Is any 'economics' being taught?

Prices- how are they formed? Economics fundamentally is concerned with the theory of value; wherein prices play a crucial role. Does the mainstream or marginalist (neoclassical theory) explain the formation of prices? In equilibrium, the forces of demand and supply interact to give the equilibrium prices and quantity purchased and sold. But, in reality, is it so? Does this theory explain the actual working of any economy?

In school textbooks, I remember being taught the law of demand, factors affecting demand and the exceptions to demand. The law of demand conveniently takes into account only one factor, which is its own price. And economists like Veblen and Giffen who tried to discuss demand were sidelined as exceptions.

Thorstein Veblen talked of ‘social factors’ like status symbol, conspicuous consumption etc which affected demand. His book The Theory of the Leisure Class explains how interdependent individuals in an economy are, and how the individual is very much a part of the society unlike the ‘rationalist atomistic individual’ as assumed by the mainstream theory.

In Marshall’s Principles of Economics, he mentions Giffen effect- a rise in the price of bread results in a large drain of resources which force them to curtail the consumption of relatively expensive items like meat; and they consume more of bread as it is still the cheapest food they can get. In India, with more than 60% percent of the populace being poor [Guruswamy and Abraham], Giffen effect is the norm rather than the exception!

This post discusses some of the microeconomic concepts taught across schools and colleges.

Scarcity

I was taught that the central problems in economics were that of scarcity, of unlimited wants and how one chooses the best option. And here optimization (a mathematical apparatus) comes to the aid of economics- in finding the optimum. But are resources really scarce? If resources were really scarce, how could an economy grow? Land, of course is scarce; but the availability of land can be increased through reclamation, deforestation etc. Economics ought to be concerned about wants that are backed by purchasing power; otherwise the theory will be trying to reconcile dreams and scarce resources.

Equilibrium

Equilibrium is reached when the demand and supply curves intersect in the graph having quantity demanded and supplied on the x axis and price on the y axis. Joan Robinson (1973) wonders why one uses a metaphor based on space to explain a process which takes place in time.

This approach has for quite some time disturbed me. Why is it that we take ‘equilibrium’ to be favorable? Equilibrium is a thing very commonly found in Physics. One of the meanings is that ‘it is a state of rest’ and this is precisely the meaning economists provide. For, in equilibrium, the quantity demanded will be equal to quantity supplied and all is well. Coming to think of it more, why would a stagnant economy be favorable? What is more frightening is that, we are taught that it is what economic policies should aim at!

Prices

Prices, according to the mainstream neoclassical theory are determined based on the intersection of demand and supply; that too in a static set up. Prices, in today’s world is certainly not fixed in the before said manner. The producers decide the price based on the cost of raw materials and other items needed for production, wages and salaries of employees, advertising costs, existing taxes, etc. So this means, prices in an economy has more correspondence to the supply side than the demand side.

What is the significance of the demand side? One of the reasons could be to point out the importance consumers have in deciding the prices in a ‘perfectly competitive’ economy. It would signify consumer sovereignty in such an economy. Again, this belief of ‘consumer sovereignty’ is something one would like to have, but is absent totally.

Perfect Competition

No student of economics graduates without studying ‘perfect competition’. It is very much entrenched in economic theory as taught today. Why? The answer given is that it is the ideal state for an economy. Or rather, as the name suggests, it is ‘perfect’. Then we are taught about imperfect competitions keeping in mind what is good or ideal-perfect competition.

One of thoughts one could have is ‘why is it considered perfect’. The price is assumed to be given or it is said that the firm is the price taker. Another query would be- is perfect competition possible? The main driving force behind corporations and businesses is money or precisely speaking, profits. Would firms like an atmosphere where they are unable to fix prices and hence unable to earn more profits? It reeks of Orwell’s Animal Farm. Why would there be any competition at all? Aren’t differences that lead to competition? Would there be any incentive to produce or to diversify?

Conclusion

This post ends on a skeptical note. Is the current mainstream economics helping the economy by tailoring productive and progressive economic policies? Is they are not, why are they still being taught as compulsory topics? Is there an alternative approach?

I would like to put forth a question regarding the notion of prices.

50 years ago, one could buy a book for a rupee; but now, a book’s average cost would be about 100. This follows for all other goods and services too. What is that which accounts for this sustained rise in prices? Is it inflation alone?

25 thoughts on “Is any 'economics' being taught?

  1. Nice post.

    Is it inflation, no not at all, why not development?

    M1 is growing, a few years back we dont have tools to exploit earth completely, now we can exploit all natural resources, it created wealth, then evolution, our brains incraesed so we are selling our ideas, these ideas in turn increased education standards and we are selling that again. this cycle made every one wealthy. If every one is capable of buying 1000 acres then what the owner will do? he will increase price with out any exogenous factors, the price growth is endogenous, if no one shows interest to buy he will decrease the price obviously but why he wish to sell several factors.

    We are finding ways to deal every thing in terms of economics, so every thing got a price, some thing thought unworthy previous was now precious.
    So our knowledge is the thing which increasing prices, and we are calling that inflation or some other bull shit.

  2. Hi,

    I would like to (attempt to) reply to some of you criticisms of fundamental economic concepts:

    Scarcity. By definition scarcity requires that demand exceeds supply when the price is zero. If this is the case a market could potentially be formed that would allocated this scarce resource efficiently. Now for many goods and services demand would exceed supply at a price of zero, so scarcity definitely holds.

    Equilibrium. I agree that the economy is dynamic and constantly changing. However, the purpose of an equilibrium is to give us an idea of where the economy will move over time. The equilibrium in itself is not optimal (just look at the outcome for a monopoly), but it is what will happen, or where the economy will tend to move, in a certain state.

    Prices. The price is the mechanism we use when we have a scarce resource. Firms set their prices based on the information they have, and as they know more about supply side considerations they will often dominate. However, firms are not static with their prices. If you go to a supermarket you will notice that certain products will often change their prices up and down. They do this in order to get information about the price-elasticity of demand, which in turn allows them to maximise profit is a more standard sense. The classical economists view that price was simply a mark-up on cost was too narrow and missed this important demand side relationship.

    You also have a question:

    “50 years ago, one could buy a book for a rupee; but now, a book’s average cost would be about 100. This follows for all other goods and services too. What is that which accounts for this sustained rise in prices? Is it inflation alone?”

    I’m afraid that the answer is inflation, in fact it is important to realise that these nominal prices don’t really mean anything. What is important is the RELATIVE PRICE of goods and services. If as you say the price of everything has increased 100 fold then it does not matter as people can still buy the same set of goods and services, and the price mechanisms role as a distributive tool still holds.
    Perfect competition. In the absense of externalities, perfect competition is ideal, as it is the state where total surplus is maximised. As you say, the issue with this ideal is the lack of potential innovation, however there is a wide amount of theoretical and practical economic literature that looks at this possibility. There is a problem with perfect competition in so far as it is a static concept. Ultimately this part of early economic teaching will change once more people are comfortable with dynamic views of the economy.

  3. Ram,

    I too would think of it as ‘development’ rather than ‘inflation’. I shall address this question in my next post.

    Matt,

    First of all, I am thankful for your comment.

    If you define scarcity to be the excess of demand over supply when the price is zero, then it holds. The problem with such a definition is that in the economic spectrum, there is no price zero. Moreover, at a zero price, consumers will definitely want the good (provided the consumer is informed and the consumer derives utility from its consumption) because they are getting it for free; but I wonder who will want to supply the good? [This holds for any good or service]

    Moving on to equilibrium, which is where an economy would will tend to move over time based on the underlying structure of an economy. The model that I referred to is the static equilibrium model which is taught, especially that of demand and supply of a good. Over time, this model will never reach equilibrium. Because there will never be a state where both the consumers and producers are satisfied; and this is essential for the economy to move forward. In one way, equilibrium tries to put the economy in a state where everyone is happy. At least that is the message it provides. In such a state and also especially with respect to perfect competition, it is such a state where there are no incentives.

    Moreover, with your definition of scarcity, an equilibrium of such a sort (where quantity demanded equals quantity supplied) can never occur.

    Coming to prices, if one assumes or believes that it arises out of scarcity predominantly, then your explanation is sufficient. But what if it is not? In one of my forthcoming posts, I plan to deal with the Theory of prices as understood by the ‘classical political economists’.

    To me, there is nothing perfect nor competitive in ‘perfect competition’.

    As an answer to the question I posed, I partly agree with your view as to the importance of ‘relative prices’ in understanding this phenomenon. Again, a full on discussion is pending as I am waiting to get feedback on the same. This will constitute a part of the post regarding prices.

  4. Alex,

    Nice Post. Here are some of my views on the issues you have raised.

    Scarcity
    I do feel resources are scarce, be it land, oil, energy…even human intellect :)
    The classic example of fixed resource is naturally land. As far as reclamation etc are concerned, it doesn’t really add much to your existing resources.
    How do economies grow? They become productive over time! The world hasn’t experienced the famine Malthus spoke about. Yes, hydrocarbons too are being exhausted at a rapid rate, but the rate of technological advancement is as rapid. I worked in the Oil E&P sector for a few months and was pleasantly surprised to see the rate at which most of these firms are progressing technologically and constantly striving to extract the maximum energy from a drop of oil…in leaps and bounds!

    Equilibrium
    I feel humans are habitually change resistant, and thus the desire for equilibrium and stability. And as you rightly pointed out, equilibrium is very uncommon in real life scenarios. For instance, the oil E&P industry displays a perfect example of a cobweb model.
    Further, in many markets, especially the real estate sector experiencing a bubble (Japan a few years ago, Mumbai, now even Delhi) a market clearing price may not even exist! I feel the same goes for salaries and perks given to chief executives :)

    Prices
    For three years during my graduation, various professors drilled down the one fact that prices are determined by the intersection of demand and supply. I’m not undermining the importance of demand and supply factors in price determination, but it’s actually much more complex than that. Firms practice a wide variety of pricing techniques; cost-plus pricing, value pricing and so on. Pricing would again depend upon whether a certain good in question is a ‘product’ or a ‘commodity’. In fact, this traditional definition of price is also inconsistent with the concept of loss leaders. Can traditional economics explain why a firm would actually prefer to keep selling a certain product at a loss??

    Perfect Competition
    I feel we all begin by learning about PC since it is an ‘ideal’ situation, which allows us to appreciate any ‘deviations’ from it, such as oligopoly, monopoly and so on.
    Though PC is a utopian concept, there may be a few instances of it in real life too. Markets such as that for foreign exchange can be said to be close to PC, though not perfectly PC, since there are times when central banks step in and are capable of influencing the price (exchange rate).

    Do visit my blog when you have some free time.

    Regards,

    Shromon Das
    http://shromondas.blogspot.com

  5. What ever economic model you believe, what ever economic theory you read, never predicts scarcity, its our inability to use resources effectively, intentionally or unintentionally, which determines price.

    Optimization is myth, one just wants to buy or consume something which is attractive or consumer is lured to be optimized, if optimization works, savings rate among public will be at better rates than 5-10% in India, and loans works less.
    Its not optimization its comfort, luxuries,attraction, spending determines the bundle he chooses.

    In real world no equilibrium, but we are students of economics, and if we say no equilibrium who will study economics, so this concept is used by us to sell our lectures.( of course we name it as model with some assumptions for simplicity)

    Perfect competition where is it? we can see that when salesmen sell to customers, PC can decrease the price to Monopoly, but in reality no PC, its just searching better ways to cheat consumer.

  6. Good to see such discussions going on.
    Economics as a pure science can’t fully explain something like price of a product. So imho its kinda futile to try to explain this using economics alone. I agree that nominal prices doesn’t mean anything.
    Marketing can explain pricing better than economics. Brands (perception of consumers), Product-Market competition, Industry Structure (monopoly-oligopoly) and hundreds of other ‘variables’ influence price, not just demand and supply. I think its better to read Kotler or a journal like Marketing Science to understand pricing.

  7. Perfect Competition – I believe we should not read more into it than what is necessary. Firstly, I wonder if it gets any attention at all in economic debates these days. Almost everyone have accepted that the concept exists only in theory.

    Secondly, though it is paid more attention than it deserves in economic textbooks, but I think there are other causes at work here. In my class 11 & 12 I used to study cardinal utility analysis to consumer behaviour. In college, I realised that that concept was given up long ago in favour of ordinal utility. But, I agreed that yes, my brain wasn’t ready for ordinal utility concept in school. Similarly, Perfect Competition is an easy concept to familiarise a person with what will follow later.

    Though, it includes the word ‘perfect’ but that should not be taken to mean that it is perfect & hence desirable. In fact, Augustine Cournot disussed this concept in ‘The Recherches’ in 1838 (maybe the first one to do so), but most of the book was devoted to imperfect market pricing. So right from the very beginning, the emphasis hasn’t been solely on Perfect Competition. There is nothing sacrosanct about Perfect Competition & it is not an ideal for any market in reality.

    I agree that it is the differences that lead to competition but again, we should not read more than what is essential for Perfect Competition. The name was given long ago (I have no idea of exactly who gave the term & when), it maybe the case that at that time such a kind of competition was desirable. It is the name given to some set of conditions. That does not means that it is actually the best form of competition that exist.

  8. Dear all

    I think the master problem of studying economics is the lack of critical on their own methodology

    Economists and Econ students should address some question on the fundamental concept such as equilibrium, price, rationality and else. But in reality we live in the world that mainstream theory is the master discourse and domimate all of others perspective of heterodox views.

    In thailand as well, heterodox economics is ignored and mainstream dominate all……thai economics students rarely interest in political economy theory, classical political economy, philosophy of economics and other philosophy/social theory that can interact to economics methodology.

    So I really love the way you are,The way that you try to address some critical views on neoclassic theory.

    It’s very late night in Thailand now, so I will be back with some discussion on your views next time.

    Best regard
    Norachit
    Bangkok, Thailand

  9. I’m surprised that no one has mentioned the most serious problem with the concept of “scarce resources”. This of course is the resource economists call “capital”. While you example about deforestation, etc…, is perfectly fine, it offers a rather weak criticism of the concept of scarcity. The real question is, does the term “scarce resources” make any sense when production of commodities is undertaken by means of commodities?

  10. the continuous rise of a neo (quasi) class with heightened purchasing power, a definite post-industrial development…
    coupled with inflation and a reverential sense of prices…

    prices have reconfigured the way we conceive of and structure our everyday lives and living

    (all from the perspectives of an economically aware individual)

  11. A belated reply…

    Scarcity

    its about resources and wants (or tasks). How you spent your 24 hours. I love sleeping and sipping. But I still to get a day just to sleep and sip. So i have to budget my 24 hours and that is optimization in economic sense. We all do it. And without scarcity I guess the value will be missing. probably it is technology -> utility->resource->scarcity->value. i am not sure how technology comes. need or r&D or chance….

    How economy goes: yap its due to increasing productivity by adopting technology. Again from personal experience, when i started research, i have no net or computer. To write a one para note on equilibrium, i had to spent half a day in the library and then another 2 hour writing it by hand, half an hour for typing it and 20 mins to make photocopies. Now with net and computer the same thing takes about 1 hour max. so my 24 hours in terms of that note has increased from 3 notes (say) to 24 notes with adaptation of better technology. Thats how resources “grows” and economy.

    But what if it is a never ending day and i live for perpetuity? Has any one ever see god as per any religion has ever made any second innovation except earth and humans!

  12. Satishvm,

    Regarding prices (market prices), i too think that marketing can do a better job than economics-clasical and neo classical.

    But Classical Political Economists believed that a natural law existed in pricing as well. And that is why they undertook the study of prices-an important component to understand value. They theorized extensively on growth, distribution and prices. They discussed magnitudes like natural prices which was estimated based on the mode of production and the share of each sector in production.

    Later Sraffa developed this concept with more clarity and conciseness in his Production of Commodities by Means of Commodities.

    Ashish,

    I don’t think that perfect competition has lost its sheen completely, even in the academic circles. The Libertarians argue for free market (less government) on the basis of the outcomes of perfect competition.

    Moreover, auxiliary assumptions like perfect information, free entry and exit, etc are widely used to lobby for ‘reducing regulation’. Their rationale is to be found in the theory of perfect competition, which (is supposed to) distributes incentives according to their preferences and also based on their marginal productivity!

    Gelgloog,

    “thai economics students rarely interest in political economy theory, classical political economy, philosophy of economics and other philosophy/social theory that can interact to economics methodology.”

    It is the same in India as well. The inter disciplinary approach is rarely found in mainstream economics. Though the mainstream approach does have history, psychology, biology, etc but all of them are further divided and sub divided into branches called behavioral economics, economic history etc. Thus, very often the (mainstream) theorist is not aware about a host of other factors affecting the economy, as they lie outside his/her specialization.

  13. N. Cline,

    “The real question is, does the term “scarce resources” make any sense when production of commodities is undertaken by means of commodities?”

    Exactly! :)

    Anwesha,

    “prices have reconfigured the way we conceive of and structure our everyday lives and living”

    This statement says quite a lot.

    BVN,

    Recession?? Where? ;)

    Rdm,

    Scarcity-This is something which the Classical’s did not worry about, because they knew that man would produce most of the things. And the fascinating thing is that, it is very easy to relate scarcity to value. Scarcity would mean that the demand is more than the supply. Scarcity is only one of the factors that result in an increase in price. But, stating that ‘scarcity’ is a fundamental problem in economics is a debatable issue.

  14. Alex, I am surprised how a young economist like you could fall into the trap of admitting that Marketing can explain prices better than Economics! Just to clarify, Marketing is an applied study of Economics! So it is like saying that calculus can explain integration better than mathematics! Economics is the mother of management science. What the demand-supply model gives us is a starting point to think about a particular problem. It is erroneous to say that the model is wrong because it can’t explain reality — this is a logical fallacy which people make in many economics arguments! I hope you appreciate the spirit of my comment. Carry on the good work.

  15. Skeptic,

    It is precisely because ‘Management/marketing’ is an applied economics branch, that they are able to ascertain prices. Well, economics fundamentally is the study of values-prices, wage, profits etc.

    For neo-classical economics, demand-supply model explains ‘price formation’. There are inconsistencies associated with determining a supply/demand schedule as well.

    Like you say, it is wrong to say that a model is wrong if it does not explain reality. But abstractions are made so that we can understand reality- some ‘data’ is chosen because the theorist feels it to be relevant and some are not. The assumptions underlying DD-SS model are very dubious.

    It would be nice if you could elaborate on how DD-SS helped you in understanding price formation.

  16. Recession man! Depression!!

    Why isn’t RBI cutting rates? Do we really need to care about inflationary pressures, i mean rice is now Rs 21/kg, if the markets are UP

    btw, I lost money in Reliance IPO

    Licking wounds!

  17. Nukkad,

    When we talk of individuals as consumers in microeconomics, we treat him as an independent entity who has no social relationships. Factors external to him do not affect his thinking nor his choices. There is no significance given to his socio economic background, without which analysis is incomplete.

  18. Alex,

    You bring up a really interesting point about the Giffen Good case in India. I wish I had thought of it when I was taking Micro Theory! I like your writing style and look forward to reading more.

    Chris

  19. Thanks for your comment on my post.

    I think you shouldn’t look into introductory economics courses for unconventional models. The models are just that: models. Idealized mathematical descriptions valid in their own domains.

    The concepts in themselves are useful, as long as they help explain certain phenomena. When they don’t, they aren’t useful. Let me briefly comment on a concepts you raised, just to illustrate.

    a) Scarcity:
    i) You ask, if things are scarce, how does an economy grow? It’s not clear why these two should be incompatible. Scarcity doesn’t mean fixed. It means: not infinite. It can grow over time. Also growth in economy can be due to increases in productivity, i.e. better uses of scarce goods.
    ii) You write: Economics ought to be concerned about wants that are backed by purchasing power. This is what price mechanism and trade does. You set a price and if someone can meet it, you trade the item. If you don’t have purchasing power, too bad.

    Having said that, as pointed out in my post, these concepts are rife with ideology and value judgements, as is the case with anything involving human nature. Let’s just take the concept “scarcity”.

    Let’s apply it to health care, currently a major issue in the US. Now apply your statement to health care.

    Economics ought to be concerned about health care wants that are backed by purchasing power

    Should it? Does everyone need to have the money to pay for his/her health care? Or should it be a right (within reasonable limits)? In addition, the “health care wants” may be involuntary, that is, it may be a ‘health care need’. Suddenly the “ought” isn’t so clear anymore (at least to me).

  20. Anand,

    Economics ought to be concerned about wants that are backed by purchasing power.

    Your comment made me rethink what I had written/meant. And I admit that I was not clear enough.
    I emphasis on ‘purchasing power’ because like you mention, there is no point in creating economic models that does not include the wants of those without purchasing power.

    And it is a contentious issue as to whether health care ‘should’ be a right or not. But our Constitutional laws were supposed to take care of them.

    I totally agree with you on ideology being rife in ‘positive’ neoclassical economics.

    Regarding scarcity, increases in goods and services can be brought about by increase in productivity. Very often scientific and technological improvements (which can be viewed as increased production of capital) go hand in hand with such productivity increases. Also, such ‘ideology’ could be a method to make labour work more (hours), so as to improve their efficiency by raising their marginal product!

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