislation, and the best policy against unemployment is to free the economy from unions and government legislation.
All this changes during 1930s, during the days of the Great Depression. In mid-1930s these views were very seriously criticized by John Maynard Keynes, who formulated his own theory of employment and tried to prove that long-lasting, involuntary unemployment is possible in capitalism. We will discuss this while reviewing the economics of Keynes.
Beside all those contributions, there were also some developments in the theory of interest made by the second generation marginalists, but we will not discuss them.
Summary.
In 1890s, we had many important contributions in microeconomic theory. Marginalists, the first and the second generation, have applied marginal analysis to demand theory, production theory, distribution theory and other areas of economic science. So the whole microeconomic part of economics has been transformed in a mathematical fashion.
However, all these developments were only an input to the new era of economic thinking – neoclassical economics. Neoclassical economists had synthesized marginalists’ contributions in a complete theory of markets. In other words the founders of neoclassical economics integrated the work of marginalists on both the supply and the demand side of markets to build complete theories of market functioning.
We can treat marginal revolution as a transitory period between classical economics, which ends in early 1870s and neoclassical economics which starts in, let’s say 1890. Neoclassical economics, especially in microeconomics ruled in economics until 1930s, and there are some economists who claim that modern mainstream economics can still be rightfully called neoclassical economics. We will talk about this issue later.
Alfred Marshall
There are two fathers or founders of neoclassical economics:
Alfred Marshall (1842-1924), English economist, main economic work - Principles of economics, 1890.
Leon Walras (1834-1910), Elements of Pure Economics, 1874 (French economist)
Walras is treated also as one of the marginalists, but his contribution exceeds only applying marginal analysis in economics, and we will see next week, what are his other contributions to economics, and why he deserved to be named as one of the fathers of neoclassical economics.
Today, we will analyze the economics of Alfred Marshall. Marshall, as one of the founders of neoclassical economics, developed an analytical framework that still serves today as the structural basis of current undergraduate economic theory and much economic policy.
Marshall was an English economist; he studied first mathematics, but later turned to economics. He was a complex person, he was a very good mathematician but shy away from using mathematics in economics, he had very extensive historical knowledge and tried to make use of it in his economics. He was very religious, and thought that reducing poverty is the ultimate aim of economics; he had an optimistic conviction that economics might provide the means of improving the well-being of the entire societies.
He is considered eminent theoretician of economics and a towering figure in the development of economics, but he refused to take rigid, strong or unambiguous positions on many theoretical and methodological issues of economic science.
He attempted to offer balanced judgments on many issues and problems, and because of that, he is sometimes considered vague, indecisive or imprecise.
He often seemed to be saying that it all depends, for example that for one reason Ricardo was right, but for other was wrong, that on the one hand abstract economic theory is good, but on the other it is wrong and the like.
Some economists perceive such flexibility of Marshall as a sign of his wisdom, but others, especially those more mathematically inclined see this only as indecisiveness.
In addition, of course, because of his inclination to formulate balanced judgements, there is now a vast body of literature that tries to uncover what Marshall really meant (but not as vast as in Marx’s case for example).
First, let’s start with the problem of the proper scope of economics.
What should economists do? What is the proper subject of economics according to Marshall?
Marshall is the economist responsible for the change of the name of our subject. In the title of his main economic work, he preferred to use the term “economics” instead of “political economy”. Most of the previous great treatises in economics were concerned with political economy. But Marshall wanted to disassociate economics from political, normative, philosophical, ethical issues, so he dropped the term political economy in favor of the term economics.
What is ironic about his choice of the term economics is that he, more than almost any of his contemporaries, was engaged in political economy and the economic policy, he focused not on the pure, scientific theory, but on the applied theory and policy.
Marshall defined economics as:
“a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man”.
It is a very general, loose definition; economics embraces almost all social sciences in this definition.
Marshall suggested that each economist should define the scope of economics to suit his or her personal inclinations, so he was very open-minded and tolerant.
As I mentioned before he thought that the elimination of poverty is the chief task of economists, and he maintained that the key to solving this problem lay in the theories of economics, economists could explain the causes of poverty and give politicians powerful means to increase the well-being of the working class and other low-income classes in the society.
Marshall’s views on the proper methodology of economics are again complex.
He was very mathematically gifted, but also he had a wide reading of history. He thought that the proper combination of abstract, mathematical theory and historical analysis is the right approach of economists. Again, he thought that some economists prefer to rely heavily on one single methodology (for example abstract theory) and he did not object to this.
So he thought that many different shades of methodologies can find its use in economics.
His views on the use of mathematics in economics are especially interesting and famous among economists.
Marshall was a gifted mathematician. Yet, he understood not only the power, but also the limits of math when it came to explaining and describing economic reality. Marshall wrote this candidly in a letter to a friend in 1906, as he approached the end of a long teaching career.
"I have a growing feeling that a mathematical theorem dealing with economic hypotheses is very unlikely to be good economics, and I go more and more on the following rules -
1) Use mathematics as a shorthand language rather than as an engine of inquiry.
2) Keep to them until you have done.
3) Translate into English.
4) Then illustrate with examples that are important in real life.
5) Burn the mathematics.
6) If you don't succeed in 4, burn 3. This last I often do."
Marshall Principles includes steps 3 and 4, it is written in a style indented not only for economists, but also for every educated reader. Mathematics is placed either in footnotes or in a mathematical appendix. The seven hundred pages long book is filled with real life examples from current or past economic experience, but also it is based on a strong, highly abstract theoretical structure (but placed in the appendix).
So far, we have said that Marshall was a complex thinker, that he was sometimes accused of being vague, not rigorous, and indecisive.
However, this was not because of his personal character. Marshall had two reasons for regarding the study of an economy as complex and difficult.
First, in the economy everything seems to depend upon everything else, there is a complex and often subtle relationship among all parts of the system.
Second, time is extremely important in the economy and economic analysis, especially because economic causes take time to work out their full effects. Therefore, the economic analysis has to take careful account of the time in which the analysis is performed.
Because of the complexity of the economy and because economic causes need time to work themselves out, Marshall developed a method of analysis which is called partial equilibrium method (or analysis).
In this method, to solve a complex problem, we isolate a part of the economy for analysis (one market for example), ignoring but not denying the interdependence of all parts of the economy. We analyze for example the supply and demand for one good, ignoring for the moment the complex substitute or complementary relations with goods in other markets. One important use of partial equilibrium method is to make a first, inexact but valuable approximation of the likely effects of a given economic cause. It is a method, which gives simple, immediate predictions about various actions in economic policy, for example, the effects of raising tariffs and the like.
Marshall’s procedure was to first analyze issues in a very narrow partial equilibrium framework (keeping most economic variables constant) and then to broaden the scope of analysis slowly and carefully to include more and more markets.
To cope with the problem of time in economic analysis Marshall defined four time periods – these are analytical period of time, they are not measured in hours or days, but in the ability of the producer to adjust the supply of the product.
the market period the amount of time for which the supply of a commodity is fixed.
Second, the short period (or short run) is the time in which the supply can be increased by adding labor and other inputs but not by changing plant size or building another plant.
Third, the long period (long run) – here the plant size can vary.
In the market period market (for all firms), supply curve is inelastic perfectly
The supply curve becomes more elastic in the long run than in the short run.
The long run supply curve for an industry can take three forms – upward slopping (increasing costs), perfectly elastic (constant costs of production) or even in some strange situations downward slopping (decreasing costs)
The 4th period, the secular or very long run, permits technology or population changes.
This analytical construction (four time periods) helped Marshall to build a proper theory of value.
As we have seen before in economics before Marshall, we had the controversy between the classical economists and marginalists concerning the relative importance of demand and supply in value theory.
Classical economists claimed that supply determines value, while marginalists hold that the demand is the most important factor explaining values and prices.
Marshall believed that this controversy can only be resolved if we correctly understand the interdependence of economic variables and the influence of time in the economy.
According to him, in general, it is fruitless to argue whether demand or supply solely determines prices.
To quote him in detail:
“We might as reasonably dispute whether it is the upper or the lower blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production. It is true that when one blade is held still, and the cutting is effected by moving the other, we may say with careless brevity that the cutting is done by the second; but the statement is not strictly accurate, and is to be excused only so long as it claims to be merely a popular and not a strictly scientific account of what happens."
Marshall maintained that in general case MU, cost of production and value or price of a commodity are interrelated and are mutual causes of each other. There is no single cause for price or value of a commodity. MU, cost of production and price of a good mutually determine their values at the equilibrium point in market.
The shorter the period of analysis, the more important the role of demand in determining prices, the longer the period the more important the role of supply – in general, hoewer, MU (connected to the demand side), cost of production (connected do the supply side) and value (price) mutually determine their values at the margin (that is at the equilibrium point).
This is a correct theory of value as it is today admitted at least on the undergraduate level or introductory level and in partial equilibrium framework.
Marshall also contributed significantly to the theory of demand by introducing the concept of price elasticity of demand – that is proportional quantity change divided by proportional price change.
Several previous authors had come close to the idea, but it was Marshall who first defined it clearly.
Marshall also was able to theoretically derive the demand curve and to prove that the curve is negatively sloped, downward sloping, but only under the assumption that there are no big income effects when the price of a good changes – that is he assumed that there is no income effect of the price change. Anyway, he did not have the theoretical tools to distinguish clearly between the substitution and the income effects of the price change.
He did not notice the theoretical possibility of the positively sloped demand curve – this is the case of inferior goods with strong income effects of the price change – the so-called Giffen goods. However, the theoretical tools for distinguishing between income and substitution effects were not developed yet in economics.
Therefore, Marshall's theory of demand is not complete and based on very restrictive assumptions. We will see later how the theory developed in the 20th century
Another contribution of Marshall is in the field of welfare economics – that is the part of economics that strives for measuring the changes in the individual and social welfare, well-being.
Marshall has shown that price is the measure of consumers' marginal utility. He developed a concept of consumers' surplus – the difference between the total amount consumers would be willing to pay and what they actually pay for the good.
Another Marshall's contribution is to the theory of firm's supply – that is the analysis of the costs of production and supply of the firm.
His analysis is until today accepted analysis of costs and supply in the undergraduate textbooks, so we can be short on this.
In the market period there is no troubles, a firm cannot change the supply.
In the short run, Marshall made the distinction between fixed and variable costs, and showed that firm would continue to operate in the short run even if it was incurring a loss, temporary loss, as long as it was covering its total variable costs – just like you have learn in the introductory microeconomics.
His discussion of the long-run firms’ costs is deficient by modern standards, but he identified the long run forces that determine the shape and position of the firms' costs and supply curves.
First, there are forces internal to the firm. As the size of the firm increases, internal economies of scale lead to decreasing costs and internal diseconomies of scale result in increasing costs.
Examples of internal economies of scale would include applying better organizational skills or using more technologically advanced machines
Examples of internal diseconomies of scale would include employing to much management and administration or as company's scope increases, it may have to distribute its goods and services in progressively more dispersed areas. This can actually increase average costs resulting in diseconomies of scale.
However, Marshall thought that the shape by the industry supply curve in the long run depends on the so-called external economies and diseconomies of scale.
These factors are external to the firm and to the industry. If external economies dominate external diseconomies, than supply curve of the firm and industry in the long run is downward sloping – larger quantities are supplied at lower price.
This is a rather strange case, because in most industries industry supply curve is constant or increasing, but Marshall found historical evidence that is some cases costs and prices have decreased over time, so he wanted theoretically explain this fact.
What can be the cause of external economies of scale? According to Marshall, the reductions in costs of all firms in the industry that take place when all firms locate together (in a close distance) and share their ideas about production and management. Close localization brings also cost-saving subsidiary industries (that deliver intermediate products for our industry) and skilled labor has the incentive to locate in the area.
So according to Marshall in the long run industry curve can possess three different shapes – it can be downward sloping (external economies dominate diseconomies), it can be constant (external economies and external diseconomies cancel out each other), or it can be upward sloping (costs are rising, because external diseconomies dominate external economies).
This was discussed further in the early decades of the 20th century and we will get back to this issue.
Marshall also made some advancements in the theory of distribution based on marginal productivity theory and explained in detail the mechanism of reaching the equilibrium in markets and noticed the very theoretical possibility of unstable equilibrium in market, when the supply curve is negatively sloped (the case where external economies of scale dominate external diseconomies of scale).
Marshall was mostly interested in microeconomic theory, but he also contributed significantly to macroeconomics analyzing the economic stability at the macro level and the forces determining the general level of price.
He generally accepted the view of classical economics that the capitalism is stable, that it is impossible to have general overproduction in the economy, the depressions are not very deep and long lasting – so he accepted the Say's Law, that we have elaborated while discussing classical economics.
However, of course, temporary economic fluctuations did happen in capitalism in Marshall’s times and he explained them with the reference to the notion of business confidence.
In the boom, when the production is increasing, business confidence is high and credit expands rapidly, during the depression, bussiness becomes pessimistic and credit rapidly contracts.
Marshall suggested that to avoid depressions and unemployment you should do two things.
control credit markets, so that credit is not over-expanded in period of rising business confidence because it may lead to depressions
in depressions, the government can help restore business confidence by guaranteeing firms against risks.
As for his contribution to the theory explaining the general level of price, he advanced the quantity theory of money (which was already in use in classical economics period). We will discuss it in the lectures devoted to the modern macroeconomics.
A short summary of Marshall's thought.
Although over a century has passed since Marshall began his study of economics his contributions to microeconomics – value theory, analysis of firm's costs and supply, partial equilibrium analysis, price elasticity of demand, the concept of consumer's surplus – still provide the basis for mainstream undergraduate theory of microeconomics. On the undergraduate level core microeconomics has not changed much since Marshall, there were some developments in mathematical analysis, but not in the substance of the theory. One exception here is the analysis of imperfect competition markets (oligopoly for example), which was done by later writers.
He did not formulate full system of economic knowledge, since he focused mainly on microeconomics and did not explain the forces determining the levels of national income and employment.
He regarded his work as a continuation of classical economics of Smith, Ricardo and mill, updated to the development made by marginal economists.
He wanted to create purely scientific, positive economic science on the belief that if we understand what the economy is, we could make better choices about what the economy and society should be. In addition, he thought, on the normative, ethical side, that society should help those in lower-income groups.
He was a complex and subtle writer, often taking conciliatory, balanced position on many economic issues. The best example here is his theory of prices – prices are the result of a vast set of complex interacting forces, there is no one single cause explaining prices.
He was a proponent of theoretical analysis in economics, but since economic models are very abstract and describe a very complex reality, he found it necessary to supplement theoretical analysis with descriptive and historical material.
Leon Walras
OK, and now we shall turn to the review of the thought of the second founder on neoclassical economics – Leon Walras.
(1834-1910), Elements of Pure Economics, 1874 (French economist)
Walras, as you remember was one of the originators of marginal revolution in economics, but his contribution to economic science is much bigger and far-reaching.
He formulated the general equilibrium theory, which had an enormous impact on economics in the 20th century. Simply it became the most important economic theory, and we had many efforts by the brightest economic minds in the 20th century to reduce all other basic economic theories to General Equilibrium Theory (GET), especially we witnessed many attempts to reduce macroeconomics go GET.
As you all know, GET is the analysis of the economy in which all sectors are considered simultaneously. All markets are considered in their interrelationships at once, you can analyze direct and indirect effects of any change in economic system, cross-market changes and the like.
Walras contribution was to model the GE system in a formal, mathematical manner. He was not a good mathematician, but he thought that economics should be rigorous, mathematical science. Therefore, he is the first economist who precisely formulated a model of the economy in its complexity through the use of mathematical notation.
For this accomplishment, he is considered to be as an important precursor of modern economic theory, which heavily relies on mathematical model building.
First, we should say something about the difference between a general and a partial equilibrium model (the first is the approach of Walras, the second is the approach of A. Marshall).
Of course, GE is more abstract approach than partial equilibrium (PE) – more factors are assumed to be held constant in PE than in GE framework.
In PE, we allow only a very limited number of variables to vary – all others are assumed constant.
GE allows many more variables to change, but not all of economic variables. For example, in most of GE models we assume that the preferences do not change, the technology, population, institutional framework of the society and the like.
But all other economic factors, mainly prices and quantities on every market is assumed to be a variable to be explained in GET.
In PE if we want, for example, explain the price of beef (a sort of meat), we would base the explanation of a very few variables, probably income, price of some substitution and complementary goods). It would be simple, not accurate, not rigorous, but probably quite good approximation.
In GE framework, everything depends upon everything; the price of beef depends on the prices and quantities of all other commodities in the economic, final commodities, intermediate commodities, and the factors of production. This is much more complex explanation, but in general theoretically it is correct and rigorous, and it is a great contribution that Walras managed to formulate GE approach.
We will describe shortly Walrasian model in words, without the mathematical notation.
The problem is to express the interdependence of all markets in economy. The change, for example, in the price of one final good (beef for example) will have repercussions in the whole system, in every market. Consumers will change their consumption patterns, maybe not in a very , but they will (demand for all other goods will change), firms will change they output (in reaction to changing demand for their products). These changes will have also impact on factor markets, since firms changing their production will change also their demands for factors, so the prices of capital, labor and other factors will change and the distribution of income in the society will be different.
This interdependence of markets is even better visible if the good is very important in the economy for example if it is gas or electricity and the change in its price is rather big.
Walras expressed this interdependence in terms of mathematical equations.
To formulate GE model, he wrote down
equations describing individual demand of household for final products as well as equations describing market demands for final goods
equations for individual supply of final goods and equations for market supply of the final goods
equations describing the conditions for market equilibrium for final products
equations for equilibrium of households (to maximize total utility), and
equations for equilibrium of firms (to maximize profits).
Therefore, he formulated a system of simultaneous equations (that is equations that share the same variables). The system describes the interrelatedness of the economy.
The most important question Walras has asked was the question is a general equilibrium solution possible. That is – is there a set of prices and quantities, which clears all markets at the time.
This is the problem of the existence of GE solution (problem of existence in short).
But there are other important questions.
Is there only one set of prices and quantities that is the solution of GE model? This is the so-called problem of uniqueness (of GE solution)
Further, if the solution exist, is it economically meaningful or will it yield negative prices or quantities
Will the solution be a stable equilibrium or an unstable equilibrium? This is the problem of stability of GE model solution.
Problems of existence, uniqueness and stability are the most important in GET.
Walras tried to solve them, but did not manage to do this satisfactory. Although he claimed that he had solved them. However, his mathematical abilities were not good enough to solve them. To do the justice to Walras, proper mathematical tools to solve those problems were developed in 1940s and 1950s, so he really did not have a chance to solve these problems. They are very difficult mathematically, but in simpler versions of GE models are taught today on the graduate courses of microeconomics.
As for the problem of the existence of GE solution, for example, Walras thought that it is enough to count the number of variables to be calculated in the model and the number of independent mathematical equations in the model. If the number of variables (prices and quantities of final goods and factors of production) equals the number of independent equations, then there is a solution of GE model. He thought that he mathematically proved the existence of GE solution.
However, this is generally not true. There might be no solution, there may be more than one solution, the solution can be economically meaningless (negative prices or solution not in the domain of real numbers).
However, the proof of the existence of solution to the GE model was made only several decades later in 1954 (and we will talk about this later).
Therefore, Walras did not succeed in answering the questions raised by his model, but his greatest contribution is the conceptualization of various sectors of the economy in a mathematical, rigorous model. The model offered great insight into the workings of markets and served as a foundation for the development of 20th century economics. In the 20th century, it has become the most fundamental economic model and all advanced research in almost all areas of economics has been done in GE models. Therefore, Walras's impact on later economic thought is indeed enormous and great. What is also important Walras demonstrated to others the power of mathematical analysis as a tool in economics, and heavily influenced the process of mathematization of economics in the 20th century.
One more thing about Walras.
His views on the proper economic policy are quite interesting.
He thought that his abstract model is a tool to be used in formulating economic policy.
He regarded himself as a socialist, but strongly objected to the views of Marx and utopian, pre-Marx socialists.
He argued that free competition results in an optimum allocation of resources, so he urged states to attempt, through, legislation, to create systems of perfectly competitive markets.
However, at the same time he thought of himself as socialist, and proposed that government intervention is desirable in many areas. Therefore, he might be called an advocate of market socialism.
For example, he demanded that state should take away all land rents from the landowners, because they represent unearned, unjust income. If that would happen, Walras thought, the distribution of income would not be so unequal in the capitalism - he thought that there is too much inequality in the totally free-market capitalism.
The last thing about Walras.
We can compare the methodological approach of the two founders of neoclassical economics Marshall and Walras. Marshall as you remember was interested in mathematical account of economic theories as far as this account is related to the real world, mathematical theory should be kept in mind and only brought into analysis when it is relevant. For Walras, economic theory in a mathematical mode is the most important thing in economics – he was searching for the most general and formal model of the economy.
Therefore, these two approaches to economics are completely different. Those approaches of Marshall and Walras still coexist in modern economics, Marshallian approach being used in undergraduate courses on microeconomics, Walrasian economics being taught in graduate courses on micro. Therefore, we can say that Walrasian approach has won the struggle between the two approaches in the 20th century and in later lectures we will see how this has happened – how economics in 20th century has become a mathematical science.
To finish the discussion of neoclassical economics we have to review the thought of one important follower of Walras, his disciple – Vilfredo Pareto (1848-1923).
He was an Italian economist and an early supporter of Walras's general equilibrium theory. He extended the analysis of Walras and applied it to welfare economics to analyze the welfare implications of various policies. He wanted to extend Walrasian economics as it would be possible to evaluate various actions in economic policy.
Pareto along with some other economists is considered a founder of modern welfare economics.
He was especially interested in the problem of how to evaluate the efficiency of resource allocation for an economy and how to assess the merits of different economic policies that affect an economy.
Before Pareto, economics did not develop particularly useful and rigorous methods of evaluating economic outcomes. As you should remember Adam Smith and classical economists in general thought that free-market economies with competitive markets produce desirable outcome and especially high rates of economic growth. They also advocated laissez-fair policies, but did not justify those policies by the use of any formal criteria of evaluation.
In the 1890s, Pareto formulated some formal criteria to be used in evaluating economic outcomes and policies. Those criteria are very well known today and named as Pareto optimality criteria.
In the simplest form, as you should know, we can state that Pareto optimum is defined as a allocation of resources in an economy, in which it is impossible to make someone better off without making someone else worse off.
Pareto wanted to accommodate his concept of optimal allocation in Walras's general equilibrium theory and in particular, he wanted to prove that the allocation, which is the solution to the general equilibrium model, is Pareto optimal. He was not able to do this in a sufficiently rigorous method, but later in the 20th century it was possible to prove such a theorem, that in GE model a competitive solution is Pareto optimal allocation – this is the so-called the first fundamental theorem of welfare economics.
And it is a very important result for all defenders of free-market, competitive economies, the resulting allocation in such economies is such that no one can be made better off without making someone else worse-off (competitive equilibrium is Pareto optimal). However, the correct proof of this theorem was possible only in 1950s and we will review these advancements later.
Insitutionalism and historical school of economics
Neoclassical economics was the important school of economic thinking in the economics between 1890s and 1930s. However, it was not the only school of economics in this period.
Economic science late in 19th century and in the first three, four decades of 20th century was pluralistic. There was no mainstream economics in this period.
Neoclassical economics was popular in England and France, but not in Germany and in the US.
At the time, there were at least two popular and powerful rival, to neoclassical economics, schools of economic thought active in the scientific world.
These were:
- historical school of economics
- institutional economics (or institutionalism)
Mostly German economists and some English economists represented historical school of economics, while institutionalism was immensely popular in the US.
Both schools were highly critical of various aspects of neoclassical economics. Later in the course of 20th century, from 1930s on, neoclassical economics has marginalized both schools, but late in 19th century and in the first 3 decades of 20th century neoclassical economics, historical economics and institutional economics has been competing for the rule in the world of economic ideas.
So let’s review quickly the economic views of those two alternative, heterodox approaches to economics (neoclassical economics is from the modern perspective said to be the orthodox economics, since it became the most popular in the 20th century).
The members of historical school (we do not have to specify their names, they were in general German economists, publishing their works in the 2nd half of the 19th century and in the first decades of 20th century) generally criticized classical and later neoclassical economics from the point of view that those theories do not apply to all times and cultures.
They thought that the conclusions of Smith, Ricardo, Mill, Marshall and others may be valid for advanced capitalist countries such as England, but do not apply to agricultural or less advanced countries such as Germany or US (especially in the mid 19th century 1840s, 1850s.
In addition, they advocated that economics should not strive for discovering universal economic laws to be applied in all times and cultures, but rather that economists should formulate the laws governing the economy on various stages or levels of development. Therefore, economics should provide some economic laws for underdeveloped countries and a different set of laws for developed countries.
Historical school of economics was also very critical of the use of abstract, mathematical models in economics, they thought that economic science should proceed by gathering a body of historical evidence and only after enough empirical evidence had been gathered, theories should emerge.
The historical school of economics had a little influence on mainstream economics, and neoclassical economics has marginalized this school from 1930s on, but I was very influential in Germany and in effect of this economics as an intellectual discipline suffered, did not develop according to neoclassical standards, in Germany for several decades.
So much on the historical school, let's now turn to institutionalism – a heterodox school of economic thought, which was active in the US in the first 3 decades of 20th century.
The intellectual father of institutionalism is Thorstein Veblen (1857-1929).
First, his criticism of neoclassical economics.
According to Veblen, neoclassical economics is not scientific. He wanted to tear down, to abolish the entire structure of neoclassical economics and rebuild a unified social science from economics, anthropology, sociology, psychology and history.
Veblen said that all classical and neoclassical theories were based on the same assumption – that there is a harmony in the economic system – this appears in the Smith's concept of the invisible hand of market, which turns private egoisms into public benefits. Also the concept of equilibrium as used by classical and neoclassical thinkers was to Veblen not a positive, scientific concept, but rather a normative one – he thought that in orthodox theory it is implied, without proof, that equilibrium is good, desirable and that the results produced by markets in equilibrium are socially benefit. It was not proved by neoclasicals according to Veblen.
Classical and neoclassical was also unscientific to Veblen because it refused to admit that the economy was constantly changing and evolving. Orthodox economists treated economy as static, non-evolving entity. This static neoclassical theory should be replaced by dynamic analysis of the evolution of the economy and society.
Veblen suggested that economists should not only study the formation of prices on markets in a static framework, but also analyze the factors they assume to be constant – such as tastes, preferences, technology, organizational arrangements of the society and the economy and so forth.
Veblen never believed in the invisible hand mechanism described by classical economists, in which the self-interest of producers corresponds to society's public interest.
Veblen maintained that individual businessmen rather strive to gain a monopoly power on markets, and to rise prices above the competitive level. In this, they act against the social interest. Large corporations do not aim to increase efficiency and to lower the prices, but to acquire monopoly power, to restrict production and gain monopolistic profits.
He also thought that the competition among firms for international markets led to conflicts and ultimately to wars.
Businessmen (or captains of industry as Veblen called the owners of capital) strive for profits will inevitably lead do depressions and mass unemployment.
In essence, Veblen rejected the classical/neoclassical assumption of perfectly competitive markets and the idea that markets in the hands of businessmen would produce socially desirable results.
Where orthodox (classical/neoclassial) theory found harmony under capitalism with an efficient allocation of resources and full employment, Veblen found disorder, unstable economy, with businessmen who sabotage the system to make exceedingly high profits. The effect is economic depression, unemployment and international conflicts.
This is different, pessimistic vision of capitalism than that found in the neoclassical orthodox economics.
One final Veblen's criticism of neoclassical economics refers to the concept of human nature used in economics. According to Veblen, orthodox economics was ignoring the developments in psychology, sociology and anthropology, building models based upon unscientific models of human behavior.
Orthodox theory, according to Veblen, was based upon the assumption that humans are driven by the desire do maximize pleasure and minimize pains, on hedonistic psychology. Hedonism is the view that people are motivated by gaining pleasures and avoiding pains only.
According to Veblen, this assumption is wrong. People are not calculators of pleasures and pains, but have a wide array of motivations (for example various instincts, habits, obligations, duties and the like).
So the whole body of orthodox economic theory is based on the wrong, unscientific assumption and hence it is not a good economics – Veblen concluded.
So much on his critique of classical and neoclassical economics.
Now we will describe his analysis of capitalism.
According to Veblen, economic theory should be interested in something very different from the static allocation of scarce resources, which was the main subject of orthodox, neoclassical economics.
He contended that economics should be a study of the evolving institutional structure of the economy and the society. (Hence the name of the school he founded – institutionalism).
He defined institutions as habits of thought that are accepted in the society (or by different classes of society) at any particular time.
So Veblen wanted to explain those economic variables, which neoclassical economics assumed as given – that is institutions like widely-shared habits, preferences, norms and the like – in general some kind of a mental culture of capitalist society.
Therefore, if he wanted to explain the prevailing culture of the society, he needed evolutionary approach, because any culture can be understood only with reference to the past cultures it has evolved from.
The most important institutions are according to Veblen entities called instincts – well-established patterns of behavior that partly come from the past. Among the instincts he distinguished: parental instinct, instinct of workmanship (of hard work), idle curiosity, and the instinct of acquisition (greediness, money-grabbing instinct).
From the economic point of view the instincts of workmanship (hard work), idle curiosity and acquisition are the most important ones.
The instinct of workmanship make people desire to produce goods of high quality, to be concerned with efficiency in production and to put effort into work.
Idle curiosity leads to seek explanations for the world around us and to technological innovations – so it is important both in science as in the industry and the economy.
Finally, the instinct of acquisition (greediness, money grabbing) leads an individual to regard his or her welfare (or the stock of capital or money) as the only important thing, the welfare of others is ignored.
Those instinctive drives in human beings create certain tensions in the economy and the society. The instincts of workmanship and idle curiosity lead humans to produce with great efficiency high quality products that are of benefit to their fellow humans.
On the other hand, the instinct of acquisition is self-regarding only, and leads to behavior that benefits only the individual, even though it might have disastrous consequences for the society.
In the economy, in every historical period, there is a conflict, tension between the instincts of those 2 kinds.
Veblen called the activities (efficient production of high quality goods) that flow largely from the instincts of hard work and idle curiosity – industrial employments.
On the other hand, activities that flow from the instinct of acquisition are called business employments. In capitalism, business employments include above all making money.
In capitalism, there are two different habits of thought (institutions) for workers and engineers on the one hand, and for the businessmen (or capitains of industry) on the other hand.
The workers and engineers are involved on a daily basis in industrial employment – the making of goods by efficient methods. Instincts of hard work and idle curiosity are prevailing in this class of workers and engineers.
Captains of industry (businessmen, owners of capital) are concerned mainly with profits, with making money and this often conflicts with making goods, because in order to achieve higher, monopoly profits, businessman tend to reduce output, restricting the production. This is against the desire of workers and engineers to maximize the production.
So there is a basic, fundamental conflict in capitalism between capitalists and both workers and engineers.
What is important here, is that Veblen considered capitalists to produce rather ill-fare, not welfare in the society, they do not contribute to social good, but rather sabotage the social welfare, by creating monopolies, reducing the production, raising prices and the like. Veblen was a harsh critic of the class of the owners of the capital.
This division between business and industrial employments Veblen applied to discuss the consumption patterns of capitalist society. I recall you business employments are activities of businessmen – mainly money gathering, industrial employments are activities of workers and engineers – producing goods.
This application to the analysis of consumption patterns was the main topic of his book the Theory of leisure class (1899), which was widely read by intellectuals of his time.
Veblen reasoned that in every phase of the development of society people want to be held in high esteem, want to be admired. In earlier phases of development, it was possible to be admired if you were physically strong and could use violence in acquiring goods and social position. In modern capitalism, it is of course, impossible so some other methods of manifesting your predatory abilities had to emerge. The fact that you have a large income or a stock of capital is in itself not sufficient, because it cannot be so easily recognized – you cannot look into people's pockets or bank accounts.
Those methods of showing to others what your social position is are your predatory potential are according to Veblen, conspicuous consumption and conspicuous leisure.
Conspicuous consumption is the most efficient mean of displaying our predatory abilities. Our cars, houses, and especially our clothes give a clear indication of our place in the predatory order of society, according to Veblen.
If the man (or the head) of the household is too busily involved in his or her business activities, than his wife or husband is expected to display the family wealth (by dressing appropriately, avoiding work, employing large number of servants and the like).
Work in this class of people, high-income class, in general should be avoided, unless it is work in strictly business employments –firm ownership, high management, banking, finance, law – are the preferred professions.
This class was named by Veblen – a leisure class. Because the class is also engaged busily in another activity, which displays the social position accurately – that is spending the time in various unproductive, highly priced actions. This conspicuous leisure includes, according to Veblen, higher education, parties, all sporting activities and the like. For example, if you often play golf or any other time and money consuming sport it surely shows that you are rather rich.
These are conspicuous consumption and conspicuous leisure – activities of leisure class, the richest class of the society, which do not have to work, at least in the production sector. This description is to some extent rather sociological than economic, but there is probably some truth in it and likely we can see many examples of conspicuous consumption and leisure even in today's capitalist societies.
This division between business and industrial employments Veblen applied to speculation about the tendencies of capitalism in the very long run. I recall you business employments are activities of businessmen – mainly money gathering, industrial employments are activities of workers and engineers – producing goods.
He thought that since there is a widespread emulation of consumption patterns in sthe capitalist society, that is members of the lower class- workers and engineers want to engage in conspicuous consumption and leisure as far as their resources allow them to to this, than it will lead to an economy devoted to conspicuous consumption, waste flowing from consumption consumption and leisure, and increased advertising and marketing costs.
Increased advertising and marketing costs because if the consumption it the dominating theme in the capitalist society, at least in the Veblen’s vision, than firms will try hard to advertise their products and bear the excessive, according to Veblen, costs, not connected to the process of production.
As long as industry is controlled by businesspeople in search of profits, we can expect the increased flow of goods, which do not satisfy real human needs, goods that impede the progress of humanity, goods specially produced for the leisure class.
However, if the working class and engineers gain the control of the system, the industrial economy might fulfill its promise of a good human life.
According to Veblen Marx was wrong. The capitalism will not collapse through the revolution brought about by the absolute poverty of the working class. It is not an absolute, but relative poverty that might be the reason for the end of capitalism.
As the economic growth is working, the working class feels being relatively poorer than the businessmen class (leisure class), and because the lower class still wants to emulate the consumption patterns of the higher class, workers and engineers want to consume the same classes of goods as the members of the higher class, it forces so much discontent on the part of the working class that it might lead to the revolution, socialist-like revolution and bring about the abolishment of the private property.
Therefore, according to Veblen socialist revolution a la Marx is possible as the future scenario of the development of capitalism, but for different reason than Marx thought.
It is the relative poverty, because people want to have more purchasing power than others, not just more purchasing power. People envy other people their standard of living.
Therefore, the supposed reason for the end of capitalism is the individuals’ concern about their own relative well-being. Therefore Veblen suggests that capitalism might collapse not because of its failure as Marx thought, who held that capitalism will bring about growing unemployment, crises, depressions, increasing absolute poverty and the like), but rather because of its success . Capitalism is growing, and probably the absolute standard of living of the working class is increasing (they have more and more commodities in their possession), but the relative poverty is growing (in relation to the leisure class, they become poorer and poorer).
However, Veblen did not think that this is the only possible vision of the development of capitalism in the long run. Against Marx, he was convinced that the evolution of capitalism is not a determined process. The future is open and cannot be predicted. So the fate of capitalism and private property is uncertain.
One possibility is the socialist revolution, but there are others also.
Alternative possibility is the so-called technocratic revolution. The growth scientific and technological attitudes generated among the working class and the engineers will lead to a replacement of businessmen, so that the control of the economy will pass into the hands of technocrats (mainly engineers).
If these developments occur, according to Veblen, it will mean an end of monopoly power in the markets, end of financial manipulation on the part of the businessmen, end of conspicuous consumption and excessive advertising and industry will be so directed as to produce goods that are serviceable to humankind.
Still another possibility is that is the rise of the economic and political right-wing movements as the working class and the engineers turn themselves to nationalist ambitions and war-like aims, and democracy in this scenario will end as a police state.
Veblen, as a careful evolutionary theorist knew that the future cannot be predicted, especially in such a wide scale and the only thing he knew for sure is that the future will be different from the present state of capitalism. Therefore, he offered various possibilities for the development of capitalism – socialist revolution, technocratic revolution and vision of the democracy turning into a police state.
A summary of Veblen’s views.
Veblen was a harsh critic of both capitalism and neoclassical economics, which supported capitalist system.
For Veblen neoclassical economics was unscientific and he wanted to fund a new united social science, based on the achievements of economics, sociology, psychology and anthropology – a science which would be evolutionary, which would explain mainly changes in the institutions – prevailing habits of thought in the society (like instincts).
Some people say that Veblen was not an economist at all, but a sociologist. In addition, as you maybe know for modern mainstream economists sociology is a fuzzy, imprecise social science – ‘a smaller tribe without a model as a totem’ – as one Nobel Prize winner in economics have said. Economists generally treat other social sciences as less scientific than economics.
This view, to treat Veblen as sociologist is to some degree correct, since he himself thought that economics is not enough to understand human behavior in the field of economic activities, and wanted to build a united social science.
Moreover, he was not interested in the same set of problems as orthodox, neoclassical economists – he wanted to explain those factors, which are unexplained in mainstream economics – motives of human actions, preferences, institutional structure of the society.
In this perspective, Veblen’s contribution can be regarded as complementary to mainstream neoclassical economics.
Veblen found many flaws in neoclassical economics – like unscientific concepts of invisible hand, equilibrium, unrealistic assumption of competitive markets, perfect rationality of economic agents, futile deductive and mathematical approach to the analysis of economic problems – but the alternatives he offered, his theoretical propositions, have not been very fruitful.
He built no grand model with easily identifiable assumptions and a logical structure, which would lead unambiguously to strict conclusions. He simply offered a literary description of capitalism, with no scientific model or theory.
Moreover the psychology of instincts that he used in describing human agents, has been later rejected by psychologists.
Orthodox, neoclassical economics has not been much influenced by Veblen critique. Economists still rather assume rational, calculating households or firms.
Perfectly competitive models of markets still play a profound role in theories and in teaching.
His view of o need for evolutionary economics received some attention in the last 30 years, and we have a school of evolutionary economics today, but it is not a very popular current in modern economics.
Another Veblen’s contribution was a critique of neoclassical economics for being to deductive, too mathematical, not enough empirical science. Veblen wanted economists to gather as much as possible of empirical facts to test empirically economic hypotheses.
Yet Veblen’s own theories were not presented in the manner suitable for empirical testing, nor did he document his statements with statistical material. His writings are amalgamation of positive (scientific) and normative assertions, he never formulated his conclusions in a precise way, which would allow other economists to empirically test his propositions.
However, this part of Veblen’s criticism did, to some extent, compel economists, mainly American economists, to be more concerned with the facts, with empirical evidence, and the fantastic growth of empirical work in economic since the II world war may be partly explained as an intellectual response mainstream of economists to Veblen’s critique.
Veblen’s followers, other members of institutional school, in the first three decades of the 20th century in America, have pioneered the institutional collection of data for economic analysis, especially for the analysis of business cycles.
This is a significant contribution of Veblen and institutionalism.
A few words on other members of institutional school. Veblen was a founder of the school, but not the only member. The school was immensely popular in America between the year 1900 and the Second World War, only just after the war it was marginalized by neoclassical economics.
Other members of the institutional school, we do not have to mention their names, did not produce theoretical results, which would have influence neoclassical economics. They were engaged mostly in the analysis of economic policy and in this field, their impact was very significant.
All institutionalists, to varying degrees, called for much more governmental intervention in the market than it is implied by neoclassical economics. Many of their ideas, especially in the social, redistribution and labor market policies, were implemented in the US and in Britain. So they had a profound impact on the institutional structure of modern capitalism, they contributed to the increased scope of government intervention in the Western capitalism.
In the area of economic theory, they had less impact. Neoclassical economics has gained supremacy in economics in the years of the Second World War, and other currents of economic thought, became of much smaller relevance and popularity. We will see why and how this happened during the lectures devoted to the 20th century thought.
In addition, one more thing. In a sense, institutional ideas have reemerged in economics from 1970s in the so-called New Institutional Economics, which is a mix of neoclassical methodology and institutional focus on the concept of institutions. However, this school is neoclassical in this that it uses most of neoclassical econmics assumptions and analytical tools, and only applied them to the problem of economic institution. We will review shortly this school later.
Austrian school of economics.
The founder of the Austrian school is the Austrian economist Carl Menger, 1840-1921.
We have already mentioned one of his contributions to economics, since he was, along Jevons and Walras, one of the originators of marginal revolution in the 1870s.
But Menger’s biggest contribution is the fact that he funded a school of economic thinking, which shares the origin with neoclassical economics of Marshall and Walras, but is quite different in its subject matter and methods used in economic analysis.
In the first place, Menger and the subsequent generations of his students did not agree with neoclassical economics about the proper method to be used in economic science.
From 1890s and especially in the 20th century neoclassical economics became a formal mathematical science, focusing on perfect competition and a narrow analysis which assumed the existence of every market and did not involve in a set of broader economic questions (like the institutional structure of capitalism, the long term development of capitalism, the problem of choosing the right economic order – that is the question of relative advantages and disadvantages of socialism and capitalism).
Members of Austrian school of economics rejected mathematical approach to economics, proceeding non-mathematically, incorporating laws and institutions into its analysis, focusing on the study of economic processes (in contrast with neoclassical focus on the analysis of static equilibria) and disequilibrium (again in contrast with neoclassical economics).
Austrian economists also disregarded the concept of perfect equilibrium – for Austrians the correct price was whatever price the correct institutional structure produced.
Furthermore, Austrians have always been engaged in the analysis of the broader economic questions rather, than narrow technical ones.
Specifically, it was this group of economists, who took part in responding to the socialist challenge concerning what economic system was preferable and in defending capitalism against socialist charges. This debate concerning economic systems has occurred in several stages in the western economic thought late in the 19th century and in the first four decades of the 20th century. We will devote the rest of the lecture to the debate and the role of Austrian economists in it.
But first, a few words on the present state of Austrian economics.
IN the 20th century with neoclassical economics, becoming more and more mathematical, Austrian school grew further and further away from the neoclassical mainstream. In the second half of the 20th century, Austrian school became perceived as heterodox current in economics.
It is still visible in academic circles, because the tradition of this thought has moved from Europe to the US; there are about 50 Austrian-like economists in the world (mostly of American nationality). Still, there are scientific journals and conferences devoted to Austrian economics and Austrian economists are employed in some quite well respected American societies. Some people say that Austrian economics is so well established in today’s world (especially in relation with the rather small number of Austrian economists), because it is financed by big business. Why? Because the members of the school are the strongest supporters of a free market economy, they support laissez-faire economic policies, and claim that almost every government intervention in the economy results in the lower economic growth, unemployment and economic waste.
We will return to some theories of the Austrian school of economics, while discussing the 20th century developments in economics.
OK, so now we turn to the so-called the debate on economic system – the debate on whether socialism or capitalism is the more rational and more efficient economic system
We should recall here the definitions of these systems.
While discussing Marx we have defined ideal capitalism as a system with two general features:
1) private ownership of economic resources; 2) market as a allocation and distribution mechanism
Ideal socialism is defined respectively as system where 1) there is a state or public ownership of economic resources; 2) market still serves to some extent as mechanism of allocation of resources and a mechanism of distribution of incomes.
Communism here would be a system with 1) state or public ownership of resources; 2) state or some central planning authority decides on the allocation of productive factors and on the distribution of incomes. There is no market.
The debate on the relative advantages of these systems went through several stages.
The first stage took place in late 19th century when some Austrian economists criticized some technical parts of Marx’s economic theory, especially his labour theory of value. However, since in Marx’s system the theory is not necessary to prove his predictions about the collapse of capitalism, then this critique did not have much importance.
The second stage of the debate on economic systems can be distinguished in the period after the communist revolution in Russia in 1917. Austrian economists have argued then that this was another failure of Marxian analysis to predict the future. They argued forcefully that the implementation of socialism by force, through revolution demonstrated the incompatibility of socialism with individual liberty and thus that socialism is not a desirable economic system.
Finally,
The third stage of the debate took place from 1920s to 1940s but some think that the debate is not resolved until today. This debate has its own name – it is the allocation of resources debate. This is the most important stage, and we will discuss it in detail.
The two Austrian economists who took part in this stage of the debate were:
Ludwig von Mises (1881-1973) and
Friedrich von Hayek (1889-1992) – Hayek is the Nobel Prize winner in economics in 1974 for his contribution to the theory of business cycles from 1920s, but also for his penetrating analysis of the interdependence of economic, social and institutional phenomena
The debate on the resource allocation.
In 1920 von Mises published an article in which he stated that a rational allocation of resources was not possible under socialism.
In capitalism a system of private ownership, Mises argued, private property provided a strong incentive for people to use resources efficiently because they bore the costs and received the rewards of their activity.
Prices established on the market signaled producers and consumers about the trade-offs they would have to make in purchasing inputs, how much should they buy of different factors of production.
Moreover, profit and loss in the firms would inform market participants about whether their business decisions are in accordance with underlying consumers’ tastes and technology. Mechanism of profits and losses inform producers whether they should continue the production or move to another activity.
In these senses, capitalism is a rational economic system, the resource allocation is efficient and economic calculation in firms is possible and executed.
In socialism, in the absence of the institution of private property and the business practices of a market economy how would socialism motivate and inform its participants in order to achieve optimal production – Mises asked.
He further argued that socialism would be without any means to achieve efficient allocation of resources.
Without private property in the means of production, Mises stated, there would be no market for the means of production, for capital especially (in socialism capital would have to be collectively owned).
Without a market for the means of production, there would be no monetary prices for the means of production, for capital especially.
Without monetary prices reflecting the relative scarcities of the means of production, there would be no way for economic planners to assess the opportunity cost of resource use.
In short, economic planning would be so many steps in the dark – socialist planners would not know how much various capital goods should they employ in production to be efficient.
There will be no economic basis upon which to pursue project A rather than project B.
The resulting system would be irrational and producing economic waste.
This is the original argument of Mises from his paper of 1920.
In the years 1936-37 Polish economist Oskar Lange, have published two papers in, which he proposed the solution to the Mises’ problem.
Lange (1904-1965), was a socialist or even Marxist, but at the same time he was extremely well educated in neoclassical economics. He started his career in Poland in 1920s, and later moved to US, where he taught economics at the University of Chicago in 1930s and 1940s. At the time he was a leading mathematical economist in the world. After the Second World War he returned to Poland and continued his career as economist and a politician too, supporting state socialism in Poland. However, his achievements in after-war period are minor in comparison with the contributions he made to several branches to economic theory, while working in the US. Lange was the most well known polish economist in the 20th century and the best one if technical abilities of economists are concerned.
To save socialism from the supposed charge of irrationality Lange proposed a model of socialist economy, which possessed two features
(1) There is a market for consumer goods and labor allocation;
(2) There is a social (collective) ownership of the production sector, but a central planner provides strict guidelines for production to enterprises.
Namely, the planner informs managers that they must price their product equal to marginal costs and produce at that level of output, which minimizes average costs.
Why ? Because those conditions must be fulfilled in competitive market economy. So the socialist solution would imitate the market economy, and socialism would produce as much as capitalism.
However, how would a central planner know what is the marginal and average cost of production in socialism, where there is no market for capital, and there are no prices for capital?
Here hides the ingenuity of Lange’s model.
Adjustments to the correct prices and costs in the model can be made on a “trial and error” method using inventory as the signal. You set a price at random and observe the volume of inventories. If inventories increase, it is a sign that the price in the firm or the industry is too high, exceeding marginal costs, and should be lowered.
If there is shortage of inventories, it is a sign that you should try and increase the price.
By this trial and error method, you can achieve the same prices and levels of production as in capitalism.
In short, these production guidelines will assure that productive efficiency will be achieved even in the absence of private property
Lange’s article possessed a stronger claim as well: not only was socialism capable of performing equaling with capitalism in theory, in practice it would outperform capitalism. Real world capitalism, Lange contended, failed to live up to its ideal because of (a) imperfect competition and monopoly capitalism, and (b) inherent business cycles.
Socialism would be as economically efficient as capitalism and further it would be deprived of those two bad tendencies. Moreover, socialism would pursue more equal distribution of income in the society. Hence, Lange claimed, socialism is a superior economic system.
In the hands of Lange, neoclassical theory was to become a powerful tool for socialism.
Modern economic theory, which Mises had thought so convincingly established his argument, was now used to show that Mises and proponents of capitalism in general were wrong.
It is safe to say that in the eyes of most professional economists, Mises was decisively defeated at this point. In addition, certainly the most prominent economists of the generation in 1930s-1940s believed that socialism was now proven theoretically possible, whether they found this desirable or not.
This was a formidable challenge, a challenge that F. A. Hayek devoted the better part of the 1940s attempting to meet. Hayek formulated several arguments against Lange’s model.
The most important of them is the following.
Hayek argued that the models of market socialism proposed by Lange and others reflected a preoccupation with equilibrium. The models possessed no ability to discuss the necessary adaptations to changing conditions required in real economic life.
In equilibrium state, Hayek admitted, Lange solution is correct.
But what, Hayek asked, what happens when tastes and technologies change and equilibrium turns to disequilibrium?
How producers are to respond in disequilibrium state? How should they change the process of production? They do not know in socialism, whether changes in demands for products and supply of labor are induced by changing technology, consumer's tastes or something else.
Since neither central planner nor managers in firms do not know what economic conditions and variables did change, they cannot rely only on observing the volume of inventories, to formulate a corrected production plan.
Hayek thought that Lange's model in general does not describe disequilibrium adjustment at all. And that in practice it would not be possible to use it as a guideline for the real socialist economy.
However, Hayek's argument considered the problems with disequilibrium adjustments to the equilibrium, and such problems were not part of Lange's model – which only described the equilibrium position of socialist economy. Moreover, Hayek's argument was not stated in a formal mathematical model, and therefore was not considered by neoclassical economists as acceptable economic argument.
This is a general opinion that since 1940s to at least late 1970s, the basic consensus among professional economists was that the Austrian argument did not hold at a purely theoretical level. Perhaps the Austrians had some political wisdom to offer against socialism, but mainstream opinion was that socialism was theoretically and practically able to rationally allocate resources.
Although Lange’s argument was accepted in the profession of economists, by the mid 1980s it was obvious that the socialist world was experiencing obvious shortcomings.
Consumer frustrations were high, technological development was lagging behind the West, and even military superiority was questionable.
In light of these developments, many economists began to reevaluate their previous thoughts regarding the status of socialism as an economic system.
Some critics of socialist economies have followed some views of Austrian economists, especially Hayek, who claimed that planners in socialist economies cannot gather the knowledge about the consumer's preferences, market conditions and changing technology and therefore cannot organize socialist production efficiently.
Such knowledge according to Hayek is revealed through the operation of markets and cannot be collected by any statistical institution in socialist state.
However, Austrian views were not accepted in the mainstream neoclassical economics. In fact, by 1990 consensus among economists held that although socialism suffered from serious problems in practice, Hayek’s arguments, which constituted an attack on central concepts of the neoclassical approach such as the idea of equilibrium, could not be accepted.
So modern, neoclassical economists such as Joseph Stiglitz, formulated their own arguments against socialism, explaining why it is not a efficient economic system.
The most popular contemporary argument of this kind can be find in the economics of information. According to the argument the incentive problems that socialist planners would confront in organizing economic life are enormous and the opportunities for opportunistic behavior on the part of planning bureaucrats are too numerous for an efficient economic organization to be realized.
Simply, it was rather naive to hold, as Lange did, that managers of firms in a socialist economy could be expected to follow rules aimed at operating plants in a efficient manner and equating prices to marginal costs.
Without the penalties existing in capitalism (such as bankruptcy), managers of socialist firms will behave in ways that will ruin the efficiency of firms. They will simply realize their own interest and not that of the firm.
In addition, similar argument concerns central planners deciding about the central plan for the whole economy. They also do not have any incentive in proposing a plan, which would imitate the functioning of capitalist economy. They rather will be engaged in opportunistic behaviour, trying to achieve some kind of political rent and they will not care about the efficiency of the economy.
Therefore, from the perspective of modern neoclassical economics, socialism cannot work; but not for the reasons emphasized by Hayek and other Austrian economists.
That the majority of modern economists think that socialism in practice is not as efficient as capitalism, does not mean that the debate on socialism versus capitalism is over. Quite to the contrary.
In recent years, some, mostly American, economists, trained in modern mainstream economics, but who held strong left-wing views, have formulated several modern arguments for socialist organization of the economy. Those models make use of modern advanced economic theories taken from economics of information and even artificial intelligence. The models are quite complicated, but formulated in accordance with mainstream standards; they are mathematical and funded on the recent achievements of mainstream economics.
So the debate on relative economic advantages of capitalism and socialism continues in some respects, but at this point, the majority of economists in the world hold the opinion that socialism is not as efficient as capitalism.
So much on the debate and the Austrian economics contribution to it.
With Austrian school of economics, we have finished the discussion of the period in which neoclassical economics ruled in economic world, that is the period from 1870 to 1930s. We have discussed the views of the founders of neoclassical economics, Marshall and Walras, and the views of some critics of this approach – institutionalism, historical school of economics and Austrian school of economics.
Modern microeconomics (1930s -)
The period of modern economics spans from 1930s until today.
Some economists and historians of economics argue that modern mainstream economics can be still called neoclassical economics, as it is no different from the approach of Marshall or Walras.
However, others, and we accept their judgment, claim that since 1930s economic theory has been changed so much, that it can not be called neoclassical anymore.
And since there is no better name for the period as far, they call this period from 1930s up to today – simply modern economics.
We have said also that modern economics cannot be called neoclassical anymore for it moved from neoclassical economics in several dimensions.
What is most important, many assumptions of neoclassical thought were rejected or modified in modern period.
For example marginal calculus was replaced by more advanced mathematical methods – set theory and others.
The assumption of perfect rationality of economic agents was modified by insights from psychology and become in many modern models rather the assumption of limited, bounded rationality.
Further, the set of issues to which economic analysis was applied expanded enormously since neoclassical. Modern economics is involved in analysis of many various areas of inquiry, which previously belonged to other social sciences.
Moreover, while neoclassical economics focused on unique equilibria states in economic models, modern economics deal frequently with multiple equilibria – there is no unique equilibrium, but many possible equilibra in modern models.
Finally, neoclassicals believed generally that is stable and economic depressions are short-lived and that the markets automatically recover from them. Therefore, they favored laissez-faire economic policy.
In modern economics, macroeconomic views are definitely much more complicated.
Since the Keynesian revolution of 1930s, we have several important and popular schools of macroeconomics in which it is claimed that there is no inherent force in capitalism, which would bring the system back to full employment in the period of depression. This view would not be allowed in neoclassical period.
Therefore, economics has changed profoundly from 1930s. Modern economics is much more eclectic (derives its assumptions and methods from several sources) than neoclassical ever was. It uses assumptions that are more diverse and cover much more areas of inquiry.
The only unifying feature of modern economics seems to be – model building. Modern economics relies on building mathematical models, which are further subject to empirical testing.
In addition, what is important here is that mathematics used in building models can be of different level of abstraction and definitely not limited to marginal analysis of neoclassical economics – we can find very abstract mathematics in modern models like the use of set theory and more applied mathematics like game theory.
This is another difference between modern and neoclassical economics, since economic research in neoclassical period was not necessarily conducted in a modeling mode.
The movement away from neoclassical economics has been ongoing since the 1940s. It was a gradual process, slow transition. Neoclassical economics is still taught in undergraduate textbooks, because the modeling approach of modern economics is too difficult to teach on this level.
We will start our discussion of modern economics by a short series of lectures devoted to the developments of modern mainstream microeconomics, later we will turn to the 20th century macroeconomic thought, and finally we will discuss some achievements of modern heterodox, non-mainstream schools of economics.
So today, we start with modern mainstream microeconomics and the main subject of the lecture is the so-called formalist revolution in economics. The impact of revolution was mainly on microeconomics, but it can be argued macroeconomic part of economics was also influenced by this process.
Something happened to economics in the decade of the 1950s that is little appreciated by most economists and even some historians of thought.
The subject went through an intellectual revolution as profound in its impact as the so-called Keynesian Revolution of 1930s. In the effect of this revolution, economics became quite a different science from its neoclassical image. In few years after Second World War, there was a profound intellectual transformation of economic science. We call it the Formalist Revolution.
In the interwar period, in 1920s, 1930s a characteristic feature of economics was that it was pluralistic. In the US we had co-existing many versions of neoclassical economics, institutional school and historical school, while in Europe above mentioned schools co-existed with Austrian school of economics and Marxian approach to economics.
A wide variety of modes of investigation, techniques of analysis and types of policy advice were acceptable in economics in the interwar period. There was no mainstream current of thought in the interwar time. For example in the US institutionalism was slightly more popular than neoclassical economics, but both types of economics were recognized as genuinely scientific and well respected. In addition, there were many advocates of historical school of economics approach, who also were considered as “true” economists.
Therefore, pluralism on the theoretical and methodological level was a dominant feature of economic science before the Second World War.
All that has changed in the decade of 1950s. In the decade institutional, Austrian, Marxian, historical and many other approaches had been marginalized, and since then the mainstream appeared in economics. Economics, and especially microeconomics, became globally uniform in the analytical style, in methods employed in the analysis, and in theoretical results considered important and valid.
The most evident feature of this transformation from pluralism to mainstream led economics is the fact, that economics just after the Second World War quickly became a mathematical science.
The process of mathematization of economics is well documented in empirical studies. For example, the proportion of articles using mathematical expressions in the two major economic journals, the American Economic Review and the (British) Economic Journal, increased from no more than 10% in 1930 to around 75% in 1980.
If in the interwar period and of course before the First World War, you could make a significant contribution to economics without the use of mathematics, it is no longer possible since 1950s. Recall that John Maynard Keynes writing in the mid 1930s managed to transform macroeconomic thinking, so we speak about Keynesian revolution in macro thought and yet he did not use any mathematical reasoning in his writings.
From 1950s economics became a mathematical science and if a contribution to economics is to be considered as scientific and serious it has to be expressed in some form of mathematical formalism.
It can be some abstract mathematical formalism as sets theory or mathematical logic, or more applied formalism as game theory for example, but some form of mathematical reasoning has to be employed if a paper or a book is to be taken as a piece of scientific economics.
It is hard now to publish a paper in a well-respected international journal if it does not use some mathematical formalism.
Moreover, as you probably know from your studies, quite extensive knowledge of various branches of mathematics (like calculus, algebra, mathematical programming, mathematical statistics, some game theory and the like) is needed to understand modern economics.
Before the Second World War, the situation was completely different. Even at many prestigious universities, you did not study any mathematics as a part of studying economics. For example, you could graduate from the famous British LSE in early 1940s, without knowing how to differentiate or integrate variables. As you know today this is a basic mathematical knowledge of students of economics.
There is more, some economists claim that economics in the period from 1950s to 1980s was more mathematical than even natural sciences, than physics. In economics, many very advanced mathematical techniques were applied, and as we learn soon, some very abstract mathematical tools were especially created by mathematical economists to prove economic theorems. Therefore, economists contributed even to the development of mathematics itself.
However, the mathematization of economic language is only one symptom, one external feature of the formalist revolution. It does not lie at the heart of the revolution; it is to some degree only a by-product of the revolution.
The essence of the formalist revolution is that in 1950s and later it was almost universally accepted in economics that the appropriate mother structure for the elaboration of economic theory is the neo-Walrasian general equilibrium theory developed in an axiomatic framework.
Neo-Walrasian – that is updated, modern version of Walras's GET.
This is the most important feature of formalist revolution. Since 1950s, most economists agreed that the most fundamental economic theory is Walrasian GET developed in axiomatic framework. They thought that it would be best if all other theories could be reduced or based on some version neo-Walrasian GET. In this sense in this view, GET was to be mother structure for all economic theories.
All theories, both micro- and macroeconomic should be in this view based on GET and if this approach would be successful, economics would be a united science – on the platform of GE. This is the general project of many attempts of mathematical economists during the time from 1950s to 1980s – to fund all economic theories on GET formulated by the use the so-called axiomatic method.
And the essence of formalist revolution is this conviction that there should be universal foundation of economic science and that the best possible candidate for such a foundation is a specific version of GET developed in a certain mathematical mode – in an axiomatic fashion.
The most important contributions to formalist revolution consisted of various attempts to develop GET in such a fashion and to reduce all other important theories of economics (macroeconomics included) to GET.
Other currents of economic thought, especially those non-mathematical in nature, like institutionalism or Austrian school of economics approach, were quickly marginalized as unscientific or not enough scientific. Simply a mainstream thought in economics has appeared, based on axiomatic GET, and other approaches became less and less popular.
Since 1950s, such approaches as Marxian, Austrian, institutional, historical are considered to be outside the mainstream and therefore not as scientific as the most popular, mainstream approach.
There were, of course, other versions of neoclassical economics than GE approach of Walras. Marshall for example has formulated the approach based on partial equilibrium, simpler that GE and not as mathematically sophisticated as GE approach.
This Marshallian version of neoclassical economics still survived after 1950s, but it was generally transferred to undergraduate textbooks and considered as useful rather only in the process of early education of economists. In research, it was considered not rigorous enough as compared with GE approach.
Formalist revolution was therefore a great after war attempt to build a mathematically well founded GET and to reduce all other important theories of economics (macroeconomics included) to GET.
It is called formalist revolution and not a GE revolution for example, because it involved a heavy use of formal mathematical methods. In addition, often, while developing GET after the Second World War, economists expressed a preference for the form of their arguments over its content.
That is their preferred even weak arguments, but expressed in a formal mathematical language over possibly stronger or more important arguments, but expressed in a less formal mathematical language.
Hence, because of this preference for formalism, for formal mathematical arguments, this process of mathematization of economics, process of the emergence of mainstream economics after the Second World War, is called formalist revolution.
Now, we said that in 1950s and later a general view of most influential economists was that all economic theory should be based on some variant of GET developed in an axiomatic mode.
Now, the question of what is an axiomatic method?
To answer this question we have to look for a moment in the history of mathematics in the 19th and 20th century. It is necessary to turn to the history of mathematics to explain the history of economics in the 20th century, because as we have stated, in the 20th century economics has become a mathematical science.
Therefore, we have to understand how mathematics had been changing in the period, because it influenced the way how mathematics was employed in economics.
In general, there are two visions of mathematical rigour that were employed in economics in the 20th century.
The first one is, we could say, the 19th century or empirical vision of mathematical rigour. The predominant attitude of economists to mathematics at the turn of the 19th century was ambivalent and suspicious. This view was shared by English neoclassical economists (e.g. Alfred Marshall and later J. M. Keynes) but also by American Institutionalists and to more extent by various proponents of the German Historical School.
Mathematical rigour to this group of economists meant that properly formulated economic concepts and theories should correspond to some measurable objects and identifiable causal relationships in reality.
That is mathematical models in economics should refer only to some events and processes which exist in the real economy – this is the most important feature of this concept of mathematical rigour, which was shared by English neoclassical economists, institutionalists, and other economists in late 19th century and in early 20th century.
However, in the early 20th century another concept of mathematical rigour appeared in mathematics and was quickly transferred to economics. This is the axiomatic approach.
According to this view of mathematics, rigorous arguments are those, which are derived axiomatically, i.e. developed by the means of formal logic from the set of basic, independent and mutually consistent propositions (axioms). Those axioms do not have in principle to correspond to any existing object, it is enough if they are consistent with one another and fertile, we could say, that is that they imply interesting consequences in theory, you can derive from them interesting mathematical theorems.
Axiomatic approach from 1920s to at least 1980s was considered in mathematics as the most rigorous approach to mathematical inquiry.
It was this new “axiomatic approach” to mathematics that has invaded mainstream economic theory from the 1950s on.
Therefore, there have been two main competing notions of mathematical, and therefore scientific, rigour prevailing in the twentieth-century mathematical economics. The “old” one, 19th century, “empirical view” associated with developing theories in a mathematical form from observations about the economy and ultimately subjecting them to empirical testing and the “new” one based on the axiomatic approach.
The former in the course of the 20th century was preferred by applied economists and econometricians, while the latter – axiomatic one was preferred by theorists in mainstream economics. In the first place, they used axiomatic approach to develop GET as a foundation for a united economic science.
The axiomatic approach is much more abstract and does not demand that the concepts used in mathematical economics have any close counterparts in economic reality. The most important thing is that this approach is mathematically reliable, if the axioms are true the approach leads without doubt to true conclusions.
Now, there is the question how the axiomatic approach was transferred to economics? And why it found a fertile ground to grow and flourish in post-war economics ?
A person “responsible” for transmitting axiomatic notion of mathematical rigor to economics
was a French mathematician and economist Gerard Debreu.
Debreu (b. 1921 in France) was awarded the Nobel Prize in Economics in 1983 for his contribution to the mathematical economics.
In 1940s Debreu was a very well trained and talented mathematician who believed that only the axiomatic approach should be identified with “good” mathematics.
In 1950 Debreu joined The Cowles Commission for Research in Economics at the University of Chicago, US, (from 1955 associated with Yale University), a centre founded in 1932 for the advancement of economic theory in its relation to mathematics and statistics. The Cowles commission contributed much to the development of econometrics and mathematical economics and it is considered the most important organization for the history of American economics.
In Cowles Commission Debreu became to reformulate GET in an axiomatic fashion. Because of his activity, axiomatic method quickly became the house doctrine, the basic economic approach, of the Cowles Commission and under the influence of the members of the Commission, it began to spread throughout American graduate education in economic theory, as the members of commission became employed into the major economics departments in America.
In addition, as you know, since in the second part of 20th century, the US has become the leading country in economic research and economics in other parts of the world has developed in accordance with American trends, the axiomatic approach has expanded to Europe and other continents.
Why the axiomatic approach and GET developed in this fashion has became so successful, why it has become the heart of the mainstream economics?
It is not an easy question to answer, but it seems that many economists in 1950s believed that that axiomatic method could promise a neutral and rigorous perspective to settle some contemporary debates and controversies (e.g. between neoclassical economics and Institutionalism, between rival versions of neoclassicism or between Keynesians and non-Keynesians).
Moreover, from the 1940s on the axiomatic approach became a mainstream in American mathematics itself. Its use in economics was therefore justified by applying the only authoritative method of “the queen of the sciences”, that is mathematical science. If this is the only real mathematics, then why use something different in economics, especially if you wanted economics to be a real hard science, similar to natural sciences.
As a digression, I can say that the shortcomings of the axiomatic approach were evident and acknowledged in the discipline of mathematics by the 1970s, and the approach was to a large degree abandoned in mathematics by 1970s.
But similar process is only now coming to economics, that is only recently economists started to doubt in axiomatic method.
OK, so far we have described how historically GET developed in an axiomatic fashion has become mainstream economics in 1950 and later decades. Economists simply assumed that this is the most general economic theory and if developed by the best available mathematical method (axiomatic one), than it could make economics a real, hard, rigorous science.
Axiomatic GET has therefore become the main, the most prestigious research program in economics in the period from 1950s to at least 1980s. There very many efforts to fund other parts of economic science of axiomatic GET.
Even today if you look at the most popular in the US advanced graduate textbook on microeconomics, than GE models cover about one-third of the book and the book is over one thousand pages long. Therefore, still, this is probably the most important part of economic theory.
So what were the greatest achievements of this program, axiomatic GET?
The most famous one is the formal correct proof of the existence of competitive equilibrium. As you remember this is the problem Walras tried to resolve in the late 19th century by counting equations and variables in his model of GE. But his solution was mathematically naïve.
There were many other attempts to provide a proof that the solution to GE model exists – that is that there is a set of prices, which clears all the markets at the same time.
First complete and correct proof was due to Gerard Debreu, of course, and Kenneth Arrow, who in 1950s was another prominent proponent of axiomatic method in economics.
In 1954, they published a paper on the „Existence of an Equilibrium for a Competitive Economy”, in which the proof was provided. It was the great achievement since it established that you can meaningfully speak about market equilibrium and you can develop the GE program further.
The proof of the existence of GE is one lasting achievements of the program, but what about others?
Of course, other important questions in GE framework are the problems of the uniqueness and stability of equilibrium.
The problem whether market equilibrium in a model is unique or there are many equilibria is important, for example in matters of economic policy, since if there are many equlibira it is not easy to predict what equilibrium will be achieved in the end. Therefore, it limits the predictive powers of economic theory. You could not say in a clear way with respect to such a model, what will be the market equilibrium, so it limits the use of economics in practical economic policy.
And the problem of stability of equilibrium is even more important
The stability question for competitive equilibrium is an essential part of the general equilibrium research program. Some have gone so far as to describe the discovery of a universal and globally stable adjustment process to market equilibrium as the ‘Holy Grail’ of general equilibrium theory.
The reason the stability question has this special status is easy to see. Without an argument establishing the existence stable equilibrium prices, equilibrium states, even if they exist and are optimal, lose their appeal.
In fact, if no convincing stability argument can be made then general equilibrium states might just as well not exist, because nothing in the operation of the economy will lead to their establishment. Alternatively, if the economy will deviate from them there is no hope that it will ever return to them – so their existence is of smaller importance.
These are important theoretical problems – let's see how mainstream economics tried to solve them.
In general, we could say that the results achieved about the uniqueness and stability of equilibria emerged to be rather negative.
In many attractive GET models, there are multiple equilibria, and there are many important ones in which there are infinitely many equlibria.
With reference to the problem of stability of equilibria we can argue that all global stability results are very special and relatively unconvincing, often the stability of equilibrium in GET models can only be guaranteed under restrictive and implausible conditions.
In general this important part of GET, as it became known in late 1970s, brought rather negative and pessimistic results.
What about the abovementioned theoretical problem of reduction of other economic theories to GET?
Mainstream economists in the period from 1950s to 1980s had pursed a project of reducing all other important economic theories, and especially macroeconomics to GET. Did they succeed?
In this project mainstream economists wanted to fund macroeconomic theories on the so-called microfundations, that is on the basis of some fundamental axioms from mainstream microeconomics, like the axioms that consumer's preferences are transitive and complete.
Since it was microeconomics, and especially GET, that was the most formal and mathematically correct econmic theory, no sub-field of economics could be said to have an adequate foudation without becoming funded on GET.
In 1960s, 1970s and early 1980s every macroeconomic model was considered suspect without some sort of microfundations in GET – that is every serious macromodel had to be formulated on the basis of microeconomic axioms, like axioms concerning consumer's preferences. In this sense, modern mainstream economics attempted to reduce macroeconomic theory to microeconomic GET.
But as it was proved already in 1970s that these efforts to reduce macrotheory to microeconomic GET were futile. The results which show the impossibility of reduction of macroeconomics to GET are known under the name of Sonnenschein-Mantel-Debreu (SMD) theorem (or theory), after the names of economists who in a series of papers in 1970s provided similar proofs of this impossibility.
And as you can see Gerard Debreu, one of the greatest advocates of and contributors to GET, was among those who proved the failure of GE to provide the basis for a universal, global economic theory.
What is the essence of SMD theorem?
The theorem implies that under standard neoclassical assumptions on the individual consumers, such as transitivity and monotonicity of preferences, so that each agent is characterized by textbook convex indifference curves one can derive market aggregate demand curves for the whole society. However, these market demand curves satisfy only those mathematical conditions that allow you to prove the existence of the market equilibrium. They do not satisfy stronger conditions needed for the proof of uniqueness and stability of the equilibrium at the aggregate, macro level.
In simpler words, in general, those market demand curves can be of almost any shape, not necessarily negatively sloped as suggested by textbooks.
To put it differently, you would have to impose different than standard, very strong, unrealistically strong, restrictions on consumer's preferences to build on the basis of those preferences market demand curves which would be well-behaved, negatively sloped, so that unique and stable equilibrium would be possible.
The conclusion from SMD theorem is that the standard micro model of GET has almost no implications for macrobehavior, formalist GET had reached a dead end – no general results beyond the existence of equilibrium were possible and it is not possible to fund macroeconomic theories on GET.
This is a very pessimistic result for mainstream economics in GE mode. The SMD theorem became well known in economics by the early 1980s and it became increasingly clear to many economists that GET could not fulfil a promise of over 30 years since 1950s.
It is difficult to overstate the importance of SMD result for neoclassical mainstream microeconomic theory. It meant that microeconomics could not yield determined general equilibrium – unique and stable.
It also meant that the project of providing aggregate macroeconomic phenomena with a basis in GE microeconomics had ended. The SMD result had an epoch-ending impact. The former champions, advocates of GET have had to abandon the field. One of the modern economic theorists, in a paper devoted to the problem of oil trade in general equilibrium modelling, wrote: “the near emptiness of GET is a theorem of the theory [of GE]”.
Once the SMD theorem called into question the central status of GET, since the mid 1980s, we can observe a stage of pluralism in microeconomics. The SMD result put an end to neoclassical GET.
Still in textbooks, applications and much of economic practice, GE persists, but other methods of research have appeared in microeconomics since the mid-1980s.
Notably, game theory, the so-called complexity approach and experimental economics began to be more and more popular. These trends were not originated by any significant theoretical or methodological innovations in those currents.
Rather, the relative fall or decline of GET, vacated the dominant position it had enjoyed since 1950s, and these alternative approaches were able to develop and to contribute to issues that the previous theory (GET) could not.
So today, even GE theorists characterize the situation in modern microeconomics, in the last 20 years as a state of moderate pluralism.
Since the mid 1980s, we have the still-continuing wave of pluralism in economic theory, at least in microeconomics, similar to the inter-war pluralism.
The most prominent of the pluralist approaches in micro, after the fall of GE, became game theory.
In early 1980s, as increasing number of economists accepted the power of SMD theorem, game theory seemed to have certain advantages over GE approach.
Game theory dealt with strategic interactions of economic agents, had been previously applied in models of imperfect competition and in 1970s and 1980s there had been a major progress in game theory.
Many new concepts of game theoretic equilibrium, over the standard Nash equilibrium, were developed in the period.
In 1980s, the turn toward game theory gained enormous momentum. Game theory became the most fashionable tool of microeconomists. Somebody said that in 1980s, “the only game in town was game theory” - it became the dominant method used in economic theory.
However, game theory reached beyond the pure theory of economics, transforming many fields, for example industrial organization and international economics. In particular, industrial organization, that is the theory of market structures (describing perfect competition, monopoly, imperfect competition, and oligopoly) was thoroughly changed – all those models were reformulated in a variety of forms in a game-theoretic language.
In short, game theory dominated microeconomics and its applied fields in 1980s.
Unfortunately, as it emerged quickly game theory suffered from several foundational problems.
A key problem for game theory was the very concept of rationality in a game theoretic setting.
The primary difficulty here is that the common solutions of game theory like Nash equilibrium concept are associated with extremely implausible, unrealistic assumptions. These are the so-called common knowledge assumptions.
Common knowledge means that each player knows each player's rationality, strategies, and the structure of the game.
Simply, quite a big body of knowledge is assumed in game theory,
The idea of strategic play, which assumes that players guess actions of other players in the face of lack of knowledge, is rather not coherent with common knowledge assumptions.
In addition, it has been shown that game theoretical assumptions and models of rationality are incompatible with experimental evidence – people in reality often do not behave as game theory suggests.
In response to those problems in standard game theory, in which it is assumed that agents maximize their expected utility, a new current of game theory was originated from about the year of 1990. So it is a very recent approach, it is called evolutionary game theory.
In this approach, economic agents are rule following rather than maximizing.
This means that agents base their actions on a specific rule of behavior – it does not have to be a rule of maximization of utility. It can be a rule of limited maximization, or it can be assumed that agents care about the utility of other agents or it can be assumed that agents not even try to be rational (in the sense of maximizing behavior).
In evolutionary game theory you seek for equilibria states, in which only the fittest agents survive, the population evolves in such a way that more successful types of agents replace less successful ones – just like in the biological theory of evolution.
Evolutionary game theory shows how far contemporary economic theory ahs come from its neoclassical origins, where rationally maximizing behavior of individuals was thought to be necessary for a good economic model.
It is no longer necessary in modern economics that the agents be rational, they can follow any rule of behavior, which is successful in the long run evolution of population.
Another example of pluralism in modern microeconomics, following the demise, the fall of GET, is the quite impressive recent rise of experimental economics – a field in which economists try to conduct scientific experiments to verify some theories, just like scientists in natural sciences (physics for example).
This field also shows how much modern economics differ from neoclassical economics of the pre-war period.
Experimental economics has become a well-established field in economics in the mid 1980s; previously papers in experimental economics were published mainly in psychological journals. This field could not flourish during the dominance of GET from 1950s to 1980s, when deductive and axiomatic methods were considered the most fruitful for economists.
Experimental method is by the nature inductive, that is, it is based on the observation of several examples of certain events or phenomena, and formulating more general statements on the basis of these observations.
From 1950s to 1980s, this method was considered as scientifically weak in economics, and many experimental results were simply ignored. For example, since 1950s it was very well known in experimental research that people's preferences are often not transitive.
Preferences are transitive if the following condition is fulfilled, if agent prefers A to B, and B to C, than he or she prefers A to C.
Still this experimental evidence was ignored, because the transitivity of preferences was assumed in GE framework as axiom, which was not subject to empirical testing.
However, more recently, since the mid 1980s, following the GET's troubles with SMD theorem, we see a different situation, a situation in which experimental results are treated seriously as scientific.
Experimental results helped recently to remove the postulates of rational, maximizing behavior from the center of modern economic theory, in favor of evolutionary game arguments of rule following of agents.
Therefore, we have discussed briefly three examples of pluralism of modern microeconomic theory: standard rational choice game theory, evolutionary game theory and experimental game theory.
These three examples of modern pluralism, following the fall of GET theory, depart in different ways from the GE program. Rational, standard game theory is interested in strategic interactions of economic agents (while in standard GE framework agents do not take into account other agent's actions).
Evolutionary game theory deviates from GE, focusing on not necessarily rational actions.
Experimental economics favors inductive approach over deductive, axiomatic approach of GE.
They all contribute to the present state of a wide variety of approaches to modern microeconomic theory – there are also some other approaches today which we did not discussed, for example the so called complexity economics, which relies on some methods of physics, or computational economics, which is based on computational methods taken from computer sciences.
Therefore, recent modern microeconomics, theory of the last 20 years, is not monolithic, but rather quite pluralistic.
Some conclusions about modern microeconomics.
Modern, post-war microeconomic theory has undergone several transformations. From interwar pluralism it became a monolithic mainstream economics of the 1950s, 60s and 70s decades. This process, the formalist revolution, aimed at funding all economic theory on GET developed in axiomatic fashion.
But GET has exhibited rather the lack of progress, especially in the context of Sonnenschein-Mantel-Debreu result. In 1980s, it became obvious that you can not prove much in GET beside the demonstration of the existence of GE.
Especially, the idea of basing macroeconomics on GE microfundations was challenged and abandoned.
The more general idea of creating any universal economic theory, which would unite micro- and macro theory was abandoned in favor of pluralist view. The formalist revolution ended in mid 1980s.
As GET began to have problems, in 1980s rational choice game theory came to be the most fashionable tool in economic theory, but the implausible assumptions about the common knowledge turned the attention of many economists to evolutionary game theory and experimental economics, even though those currents reject, respectively, the long-held economic assumption of rational maximization of agents and formalist axiomatic style of reasoning.
So today's microeconomics is a plural environment.
From inter-war pluralism, through post-war mainstream monolithic economics, in the recent 20 years economics returned to moderate state of pluralism.
There are many unsolved problems in contemporary microeconomics, in various versions of game theory, and in experimental economics, and still GET plays an important role in modern economics, although it is generally recognized that it is plagued with the problems of determination of equilibria, described in SMD theorem.
So today's microeconomics is very diverse and its future evolution is uncertain, but there is one constant factor in all those developments of since 1950s. This is the persistence of the mathematical mode of reasoning. All the postwar microeconomic theory we described, had been stated mathematically.
Even experimental economics, which is more empirical and inductive in nature, in nearly always about testing some mathematical model.
Modern Macroeconomics
Economists' interest in macroeconomic issues has fluctuated throughout the history of economic thought and reached its lowest point around the turn of the nineteenth century.
The attitude of economic profession at that time, late 19th century, to macroeconomics can be characterized almost as neglect of those issues, macroeconomics was almost abandoned. Neoclassical economics in the hands of Marshall and Walras was interested mainly in static micro issues of optimal allocation of resources in partial and general equilibrium framework.
Other important school of economic thinking at the turn of 19th century, historical school of economics and institutional economics were interested rather in criticizing neoclassical microeconomic approach or involved in broadening the subject of economics to analyze some interrelations between economy and culture.
Traditional macroeconomic subjects like economic growth, economic fluctuations, inflation and the like were not analyzed in detail.
Especially, economic growth, which had been the focus of Adam Smith's work, received only slight treatment in later classical and neoclassical periods. Economic fluctuations were not sufficiently treated as well, neoclassical economists simply assumed full employment of all resources, funding this assumption on Say's Law (which claims that supply always creates its own demand).
This state of macroeconomic thought continued until 1930s, when the Great Depression, that is the biggest economic crises in the history of capitalism, led to new works on understanding business cycles. During the period from the 1930s to late 1970s, macroeconomics continued to focus on business cycles, it was the most important single macro issue in mainstream macro theory.
In this period, several approaches to the problem of business cycles were formulated. First in 1930s we had the Keynesian revolution, John Maynard Keynes proposed a new theory of economic fluctuations, which aimed at explaining why economic depressions in capitalism can be severe and long lasting. Keynes also wanted to show why there is no inherent mechanism in capitalism to self-adjusting to full employment.
In short, Keynes rejected almost all classical and neoclassical views on the problem of business cycles.
In subsequent decades of 1940s, 50s and 60s, neoclassical economists managed to incorporate several Keynes's ideas into macroeconomic theory known as neoclassical synthesis – a combination of neoclassical assumptions and Keynesian prescriptions in economic policy.
Mainstream macroeconomic thought in this period from 1940s to 1960s was generally neo-Keynesian (combination of neoclassical and Keynesian macroeconomics) in admitting that free market capitalism is prone to frequent and sometimes severe depressions and that it the government should play an active role in preventing economic depressions or bringing the economy back to the full employment.
In 1970s and 1980s, economics witnessed a strong reaction against neo-Keynesian macroeconomics; several classical or neoclassical in spirit approaches to business cycles were formulated. The general view defended by these approaches was that it is the government, who is responsible for major economic depressions and that the state cannot help free market economy in adjustment to full employment.
This turn to neoclassical views in macroeconomics of 1970s' and 1980s found in turn a strong reaction from the followers of Keynes's approach – since 1980s, several the so-called New Keynesian models of business cycles have appeared in economics.
However, this battle between classical or neoclassical on the one hand and Keynesian or new Keynesian approaches to the problem of business cycles, has lost much appeal in 1990s. Since 1990s, the primary focus of leading macroeconomists has been economic growth. There were mainly two reasons for this shift from focusing on business cycles to increased interest on growth.
First, empirical evidence suggests that the phenomenon of economic growth is much more important for the well-being of societies, than business cycles, it is better for the society to stimulate growth, than to try to prevent business cycles.
Second, some revolutionary theoretical developments in the theory of growth have been made in 1990s, and a class of new models of growth has appeared, these are the so-called endogenous models of economic growth.
Modern macroeconomics consists mainly of three parts: the theory of economic growth, business-cycle theory and the theory of general level of prices.
A short review of economists’ views on these three topics in the early 20th century, before 1930s.
We start with growth theory.
We have already stated that after Adam Smith had given his insights about economic growth, the attention of most of mainstream economics turned to microeconomic issues like determination of prices, distribution of income and the like.
Moreover, most of later classical economists, like David Ricardo and John Stuart Mill were rather pessimists about economic growth; they thought that they scientifically proved, as you should remember, that capitalism progresses towards the stationary state, a state in which the rate of economic growth is equal to zero.
They thought that increases in capital and labor as well as the technological improvements are not enough to counterbalance the decreasing returns from labor and capital, and that in the long run the economic growth will simply stop.
In the neoclassical period, economists focused even more on microeconomic issues, most of them late in 19th century and in the first half of 20th century did not deal with growth.
One important exception was Joseph Schumpeter (1883-1950), an Austrian economist (though not an 'Austrian economist' in the sense of being a member of the Austrian School of Economics), because Schumpeter is hard to fit into any economic school of thought. He was close in some of his views to Austrian approach to economics, while being also neoclassical in other respects.
Schumpeter laid the foundation for his theory of economic growth in The Theory of Economic Development, published in 1934.
Schumpeter in his explanation of economic growth has stressed several non-economic causes of growth. He insisted that the principal factors influencing growth, and at the same time, the factors that will reduce growth in the long run development of capitalism, are non-economic in nature.
Those non-economic factors of growth are to be found, according to Schumpeter, in the institutional structure of the society.
Schumpeter thought that the tremendous economic growth that took place in capitalist world was the effect of some special activities of some businessmen, those who take risks of starting new firms, introduce innovative products and new technology into the economy. Those businessmen were called by Schumpeter – entrepreneurs.
Schumpeter distinquished between the process of invention and that of innovation.
Invention is the creation of something new, a new good or service, but what really matters for economic growth is innovation, the act through which these new ideas are successfully introduced to the market.
Only a few far-sighted innovative businessmen are able to grasp the potential of a new invention and exploit it in the process of innovation for personal gain. Those are real entrepreneurs, quite unique businessmen, who are not afraid of taking risks. After they introduce innovations into the economy, other more risk averse businessmen follow them, and the innovation – new product or technology, will spread throughout the economy.
The real source of technology-driven economic growth lies in the activities of only those most brave businessmen, entrepreneurs.
Therefore, economic growth is accelerated in the institutional framework of the economy, which is friendly to those special businessmen, entrepreneurs, which rewards and encourages their activities.
Early capitalism, 19th century capitalism, with private property and laissez faire economic policy, was ideally suited to economic growth, state and government did not intervene much in the economy, so the entrepreneurs acted in a very favorable environment.
In a mature capitalism, according to Schumpeter, economic growth will stop. The development of capitalism will be brought to its end, paradoxically, because of the success of capitalism.
First, the role of entrepreneur will diminish because, in mature capitalism large, big firms appear, they eliminate smaller firms in the process of competition, and they become risk averse. Those big firms, monopolies, oligopolies, will be run by bureaucratic committees, not by innovating entrepreneurs.
Those committees or managers hired to run companies in mature capitalism will not be so brave, so risk taking as entrepreneurs in early capitalism. Therefore, the main source for technology driven economic growth will disappear.
Moreover, according to Schumpeter, the political support for capitalism will die out in the long run. Companies will be owned by stockholders, and directed by hired managers, so the desire to defend private property will not be as strong as in early capitalism.
Entrepreneurs are gone, and nobody in the society cares enough about whether the economy is based on private or on the collective property.
This attitude toward private property will prevail also among the working class and public at large.
Finally, according to Schumpeter, mature capitalism, with high level of incomes and wealth, will produce a class of intellectuals
Intellectuals, according to Schumpeter, are people who can earn their incomes because the mature capitalist society is in general wealthy, and they can be employed at various occupancies, but people who at the same time criticize capitalism. They will radicalize labour union movement, advice politicians, and will be able do disseminate throughout the society a discontent with the institutions of capitalism.
So Schumpeter thought that intellectuals hold in general leftist views, they are proponents of some version of socialist economy.
Himself Schumpeter was a defender of capitalism, he held conservative views, but thought that abovementioned processes are inevitable, he was not happy with his vision, but thought that this was a scientific vision of the development of capitalism.
So, he predicted that slowly but surely entrepreneurs will demise, government will intervene more and more in the economy, intellectuals will act against capitalism, innovations in the economy will become a rare thing and in the end economic growth will stop and economy will become socialist.
In Schumpeter’s theory of economic growth the main factor, which determines the fate of economic growth is non-economic, it is rather cultural or sociological factor – the role of entrepreneurs will be diminished because in wealthy capitalism people will have less incentive to be risk taking businessmen, they will rather engage in easier tasks.
In addition, the class of intellectuals appears which will speed up the process of the demise of capitalism - this is also a sociological factor in this growth theory.
Schumpeter theory did not influence mainstream economics in subsequent years, in large part because he did not present his vision in a formal, mathematical model, but in a literary prose, and this was not acceptable to rising mathematical economics in the 2nd part of 20th century.
Formal, mathematical models of growth appeared only in 1950s and we will return to those models, but from the 1930s to 1980s, the economic profession did not have much interest in growth models and concentrated on the problem of business cycles.
Few words on the theory of general level of prices before Keynes.
Before 1930s, classical and neoclassical economists were heavily interested in the problem of what determines the general level of prices in the economy, to explain movements in prices, inflation or deflation, for example.
To answer this question classicals and neoclassicals formulated several versions of the so-called quantity theory of money. We have already mentioned this theory, because David Hume formulated its first version in 18th century.
In essence, quantity theory of money, in one specific version states that, as you know probably that
MV = PT,
where M is the quantity of money in the economy, V is the velocity of money (how often each unit of money is spent during every year), P is the measure of the price level, and T is the volume of transactions (total number of commodities purchased during a year with those kind of money represented by M.
There is an assumption in the theory that V and T are determined by non-monetary factors, that is that M and P do not influence V or T.
So, according to the theory if you increase the supply of money in the economy, M, they the only effect in the economy will be an increase in prices, P, and in particular, this will not influence national income or the volume of transactions T.
The implication is that monetary policy cannot influence production, unemployment or bring back the economy from the depression.
This was the view of neoclassical economists before 1930s.
The last thing about the macroeconomic views before 1930s – what were the views on the problem of business cycles?
Although fluctuations in economic activity, business cycles, that is periodic expansions and contractions of economic activity, had been occurring since the beginnings of capitalism, orthodox economists made no systematic attempts to analyze this phenomenon until the 1890s.
Of course, Marx analyzed business cycles, but his works were largely ignored by orthodox, classical and neoclassical economists.
One major exception to the generalization that orthodox economists prior to 1930s were not interested in business cycles, is the wok Mikhail Tugan-Baranovsky (1865-1919), Ukrainian economist.
In 1894, he published, first in Russian, a book called Industrial Crises in England.
He reviewed all prior attempts to explain business cycles, for example Marx’s analysis, and found all of them unsatisfactory.
Tugan-Baranovsky’s main contribution to our understanding of business cycles was his statement of two principles:
that economic fluctuations are inherent in capitalist system, because they are the result of forces within the system
that the major causes of business cycles are to be found in the forces determining investment spending.
But he did not formulated any model explaining how distortions in investments can lead to business cycles, only identified that investments are the main trouble leading to depressions. So his contribution is very limited in fact, it is not a complete, well-specified theory of business cycles.
The economics of John Maynard Keynes.
Last time we have discussed the developments in macroeconomics of the first 3 decades of 20th century – that is 20th century macroeconomics before 1936, when John Maynard Keynes published his General theory, which changed the whole field of modern macroeconomics.
Before Keynes, general economic thought consisted of fairly well developed microeconomics explaining the allocation and distribution of resources in the economy, a macroeconomic theory explaining the forces determining the general level of prices (that was quantity theory of money) and also a very loose set of notions concerning economic growth. The theory of business cycles was missing.
John Maynard Keynes is doubtlessly one the most important figures in the entire history of economics. His writings completely revolutionized macroeconomic theory and practice of economic policy in the 20th century.
His book The General Theory of Employment, Interest and Money, General theory, in short, published in 1936, is generally regarded as probably the most influential social science treatise of the 20th Century, in that it quickly and permanently changed the way the world, scientific and public, looked at the economy and the role of government in society. No other single book after Keynes’s has had quite such an impact.
Born in 1883 (died 1946), he was a son of John Neville Keynes an important British economist on his own right.
He was educated at Cambridge University, and after performing some functions for British government, he returned to Cambridge and become an academic economist.
But he was not only an economist, he was engaged in many different activities, was interested in theatre, literature, and the ballet – he married a ballerina and was associated with a famous group of British intellectuals and artists, which included Virginia Woolf, for example.
He took a number of government posts throughout his life. He was active in business affairs for himself, he was a stock investor – and very able in this activity, his net wealth rose from near bankruptcy in 1920 to more than 2 million US dollars by the time of his death in 1946.
He was also a very able mathematician; in 1921, he published a very good treatise on probability.
However, the single most important aspect of Keynes as economist is his orientation toward policy. He attended the peace conference after the First World War as a representative of British treasury Department, and published two books concerning problems of practical economic consequences of peace and war.
In 1926, he published a short book under the title The End of Laissez-faire, in which he claimed that the automatic adjustment of the economy to equilibrium position at full employment is only an economic myth, fiction, it is not a correct deduction from the principles of economics.
So Keynes did not believe in Adam Smith’s metaphor of invisible hand of markets.
He rejected this vision because for him it was an intellectual mistake and because it constituted for him a dangerous illusion when it informed one’s political vision in matters of economic policy.
In 1944, he was instrumental in the formation of the International Monetary Fund (IMF) and the World Bank, very important economic institutions in the 2nd part of the 20th century.
But his most important contributions to economic policy, and of course to economic theory, are contained in his General theory, of 1936.
In General Theory Keynes stated that his theory is a general theory in the sense that previous theory is a special case to be placed within his more general framework. By previous theory, Keynes meant both classical and neoclassical economics, the economics of Ricardo, Say, Mill, Marshall and others.
Classical and neoclassical economists assumed that equilibrium at macro level in capitalism could only be achieved at full employment of resources, especially labor. So in general classical and neoclassical economists held that unemployment in capitalism is either voluntary (people do not wan to work at market wage), or that unemployment is temporary, short lived, or that unemployment is caused by government intervention (for example minimum wage legislation).
Therefore, the best policy to achieve macroeconomic equilibrium and full employment is laissez faire policy, policy of governmental non-intervening in the economy.
The basic point made by Keynes in his General theory is that equilibrium at less than full employment of resources (especially labor) could exist in capitalism for a long period. And that classical and neoclassical view of full employment of resources in capitalism is only a very special situation, which rarely occurs in reality. In this sense, he thought that his theory is more general than classical macroeconomics, which could be applied to explain the economy only in one, very special case of full employment of resources.
Therefore, he rejected the view that capitalism is a stable and self-adjusting economic system,
According to Keynes, there are forces inherent in capitalism, which could bring the system to a long-lasting depression.
In this, Keynes rejected the optimistic vision of classical and neoclassical economists about free market and laissez faire capitalism as a economic system which is optimal on the macro level.
According to Keynes, orthodox theory (classical and neoclassical macroeconomics) was unable to explain such problems as business cycles, long-lasting depressions or involuntary unemployment. This was the major problem with orthodox macroeconomics, because the problems of business cycles and unemployment were the most serious economic problems of his time.
I should recall you here, that since 1929 capitalism had been suffering the great depression, so the publication of General theory in 1936 was in part a intellectual response to this biggest economic catastrophe of capitalism in history.
Few words on the great depression
The Great Depression was the worst economic slump ever history, and one which spread virtually all over the industrialized world. The depression began in late 1929 and lasted for about a decade.
The worst hit were the most industrialized countries, including the United States, Germany, Britain, France, Canada, and Japan.
Construction industry, for example, virtually stopped in the United States and other countries. Incomes for Farmers in US dropped by about 50%.
Unemployment rate rose in US from 3% in 1929 to 25% four years later - it was a drastic increase in unemployment.
US production level dropped by about 30% in the first two years of the depression.
More or less disastrous were the consequences of the depression in other capitalist countries.
Therefore, it was a devastating international crisis.
We should remember that Keynes’s General theory was published in such a time, the years of most severe international economic depression. Keynes’s motivation was, in part at least, to find a scientific explanation for such crises and to develop political tools to ease the consequences of the depression.
Since orthodox economics could not explain such deep and long lasting depressions and laissez-faire policy (policy of not intervening in the economy), could not help in bringing the economies back to the full employment states, Keynes had to depart from orthodox macroeconomics. He therefore constructed completely new macroeconomic theory.
Let’s examine his theory in a little more detail.
First, in general theory Keynes rejected the classical macroeconomic concept of Say’s Law. Say’s Law accepted by majority of classical and neoclassical economics holds that supply creates its own demand, which means that production generates expenditures and demand by firms and households, which are just sufficient to buy out all commodities produced.
If Say’s law holds in the economy, than there is no place for any serious economic crisis.
Production is determined by real factors, like the stock of labor, the stock of capital, technology and the like, and the production process creates sufficient purchasing power to maintain the full employment of resources. There is always full employment of economic resources. This was the view of classical macroeconomists.
Keynes rejected Say’s law, and argued that it is not production, which generates demand, but it is rather that production adjusts to demand created by firms and households.
The demand side of the economy determines production and employment level in Keynes’s analysis; they depend on the expenditure decisions of households and firms.
Keynes stated that production and employment are determined by the so-called effective demand, the sum of investment and consumption expenditures by firms and households.
In this view Keynes has turned classical theory on its head – production is determined by demand, while in classical view demand was adjusted to production.
The most important implication of this theory of effective demand is that the level of production determined by demand (the sum of investment and consumption expenditures) is at equilibrium point, but this equilibrium does not have necessarily to be at full employment of resources.
Since it is effective demand that creates production, than if effective demand is not as great as full employment demands, than it will generate production level, which does not require full employment of resources. The implication of Keynes’s view is that there could be equilibrium in capitalism at less then full employment of resources.
In classical view it was impossible because, equilibrium was determined by the production, supply side of the economy, so classical economists assumed that there is full employment of resources and that production at full employment generates demand and equilibrium state.
The rejection of Say’s law and the statement that effective demand generates production allowed Keynes to argue that there is a possibility of equilibrium in capitalism at less than full employment of resources.
Why there should be an effective demand not sufficient to generate the production that would require full employment?
What is the reason for which effective demand could be so low, as to create low level of production – the level that would not require full employment of labor, for example?
In other words, what is Keynes’s explanation of the instability of capitalism? Why capitalism can achieve equilibrium at less than full employment of resources? For what reason effective demand could not generate full employment level of production?
As we stated before effective demand is the sum of aggregate investments and consumption.
Keynes focused on the problem of why investment part of effective demand did not normally settle at the level that guarantees full employment.
Investments in his theory depend on the so-called marginal efficiency of capital, which is an estimate of the future returns of investments, in other words it is the rate of return from capital that businessmen expect to achieve.
The problem is that the businessmen assess the profitability of investments on the basis of their expectations about future – marginal efficiency of capital is the expected rate of profit. So their calculations of the marginal efficiency of capital are based on their assessments about the future trends of the economy, and those assessments are influenced by psychological, irrational factors.
Future is uncertain and expectations are volatile, they change quickly and irrationally. Investors moods (waves of optimism or pessimism), states of confidence, and what Keynes called ‘animal spirits’ of the investors play a key role in the formation of their expectations and investment decisions.
By animal spirits, Keynes meant some kind of intuitive, unconscious mental actions, irrational actions, not based on economic calculation.
If such irrational, psychological factor influence investors assessments of marginal efficiency of capital, than their investment decisions are not rational.
Since investments as a part of effective demand, play a big role in determining levels of production and employment, than those levels of production and employment depend on uncontrollable, and extremely unstable psychological factors – like those animal spirits.
So, investment decisions are to a large degree not rational and therefore investment levels are volatile – this is the fundamental reason for which effective demand can, for example, fall drastically even if the economy if performing well from the rational point of view.
Unstable investment expenditures are the main reason for capitalism being unstable in Keynes’s system. If investors driven by irrational moods, animal spirits, lose confidence in the future prospects of the economy, than the effective demand can decrease significantly and for a long period, and the equilibrium will be achieved at less than full employment of resources.
These are, in short presentation, Keynes’s reasons for why in capitalism there can be long lasting economic depression.
Keynes made also a very important contribution in the theory of interest rate by stating that the market interest rate is determined not in the investment-savings market (as classical economists thought), but in the market for money, for him interest rate is determined by the forces that shape the supply and demand for money.
What is important about theory of money, and monetary policy, is the fact, that Keynes did not believe much in the effectiveness of monetary policy in fighting with economic depressions. There were several reasons for this belief of Keynes, for example, he thought that monetary authorities are not able effectively to control the money supply.
In overall, from our point of view it is important to know, that he was very sceptical about the power of monetary policy to influence real variables, like the level of production of employment.
Keynes’s revolutionary book concludes with an important chapter on the “social philosophy toward which the General theory might lead’. This is the chapter about Keynes’s economic philosophy and his views on the economic policy. He described here what tools of economic policy could help the economy to recover from major depressions.
As we said before, already in 1920s, Keynes was against the laissez-faire policy, but in General theory (published in 1936) he came to a more extreme anti-laissez-faire position. He stated that government should intervene in the economy in many areas.
First, state should control the level of interest rates in the economy, tending to lower market interest rates, to increase investments and therefore, to increase effective demand.
Further, the action of the state should be extended to two fields in which laissez faire policy (policy of not intervening in the economy) had most clearly shown its deficiencies: 1) the determination of the level of output and employment; 2ndly – the distribution of wealth and income.
On the first field, Keynes even reached the point of preaching some form of “socialization of investment”. Given that the level of investments normally, in a laissez faire regime, tend to lead to the economy with underemployment equilibira, the state should have right or duty, to intervene in order to ensure full employment.
Therefore, state should control the level of aggregate investments, probably by taking public investments in private enterprises, or originating of some kind of public-private partnership in investment projects.
In any case, state should be actively monitoring the level of investment, and intervening if the level was not sufficient for the full employment.
In regard do the distribution of income and wealth, Keynes pointed out that the natural tendency of a laissez-faire policy is towards the determination of arbitrary and unjust distributive patterns – he thought that there is too much inequality and poverty in laissez-faire capitalism.
He believed that large amount of savings generated by a very unequal distribution of income in laissez-faire capitalism, serve only to keep the level of aggregate demand at a low level, because there is a class of people in capitalism who do not invest their money directly increasing the demand, but receive their incomes from savings and do not perform very useful functions in the economy.
So he proposed lowering the interest rate to diminish the role of rentier class in the economy, he even proposed the program of the euthanasia of the rentier class. He of course meant economic euthanasia, not physical one.
Therefore, state should intervene to create more equal distribution of income and wealth in capitalism, by various means of fiscal policy.
All those propositions in economic policy seem to be quite radical, and many economists both contemporary to Keynes and modern economists, consider Keynes to be radical, anti-liberal or even socialist, but himself Keynes thought that he was not radical, but rather conservative.
He did not aim at introducing drastic changes in the institutional structure of capitalism.
He was basically conservative, he was a proponent of personal freedom and private property, and generally advocated only such changes as would preserve the essential elements of capitalism – like private property and markets.
His view was that if the worst defects of the system were not removed, individuals would reject capitalist system and lose much more than they gained. He thought that the continuation of laissez faire policy, would lead to some kind of revolution leading to socialism or authoritarian or totalitarian state.
Himself he was not a socialist, he did not advocate that state should take over the ownership of the means of production.
He rejected Marx’s vision and theory, both because he thought Marx’s economics was not scientific and because he recognized that Marxian social system would destroy the classes of entrepreneurs and intellectuals.
He was against socialist and totalitarian systems, although he admitted that those systems could solve some of the economic problems he dealt with. As for example, socialism can introduce egalitarian society, at least in principle.
At the same time, he knew that socialist or totalitarian solutions would be achieved only at the cost of losing private property and individualism, associated with capitalism.
Those characteristics of capitalism –individualism and private property, did possess for Keynes important economic and political advantages – greater economic efficiency, innovative economy, variety of life, freedom to choose and the like.
As you can see Keynes held a broad, philosophical view about the economic policy, and his vision was based on particular ethical values – he cared about liberty, efficiency and equality.
In general, he was a proponent of some version of a third way between capitalism and socialism or advocated refined, amended capitalism, capitalism free of two important evils – unemployment and inequality.
He proposed that state should intervene in the economy on a wide scale, but he wanted that those interventions did not damage the fundamentals of capitalism – free markets and private property. He was anti-laissez-faire economist, but still he was liberal, he was not socialist or radical.
He thought that it is possible to correct the evils of capitalism (unemployment, excessive inequality) without destroying capitalism and its benefits (freedom and efficiency).
Good afternoon,
Last time we have discussed the economics of John Maynard Keynes, we have outlined some theoretical developments in his general theory and the policy prescriptions implied by his Keynes’s theory.
Today we will continue the review of the developments in the 20th century macroeconomics.
Last time I described the policy proposals he advocated, to recall you, he proposed that the state should control the level of interest rates in the economy, and also the level of aggregate investments in the economy by “socialization of investment”, that is by by taking public investments in private enterprises, or originating of some kind of public-private partnership in investment projects.
Also he thought that state should intervene in the distribution of wealth and income by making this distribution more equal.
All those propositions in economic policy seem to be quite radical, and many economists both contemporary to Keynes and modern economists, consider Keynes to be radical, anti-liberal or even socialist, but himself Keynes thought that he was not radical, but rather conservative.
He did not aim at introducing drastic changes in the institutional structure of capitalism.
He was basically conservative, he was a proponent of personal freedom and private property, and generally advocated only such changes as would preserve the essential elements of capitalism – like private property and markets.
His view was that if the worst defects of the system were not removed, individuals would reject capitalist system and lose much more than they gained. He thought that the continuation of laissez faire policy, would lead to some kind of revolution leading to socialism or authoritarian or totalitarian state.
Himself he was not a socialist, he did not advocate that state should take over the ownership of the means of production.
He was against socialist and totalitarian systems, although he admitted that those systems could solve some of the economic problems he dealt with. As for example socialism can introduce egalitarian society, at least in principle.
But at the same time, he knew that socialist or totalitarian solutions would be achieved only at the cost of losing private property and individualism, associated with capitalism.
And those characterstics of capitalism –individualism (personal freedom) and private property, did possess for Keynes important economic and political advantages – greater economic efficiency, innovative economy, variety of life, and the like.
So, as you can see Keynes held a broad, philosophical view about the economic policy, and his vision was based on particular ethical values – he cared about liberty, efficiency and equality.
In general he was a proponent of some version of a third way between capitalism and socialism or advocated refined, amended capitalism, capitalism free of two important evils – unemployment and inequality.
He proposed that state should intervene in the economy on a wide scale, but he wanted that those interventions did not damage the fundamentals of capitalism – free markets and private property. He was anti-laissez-faire economist, but still he was liberal, he was not socialist or radical.
He thought that it is possible to correct the evils of capitalism (unemployment, excessive inequality) without destroying capitalism and its benefits (freedom and efficiency).
Macroeconomics after Keynes
In the years of Second World War and after in 1950s and 1960s, Keynes-like or Keynesian economic policy became very popular in Western world.
The depression of 1930s had changed the general view of economists and society on the free-market capitalism.
Prior to the depression the general orientation of almost all individuals in western world, except radicals, was against major government interventions in the economy. However, during and after the depression this attitude began to change. Many people felt that if the free market could lead to such economic catastrophes as existed during the depression, than maybe it is time to consider alternative economic systems and policies.
Economists also began to become less confident of neoclassical theory and its policy prescriptions and Keynes’s views, which demand that government has to control aggregate demand through monetary, and especially fiscal policies, began to be more and more popular.
During the 1950s and 1960s, Keynesian economic policy became predominant in the western world. In practice, some followers of Keynes proposed that governments should follow a policy of ‘functional finance’.
Policy of functional finance allowed the government to “drive” the economy, monetary and fiscal policy were portrayed as government’s steering wheel. Monetary and fiscal policy should serve to achieve macroeconomic goals of high employment, price stability and high growth. In practice, the prescriptions of the functional finance were the following:
- In times of growing unemployment, government has to increase budget deficit and the money supply
- In times of small unemployment, government has to do the opposite - decrease budget deficit and decrease the money supply.
So the years after the war, 1950s and 1960s can be perceived as the golden age of interventionism in economic policy, western governments did intervene in the economy in many areas to ensure full employment, price stability and high rate of growth.
In general, economists in the two decades after the Second World War began to become less confident of neoclassical theory and its policy prescriptions (laissez faire policy).
Keynes’s economic theory and policy, which demand that government has to control aggregate demand through monetary and especially fiscal policies, became central in western macroeconomic thought.
What is more important for the history of Keynes’s views, immediately after the publication of General theory, neoclassical economists started to attempt to incorporate Keynesian economics in neoclassical framework.
Attempts to absorb Keynes views and to build one unified macroecnomics started as quickly as in 1937, a year after the publication of General theory. This project of incorporating Keynes theory in neoclassical theory occupied economists for about another two decades, to the mid 1950s.
In this period, a new theoretical approach to macroeconomics appeared, which synthesized neoclassical and Keynesian views. This approach was called neoclassical synthesis, and it constituted the heart of macroeconomics of business cycles after the second world war, up to the 1980s.
Several economists in the framework of the so-called IS-LM model did this synthesis of Keynes’s and neoclassical theories.
In the model the downward sloping IS curve represented combinations of interest rates and output for which planned savings (directly related to national income) and planned investment (inversely related to interest rate) were equal.
The upward sloping LM curve represented combinations in which the demand for money (directly related to income and inversely related to interest rate) equalled the fixed supply of money.
The crossing point of the curves determined the level of aggregate demand in the economy. Further, the crossing point between the aggregate demand (the so-called AD curve) and the curve of aggregate supply (AS curve) determined the level of national income and employment in the economy. (This was called as AS-AD model).
This model, ISLM model, was created with the aim of formulating a more general theory than that of Keynes.
In the model economists obtained, as special cases, the traditional neoclassical and the Keynesian model. For example, if you assumed that LM curve is highly inelastic you could obtain neoclassical solution (full employment of resources), while if you assume highly elastic LM curve than Keynesian solution appeared (that fiscal and monetary policy could influence the level of national income and employment and help the economy to recover from depression).
In 1950s, 1960s, at least in textbook presentation, Keynesian and neoclassical came together in general neoclassical-Keynesian model of ISLM analysis. The dispute about macroeconomic problem of business cycles was only about the parameters of the ISLM model.
Economists from different theoretical positions (Keynesians and anti-Keynesians) disagreed only about the values of the parameters of the model, but they agreed that it is the correct representation of the macro side of the economy.
Another important tool of Keynesian economists and proponents of government intervention in the economy was the so-called Phillips curve.
In empirical works in 1950s, William Phillips, found a negative relationship between historical British wage inflation and unemployment. The modified version, with price inflation, implied that governments faced a short-run trade-off between these two variables.
His analysis was interpreted by many Keynesian economists as suggesting that governments could choose the level of unemployment if they accepted a given rate of inflation. This gave another powerful argument for the advocated of interventionism as it suggested that government can control at least one important macroeconomic variable – unemployment at the price of inflation, or inflation at the price of unemployment. In general, it was a strong argument for the active involvement of the state in the economy
But returning to ISLM model.
ISLM analysis remained a part of macroeconomic education until 1980s, but in 1990s even in undergraduate textbooks, it was replaced by other approaches. Today the model is old-fashioned and not longer taught in the best undergraduate textbooks, but still remains in some not so up do date.
What were the problems with the ISLM analysis of aggregate demand and employment, that cause economists to finally abandon the model?
First, the model is useless if you want to explain the problem of inflation, which from the 1960s has become very serious economic problem for western economies.
Second, many concepts used in ISLM model, were not formulated in terms of GE model and since the model in the second part of the 20th century became the central model of all economics, ISLM model has lost its appeal with time.
Nonetheless, the model was accepted for several decades, because it was neat, quite simple, it was a unambiguous tool in matters of policy and was easy to present for students – in short it was the best model available.
But as I mentioned before, since 1970s and 1980s many economists argued that we should abandon ISLM model and formulate a macroeconomic model, which would be framed in microeconomic terms, that is a model in which aggregate curves (for money demand, investments, and the like) would be derived from the decisions of particular households.
Thus, starting in the 1970s we saw a reaction against Keynesian economics and the neoclassical synthesis.
The opposition to Keynesian economics and neoclassical synthesis in 1950s and 1960s.
In those decades, the principal opposition to Keynesian macroeconomics and interventionism in economic policy was a current of thought called monetarism.
Monetarism was for many years the chief alternative to mainstream Keynesianism and the Neo-classical Synthesis. The group is closely associated with the University of Chicago where many of its main figures taught or studied. By far the most important figure in monetarism is Milton Friedman, who originated monetarism.
Monetarists are in the tradition of classical and neoclassical economists, using similar assumptions to draw similar conclusions.
The monetarists assumed that in the long run money is neutral, that is that money in the long run does not influence real variables, like real national income or the level of unemployment. The only variable which is affected in the long run by increase in the money supply is the level of prices.
This assumption stood in a direct conflict with a trade off between inflation and unemployment as suggested by Phillips curve.
In the late 1960s monetarists developed models in which they argued that the trade-off between inflation and unemployment is visible only in a very short run.
In other words they argued that monetary policy can affect real output and unemployment only in the short run. In the long run the Phillips curve was vertical at the so-called natural rate of unemployment, which is determined by tastes, technology, resources and institutions. The natural rate of unemployment cannot be influenced by standard Keynesian methods of economic policy, monetary and fiscal policy cannot decrease this natural rate.
The monetarists’ models of natural rate of unemployment were powerful arguments against Keynesian economics and interventionism in general.
In matters of economic policy, monetarists advocated that monetary policy should be conducted according to simple and fixed rules. This is evidently against Keynesian proposals. Followers of Keynes thought that monetary policy should be used when needed to stabilize the economy especially in times of depression, that is Keynesians thought that monetary policy could be uses discretionary, if there is a rise in unemployment government can estimate how much it should increase money supply and implement the proper increase.
Monetarists preferred a policy based on fixed rules that target a relatively narrow monetary aggregate (the monetary base or M1) – every year the target should be increased by a fixed percentage, for example we should increase monetary base by 5% every year.
Monetarist’ justification for such a policy was complex. It was a partly based on Phillips curve, partly on distrust in econometric modelling (they did not believe that government could estimate how big should be an increase in money supply to counteract the rise in unemployment).
Partly the argument for monetary policy based on fixed rules was based on laissez faire philosophy. Most monetarists believed that in general government should not manipulate people’s behaviour, that it would be best if government did not intervene directly in the working of a free market economy.
Monetarists thought that economic policy should be confined to monetary policy, that fiscal or income redistribution policy should be avoided, because it only creates distortions and depressions in the economy. Monetarists were close in their policy prescriptions to classical and neo-classical economists, proponents of laissez-faire policy.
Monetarism influenced, and continues to influence, central banks around the world. Especially important in this respect are the monetarists’ notions that monetary policy can effectively target only nominal quantities and therefore ought to target inflation, real variables are not influenced by monetary policy and therefore central banks cannot fight unemployment or falls in the national income.
Moreover, monetarists’ views influenced the notions that central banks should be independent of political control and follow transparent rules. These are very popular ideas nowadays around the world, in Poland too.
Beyond this general influence of the working of central banks, strict monetarism as a economic policy was attempted rarely in practice, for example in the US, but only for a brief time between 1979 and 1982 as a response to high and accelerating inflation.
The experiment collapsed mainly as a result of instability of the demand for money in the face of financial innovation – that is it emerged that you can not easily control any monetary aggregate as the M1 for example, because banking sector introduces new financial products that serve as money for people and firms, and you can not control the money supply.
Monetarists models received a strong boost, strong support in early 1970s, when inflation and unemployment rose simultaneously in most developed countries – this phenomenon was in a direct conflict with the Keynesian Philips curve and much of Keynesian policies and theory lost favour in economics (in 1970s).
Fiscal policy as suggested by Keynesian proved politically to hard too implement, decisions on spending and taxation were made for reasons other that their macroeconomic consequences.
In 1970s, the monetary policy became the only game in town, but the Keynesian models were not suited well to deal with the effects of monetary policy, so there was a movement away from Keynesian economic models for formulating policy.
But at the same time monetarism as the alternative to Keynesian economics also failed, it emerged that it is not possible to control the money supply, and more in 1980s and early 1990s there were important econometric studies published which suggested that money is able to exert a significant the influence on real variables like national income or unemployment – which was a strong argument against monetarists claims.
What is even more important both currents Keynesian economics (or neoclassical syntesis) and monetarism are quite similar on the methodological level. Both approaches showed little interest in developing microfundations of their macrotheories, that is both approaches start with the analysis of the interrelations between aggregate economic notions (like aggregate demand, aggregate investments, national income and the like) and do not build those relationships from the first principles.
That is those models, both Keynesian and monetarist, do not start with the microeconomic analysis of the behaviour of households and firms. Some important economists in the 1970s started to think that the proper macroeconomics should be based on the microeconomic analysis of the behaviour of agents, and this was the important reason for which those Keynesian and monetarist models started to lose popularity and appeal since the 1970s.
In the 1970s, 1980s and 1990s several quite new approaches to the macroeconomic problem of business cycles were created.
From 1970 on, a program called New Classical Macroeconomics has appeared in economics. This program attacked the theoretical foundations of Keynesianism and monetarism.
Leading economist of this approach, Robert Lucas, sought to combine neoclassical or monetarist prescriptions in economic policy with the developing program in general equilibrium foundations of macro theory. That is he wanted to create a macroeconomic model of business cycles, which would be based on GET and which would imply that government does not have to intervene actively in the economy.
Lucas in his model introduced into macroeconomics the concept of rational expectations, developed in economics a little earlier by John Muth.
The rational expectations hypothesis can be formulated in various ways. Lucas preferred to see it in a following way: what people are modelled to expect is what the model itself predicts, so people with rational expectations in the model would still make mistakes, but those mistakes are unpredictable by economists and governments.
He added rational expectations assumption to a monetarist model based on GET and the outcome was that both in the short and the long run, monetary policy did not have an effect on real variables, unemployment for example.
So in Lucas’s model, only unexpected changes in money supply can have real effects on income and unemployment. This means that government cannot perform any kind of stabilization policy to prevent economy from the depression or ease the consequences of the depression.
Monetary, and fiscal policies, are useless to policy maker, they do not have any systematic real effects.
So this is strong conclusion from this part of New Classical Macroeconomics, government cannot affect unemployment and real national income. This is the infamous policy ineffectiveness result, which argues that no systematic stabilisation policy, neither fiscal nor monetary, has any real influence on the economy
Only nominal variables, such as inflation, are affected. Policy can only have a real effect if it is unanticipated – but since there is rational expectations assumption, in the model, than the policy would have to be unanticipated for the government and that makes no sense. So according to the proponents of New Classical Macroeconomics, stabilization policy is not effective.
Towards the end of the 1970s confidence in the Lucas’s model has diminished or died out, mainly as a result of it being invalidated (or falsified) by econometric studies, and the economists associated with New Classical Macroeconomics approach developed an alternative – the so called real business cycle approach.
Real business cycle theory, as developed in 1980s by Finn Kydland and Edward Prescott, holds that nominal variables, such as the money supply and the price level, do not influence real variables, such as employment and real GNP. Fluctuations in these real factors can only be explained by real changes in the economy.
According to them, the business cycles emerge because of voluntary changes in people's willingness to trade off work and leisure between the present and the future. Those changes are induced by technological shocks - random fluctuations in the productivity level.
Examples of such shocks include innovations, bad weather, imported oil price increase, stricter environmental and safety regulations.
Since those shocks are random, unpredictable, than government cannot predict them and there is no role for government in fighting business cycles. Therefore, the best policy, according to real business cycles theorists is laissez faire policy.
Real business cycles theory is still popular among macroeconomists, but in 1990s, there were several econometric studies published, which suggested that random technological shocks are not frequent enough and not deep enough to explain the fluctuations in the production and unemployment levels. So the theory is not well supported by the empirical evidence.
So much on the New Classical Macroecnomics.
Since 1980s, in reaction to the development of New Classical Macroeconomics in economics appeared a current called new Keynesian Macroeconomics.
Economists who created this current argued that in the face of the developments in new classical macroeconomics, new foundations for Keynesian-like macroeconomics are needed, and moreover, that those new foundations actually can be formulated.
New Keynesian macroeconomists has accepted the use of rational expectations assumption in macroeconomics, but they argue that there is nothing contradictory between Keynesian economics and rational expectations.
They built several different models in which there is an assumption of rational expectations, but monetary and fiscal policy still plays some role in stabilization of the economy.
For example, there is a class of models belonging to New Keynesian macroeconomics, which suggests that there is a place for active government policy in the management of aggregate demand, if
real wages and prices in the economy are sticky (do not change or change slowly in reaction in changes in demand or supply).
There are dozens of new Keynesian models explaining stickiness in prices and wages, and many completely different models which focus on different reasons for Keynesian like policy even in presence of rational expectations assumption.
We do not have time to discuss these models. Most of new Keynesian works is highly abstract and theoretical, starting with abstract game theoretic models. For the most part those models have not filtered down to introductory or even intermediate textbooks on macroeconomics, but probably in the end, they will.
The problem with New Keynesian Macroeconomics is that, new Keynesians have never offered a systematic vision or a comprehensive model of the economy similar to that of the New Classical Macroeconomics. So, this approach is less general and convincing than the approach of new classical theory.
The revival of theoretical interest in Keynesian economics that we observe since 1980s does not mean that what were known as Keynesian economic policy, have regained its power in practice
Since 1970s, many Keynesian economists argued that monetary and fiscal policy were politically useless to utilize and that politics, not sound economic principles, determined the size of the budget deficits and the growth of money supply. Even Keynesians were disappointed with the original Keynesian-like economic policy. So today’s economic policy in the western world in the field of stabilization of the economy is much more limited than in the golden age of Keynesianism (that is the decades of 1950s and 1960s).
Those developments in macroeconomics since 1980s, that is the rise of New Classical Macroeconomics, real business cycle theory and new Keynesian economics are still quite new, so it is too soon to attempt to provide a sensible history of macroeconomics in the past two decades.
It is a fact that in today’s macroeconomics we observe the battle of the schools – those close to neoclassical approach like new classical macroeconomics and real business cycles theory, and those close to original Keynesianism like new Keynesian macroeconomics. The most evident difference between those schools is in the matters of economic policy, the former argue that there is no role for government in preventing or fighting business cycles, while the latter argues the opposite, that there are some useful means of fiscal and monetary policy to counteract economic fluctuations.
Still we can draw some important conclusions about the state of macroeconomics in the beginning of the 21st century.
The insistence, first made in 1970s by new classical macroeconomics, that macroeconomic theory should have microfoundations (should be based on some kind of microeconomic theory), has been adopted by almost all mainstream macroeconomists.
Another important feature of modern macroeconomics is that all schools, new Classicals, new Keynesians and even heterodox macroeconomists, use the same empirical methods to validate their results. All macroeconomists use for example structural VAR models. In addition, the empirical method of the so-called calibration, which abandons econometric estimation in favour of specific simulations, although controversial, is in a quite widespread use in modern macroeconomics.
So at least in terms of methods used in empirical inquiry, we have consent among macroeconomists.
On macroeconomic policy, there is now general agreement that monetary policy can have important, systematic real effects in the short run. It was established in serious empirical studies.
But there remains disagreement over whether the economy is sufficiently self-adjusting in the short run that active government management should be abandoned or not.
Finally, perhaps the 1990s were in the Western world less prone to economic fluctuations and more prosperous than the 1970s and 1980s, macroeconomists have turned their attention from the problem of business cycles to the macroeconomics of economic growth, and especially to the role of technical change and social and political institutions in the growth process.
Today questions of economic growth are the most important to macroeconomists and the debate or the battle of the new Classicals and the new Keynesians on the problem of business cycles is somewhat of secondary importance.
In the modern research program on economic growth so far, there are no similar divisions between alternative schools of thought similar to those that plagued the macroeconomics of business cycles.
The modern analysis of growth started in 1950s. In this decade, Robert Solow developed a model of growth, called later Solow’s model as a response to the Harrod-Domar standard model of growth from 1930s, 1940s.
Harrod-Domar model of growth argued that growth was something very unique and that unless the economy was very lucky, it would likely fall into a depression (the economy was unstable according to H-D’s model). The model was very unrealistic (it assumed for example a fixed capital to labor ratio through time), but still it was the best available model of growth before 1950s.
Solow’s model challenged the conclusion of Harrod-Domar’s model by eliminating the unrealistic assumption of a fixed capital to labor ratio. Solow’s model showed that the economy would always come back to a balanced growth path – so that long run depressions are not possible.
The economy was stable, not unstable according to Solow’s model. The Solow’s growth model, also called the neoclassical model of growth, focused completely on supply, demand played no role in determining output. In this sense, it was an extension of classical model of growth, where the only force determining the output was also the supply.
In 1960s and 1970s, mainstream economists tried to develop Solow’s model further to explain why growth rates among countries differed, but in general, they did not succeed.
In early 1990s, a new class of growth models where developed and Solow’s model was supplemented with the so-called endogenous growth theory.
In endogenous growth theory, technological change was not considered something that occurred outside the economic model (as it was in a Solow’s model, where technological change was not modelled).
Technological progress in this research program is considered to be a natural result of investment in research and development, it is modelled inside the model, it is endogenous, hence the name endogenous growth theory. The theory also allowed increasing returns to be analyzed in models. The result of models with increasing returns is continual growth and no eventual movement to the stationary state (where the rate of growth is zero) – as it was in the Solow’s model.
The stationary state is not inevitable in endogenous growth theory.
These developments brought mainstream macroeconomics back into the optimist vision of classical economics, where the potential for growth was unlimited.
So today’s macroeconomics is, for the most part, the theory of economic growth, and the problems of business cycles are considered to be uninteresting to many economists.
Theory of growth occupies the major part of intermediate and advanced textbooks on macroeconomics.
In recent endogenous theories of growth, not only technological progress is modelled, but also the effects of other various factors of growth are considered (for example the effect of social and political institutions).
It is a very popular and promising research program in modern economics.
A summary about modern macroeconomics.
The history of macroeconomics has been marked by changing interest in growth, business cycles and inflation. While Adam Smith was primarly interested in the question of economic growth, later classical economists focused their analysis on the distribution of income and saw the economy as in the end being driven to a stationary state, where there is no economic growth.
Classical economists also saw prices as being primarily determined by the quantity theory of money, and they thought that money do not have any influence on real economic variables.
They saw the economy as essentially self-correcting, with little need for government intervention.
Keynes’s general Theory marked a significant change in the focus of economics from neoclassical insistence on microeconomic questions of resource allocation to macroeconomic question of business cycles. Keynes offered a new theoretical framework to explain the forces determining the level of economic activity, especially in the short run.
He not only found capitalism inherently unstable, but also concluded that the usual outcome of the automatic working of the market was to produce equilibrium at less than full employment of resources. For Keynes the reason for this was a failure in the process of investment spending of businessmen.
A great deal of literature followed that extended and improved original Keynes’s statement. Keynesian concepts were formulated in a mathematical language and empirically tested.
The revolution in economic theory was followed shortly by a policy revolution as the major industrialized countries began programs and constructed agencies designed to foster full employment. All theory and practice of macroeconomics has changed.
Keynesian ideas were incorporated into mainstream macroeconomics, and ISLM model became the dominant macroeconomic model in 1950s and later.
In late 1970s, the ISLM model was found to be unsatisfactory for economic research as it was unable to explain inflation. The model could not be constructed on microeconomic basis, and this contributed to its demise.
From 1980s several new theoretical approaches to macroeconomics were develop and no single approach is accepted by all economists, there are proponents of new classical macroeconomics, advocates of new Keynesian macro, followers of real business cycle theory, and, what is most important, leading macroeconomists are interested rather in the questions of growth than in the problem of business cycles, which inspired Keynes.
Today’s macroeconomics is a field of pluralism and scholars are carrying on a wide range of research programs addressing many different economic questions.
Development of empirical methods in modern economics
Another topic in the history of 20th century economics is the development of econometrics and empirical methods in economics.
Almost all economists (but not all) believe that economics must ultimately be an empirical discipline, that their theories of how the economy works must be related to (or if possible tested against) real world events and data.
However, economists differ on how one does this and what implications can be drawn from testing economic theories.
In testing or relating theories to the evidence economists used and still use different approaches, from simple common sense observation of data, through statistical analysis, to sophisticate econometric testing.
The most important approach remains econometric testing, which in itself is divided into several approaches: we have classical econometric approach, Bayesian econometrics and several approaches that are more recent.
In the second half of the 20th century, the development of computer technology heavily influenced economists’ approach to empirical testing. Several modern techniques of empirical investigation are closely connected to the use of computers, for example, VAR modelling, calibration method, simulations and the like.
Since 1960s advances in computer technology made it possible to conduct extremely complicated empirical work, statistical tests that earlier would have taken days (or were simply impossible) now could be done in seconds.
During this days (1960s, 1970s) the hopes for econometrics were high. Some believed that econometrics would make economics a science in which all theories could be tested and rejected if falsified by the evidence.
Unfortunately, most of those hopes, as we know today, have not been realized so far.
Let’s start with the history of empirical analysis in modern economics.
Early attempts at empirical work in economics were the exception, not the rule. In the late seventeenth century, most classical economists were satisfied with theoretical work, or in the best case used some kind of common sense empirical work, supporting their theories with examples from the real world.
In the late 19th century, during the heyday of neoclassical economics, this approach was called into question. Neoclassicals wanted economics to become a real, hard, exact science and formalized their theories in a mathematical language. Many of them thought that formalized economic theories should be tested statistically, but neoclassical economists have done not much of this kind of work.
Notable examples include some American economists, who introduced statistical methods in economics early in 20th century.
Henry L. Moore in the first two decades of 20th century used statistical methods to verify some economic theories, like marginal productivity theory. He also tried to estimate demand curves for agricultural goods and empirically measure business cycles. His work was bothered with theoretical and empirical difficulties, but he remains the first economist who empirically measured a demand curve.
From 1920s, we can observe the rise of econometrics as a part of economic science. One of the most important early econometricians was Ragnar Frisch, who was a highly trained mathematician, who contributed to both macro and microeconometrics. He coined the term ‘econometrics’.
He played an important role in creating a field of macroecometrics by developing a macroeconometric model of the economy in a book published in 1934.
Another person important in the development of econometrics is Trygve Haavelmo, a Norwegian economist, who has been credited with introducing the probabilistic approach to econometrics, in a paper published in 1944.
Before the introduction of the probabilistic approach, economists assumed that the underlying economic variables they were trying to measure were exact. If one could in fact hold everything else constant, one would have measure variables exactly and find exact relationships between variables.
Haavelmo argued against this assumption, contending that we should treat economic theories as probabilistic theories that do not describe exact relationships, but, instead, describe probabilistic relationships.
Acceptance of the use of the probability theory in economics, that followed Haavelmo’s work, allowed the formal use of many statistical techniques and tests that previously were used without formal foundation in economics, and it lies at the heart of the modern approach to econometrics. In recognition of this Haavelmo was awarded the Nobel Prize in economics in 1989.
Haavelmo’s probabilistic approach was accepted by researchers in the The Cowles Commission for Research in Economics at the University of Chicago, US, (from 1955 associated with Yale University), a centre founded in 1932 for the advancement of economic theory in its relation to mathematics and statistics. The Cowles commission contributed much to the development of econometrics and mathematical economics and it is considered the most important organization for the history of American economics (because it contributed so much to the mathematization of economics and the rise of econometrics).
The cowls commission did much of what is now considered standard econometric work. This work included estimating whether the ordinary least square estimator would be biased or not, developing The Monte Carlo approach to small data sets and working on issues of asymptotic convergence und unbiasedness of estimators.
During this time, 1940s, is should be remembered that computational difficulties were enormous, because the computer as we currently know it, did not exist. Those early econometricians had to perform the calculations manually.
The Cowles Commission followed Haavelmo in assuming that the best approach to econometrics was the probability approach, in which the structural equations of the model had an assumed distribution of error terms. This probabilistic approach became known as the Cowles Commission or standard approach to econometrics.
In following years, members of the Cowles Commission formulated several econometric models of American economy, based on probabilistic approach.
One of the most famous of these models was the Klein-Goldberger macroeconometric model, which was the first empirical representation of the Keynesian vision of the economy.
The model contained 63 variables, including 43 exogenous or lagged variables. It was a really large model.
In 1960s, several similar large econometric models of the economy were developed, to serve as predictors of the economy. These macro models remained popular through early 1970s, but in the mid-1970s, this work was losing support.
The main reasons for this were the deficiencies of classical statistical tests in the hands of economists.
The validity of those tests depends upon theory being developed independently of the data. In reality, however, most empirical economic researchers “mine the data”, looking for the best fit, that is the formulation of the theory that achieves the best R2, t and F statistics.
This procedure, data mining, misuses statistical tests and their results cannot be considered correct.
Another reason for doubting in large macroeconomic models of the economy in the mid 1970s was the limited availability of data – you had to introduce many proxies in models, which were not necessarily very appropriate.
Further, economists started to realize that almost all economic theories include some immeasurable variables, which often were relied upon to explain statistical results that did not conform to the theory.
In general, since the mid 1970, the attitude toward econometrics began to be much more reserved or even sceptical.
However, since the 1980s several new econometric techniques were develop that do not possess disadvantages of the standard (Cowles Commission) approach to econometrics, such as VAR (Vector Autoregression) approach or general to specific modelling. These approaches have their own deficiencies, but we do not have time here to discuss them.
What is interesting here is that those problems with standard econometrics have turned the attention of many empirical economists toward other, non-standard approaches, such as Bayesian econometrics or experimental economics and simulation methods.
Thomas Bayes suggested Bayesian approach, British mathematician, in 18th century. The approach is very different from classical approach to statistics.
It proposed a subjective interpretation of statistics as opposed to an objective interpretation in the classical approach. Bayesians therefore propose dropping traditional classical econometrics.
We do not have time to discuss the approach in detail, especially since for the most part economists have not used Bayesian methods, mainly for practical reasons (for example, it is hard to convince other economists to you subjective assessment of probabilities). Still a number of leading econometricians are seriously committed to this approach.
Few words on experimental economics and simulation methods.
Recently, from 1980s, a group of economists has begun to undertake a different approach to empirical work in economics.
They use animals or people to act as economic agents (buyers or sellers) and conduct experiments to verify whether various economic theories correctly predict results that occur in those experiments.
Experimental economics claims to have proved various economic propositions through their experiments.
The most well known proponent of experimental economics is American economist, Vernon Smith, b. 1927, who was engaged in conducting experiments in economics since 1950s. However, only late 1980s experimental economics became an established part of economic science.
In 2002, Smith was awarded the Nobel Prize in economics "for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms". So it can be considered as an institutional recognition that experimental economics has become an important field in economics.
Smith conducted pioneering economics experiments on the convergence of prices and quantities to their theoretical competitive equilibrium values in experimental markets.
He studied the behaviour of "buyers" and "sellers", who are told how much they "value" a fictional commodity, and then are asked to competitively "bid" or "ask" on these commodities following the rules of various real world market institutions used in many stock exchanges, as well the other models of auctions.
Smith found that in some forms of auctions, prices and quantities traded in such markets converge on the values that would be predicted by the economic theory of perfect competition; despite the well know fact that the many assumptions of this model are not met in the real world (assumptions like large numbers of agents, perfect information and the like).
Other examples of successful economic experiments would include for example experiments concerning the so-called “social preferences” of individuals.
The term "social preferences" refers to the concern that people have for each other's well-being, and it encompasses altruism, taste for equality, and tastes for reciprocity.
Experiments on social preferences generally study economic games, in which players interact in various settings. Some of those experiments have shown that people are generally willing to sacrifice monetary rewards when offered unequal allocations, thus behaving inconsistently with simple models of self-interest. People care about equality in monetary rewards in games, at least when stakes are not very high.
Given that in general problems of empirically testing economic theories are quite serious, experimental economics has gained some importance. It is now a growing subfield of empirical economics; it is very promising.
Experimental economics have opened new perspectives for economists, who want to confirm or verify economic theories.
A related development, similar to experimental economics, is the use of computer simulation. In this work, models are designed that have multiple agents that follow simple, assumed rules of behaviour. Then simulations are run, in which agents interact with each other and it is determined which rules of behaviour survive and which do not.
This allows choosing assumptions (those rules of behaviour) for economic models, which are empirically confirmed to be efficient – agents who live by those rules survive and prosper.
However, this field of simulation is even much younger than experimental economics and its future position in economic science is uncertain.
Summary of the developments in modern empirical economics.
As far as econometrics is concerned, the theoretical progress in econometrics has been enormous. Several sophisticated approaches to conducting econometric study were developed, including many quite new, such as VAR (vector autoregressive) modelling or general to specific approach. It is too early to assess whether those approaches have fulfilled the great hopes and expectations that existed when econometrics were born in 1940s and 1950s.
Yet many modern mainstream economists are disappointed with econometrics ability to explain and predict economic phenomena. For example, we are still not able to predict accurately economic growth, or many other macroeconomic aggregates, in a longer perspective, than one or two years.
So the fair evaluation of the developments in econometrics can be made only in future.
However, there is at least one very interesting and positive thing about the advance of empirical methods in economic in the 20th century – that recently economists have turned their attention to non-econometric methods of empirical verification of their theories, such as experimental economics or computer-based simulations. Those methods for sure enrich economics and make it more empirical and therefore more scientific.