Category: Economic Philosophy

A Case for Pluralism in ‘Microeconomics’

[My return to blogging is motivated by the extremely warm response I’ve received in person – in the last 6 months – from several people who have been readers of this blog. I’m also happy to announce the publication of my co-edited book on the history of economic thought.]

The subject matter of microeconomics is enshrined in the economics curriculum at all levels – school, undergraduate, postgraduate, and doctoral. The central objective of microeconomic theory is to provide a solution for equilibrium price and quantity in both the commodity (say, apples or coconuts) and factor (wage and ‘capital’) markets. Indeed, questions of what is the source of value and what is the exchange value of two commodities have been posed much earlier. You can find answers in Kautilya, Aquinas, Petty, and Cantillon – all of them writing prior to Adam Smith’s foundational treatise on political economy.

 

Kautilya’s Arthashastra contains discussions of a fair price. Aquinas, drawing inspiration from Aristotle and Christianity, tries to arrive at the notion of a just price. One of the founders of political economy, William Petty, derives the distinction between necessary price and political price and possesses a rudimentary labour theory of value. Following Petty, Cantillon distinguishes between ‘intrinsic value’ and ‘market price’ based on a land-cum-labour theory of value. The contributions of Smith, Ricardo, Marx, and Sraffa to value theory follow this tradition of objectively determining value.

 

The dominant theory of value in contemporary economics is not the objective theories of value found in Ricardo, Marx, or Sraffa but the subjective theories of value whose pioneers are Jeremy Bentham, William Stanley Jevons (whose son taught at Allahabad University), Alfred Marshall, AC Pigou, and Paul Samuelson. The value theory (or microeconomic theory, as it is now called more fashionably) found in the textbooks of Hal Varian or Gregory Mankiw take the following as data when solving for equilibrium prices and quantity: (i) preferences, (ii) technology, and (iii) endowments. On the other hand, Piero Sraffa’s value theory, found in his Production of Commodities by Means of Commodities (1960), takes the following as given when arriving at a solution for prices and one distributive variable: (i) size and composition of output, (ii) technology, (iii) the real wage or rate of profit.

 

How do you measure the data listed above’ While technology, endowments, and real wage can be measured in terms of the commodity-mix, the rate of profit is a pure number. However, how are preferences measured (or ordered)’ They are measured in a subjective manner. This is one of the core differences between the dominant marginalist theory of value and the Classical/Sraffian objective theory of value. Given this core difference, it is incorrect to treat the objective theory of value found in Ricardo or Marx as a precursor or rudimentary version of modern subjective theory of value. And therefore, it is important that students of economics learn about different value theories in microeconomics.

 

I shall end by drawing your attention to the practical implications of believing in the marginalist conception of the labour market vis-a-vis that of the classical economists (see an earlier post on wages). Under conditions of perfect competition, the equilibrium real wage is determined by the marginal product of labour. Any intervention, such as a minimum wage legislation or collective bargaining by the workers, results in imperfections and consequently leads to unemployment. However, in classical economics, real wage is exogenously determined though historical and social factors. If you believe in the marginalist conception, the logical policy recommendation is to eliminate any intervention/imperfection (such as minimum wage legislation or collective wage bargaining) whereas if you believe in the classical conception, you would treat collective wage bargaining and minimum legislation as legitimate ways of improving workers’ conditions.

 

This post argues that value theory matters for both contemporary politics and policy. And consequently, the teaching of microeconomics needs to become pluralistic. Moreover, as pointed out earlier, the politics of microeconomics ought to be made explicit. It is, as Keynes, said that we are the ‘usually the slaves of some defunct economist.”

 

Bernard Mandeville and his Unorthodox Economics

mandevilleI first came across Bernard Mandeville (1670-1733) while reading Keynes’s General Theory as a student at the University of Hyderabad. Mandeville’s Fable of the Bess: or, Private Vices, Publick Benefits was published in two parts in different times. This work has its origins in an earlier work of his: The Crumbling Hive: or Knaves Turn’s Honest (1705). I recently read the Fable of the Bees edition published by Oxford University Press in 1924 with a commentary by F. B Kaye; interestingly, this work is an expanded version of Kaye’s PhD dissertation submitted at Yale University in 1917. On looking up the Yale University Library Catalogue, I found out his complete name and the years he lived – Frederick Benjamin Kaye (1892-1930).

Mandeville was born into a family of city governors, physicians, scholars, and naval officers. He studied medicine and philosophy. The other notable ‘physician-economists‘, as Peter Groenewegen, the emeritus historian of economic thought at University of Sydney, labels them, are William Petty and Fran’ois Quesnay (for a short account of the ‘natural’ origins of economics, read this). Mandeville also published a book entitled A Treatise of the Hypochondriack and Hysterick Passions (1711). Kaye informs us that his books sold very well.

The Root of evil Avarice,

That damn’d ill-natur’d baneful Vice,

Was Slave to Prodigality,

That Noble Sin; whilst Luxury.

Employ’d a Million of the Poor,

And odious Pride a Million more

Envy it self, and Vanity

Were Ministers of Industry;

Their darling Folly, Fickleness

In Diet, Furniture, and Dress,

That strange, ridic’lous Vice, was made

The very Wheel, that turn’d the Trade.

(p. 25; or see the online source)

In the above passage, Mandeville is arguing that prodigality, considered a virtue, is actually a public vice and luxury, considered a vice, is a public virtue. The importance of consumption in the growth of the economy is also to be found in Sismondi, Malthus, Marx, and Keynes. As Kaye puts it, this is Mandeville’s thesis: ‘vice is the foundation of national prosperity and happiness’ (p. xlvii). In other words, public benefits are a consequence of private vices ‘ ‘pride’ and ‘luxury’.

According to Mandeville, all actions were influenced in part by selfishness. If all people behaved selflessly, Mandeville argued that trade and crafts would be abandoned.

As Pride and Luxury decrease,

So by degrees they leave the Seas.

Not Merchants now, but Companies

Remove whole Manufactories.

All Arts and Crafts neglected lie;

Content, the Bane of Industry.

(p. 34; or see the online source)

How can vice become a virtue’ This is the paradox, much like Keynes’s paradox of thrift where increase in saving, while good for the individual, is bad for the economy as a whole.

THUS every Part was full of Vice,

Yet the whole Mass a Paradise;

(p. 24; or see the online source)

Mandeville thus argues that private vices have public benefits. What is ‘good’ or ‘virtuous’ for an individual need not be beneficial to the public or society. In the General Theory, Keynes approvingly cites Mandeville’s The Fable of the Bees before articulating his fundamental point: ‘capital is not a self-subsistent entity existing apart from consumption’ (p. 106). And, again on p. 371, he places Mandeville among ‘the brave army of heretics’ alongside Malthus, Gesell and Hobson (see Keynes’s short commentary on Mandeville on pp. 359-362 in ch. 23).

It must be noted that Mandeville favoured virtuous vice and not vicious vice (such as crime and theft). Moreover, his thesis is not that all private vices have public benefits. The Fable of The Bees, Kayes cautions us, ought not to be taken literally. As Kaye elaborates, ‘it is not ascetic virtues, such as hoarding frugality, which make a nation prosperous’ (p. lxviii).

Let me now summarise Mandeville’s position on luxury spending. First, he disagreed with the extant view that frugality is a virtue. Second, he disagreed with the dominant view that luxury is bad for the economy. We must also remember the context in which he is writing ‘ luxury was condemned by Christianity. Indeed, Mandeville was challenging the extant religious and economic orthodoxy with his arguments favouring luxury.

Mandeville argued for freer trade both domestically and internationally (pp. xcviii ff.). His argument was anticipated by mercantilists such as Charles D’Avenant, Dudley North, and Josiah Child. According to Kaye, it is in Mandeville’s work that ‘individualism became an economic philosophy’ (p. ciii). In fact, F. A. Hayek labels Mandeville ‘an advocate of laissez-faire as Adam Smith’ (p. 135) in his 1966 lecture at the British Academy (published in 1967; this lecture is publicly available). And, as is to be expected, he thinks that Keynes’s enthusiastic approval of Mandeville is unfounded (p. 133). Moreover, Hayek finds Mandeville’s ‘understanding of human nature’ noteworthy but not his economics ‘ of division of labour and luxury consumption (pp. 125-6). Karl Marx notes that Smith’s ideas on division of labour were strongly influenced by Mandeville’s work but that there is no mention of Mandeville in the Wealth of Nations. However, Smith discusses Mandeville’s views on vice and virtue in his Theory of Moral Sentiments.

Perhaps, it is befitting to conclude this essay by summarising Marx’s views regarding Mandeville. After all, Marx is one of the greatest unorthodox economist whose political economy is of enduring value.

Originally, Political Economy was studied by philosophers like Hobbes, Locke, Hume; by businessmen and statesmen, like Thomas More, Temple, Sully, De Witt, North, Law, Vanderlint, Cantillon, Franklin; and especially, and with the greatest success, by medical men like Petty, Barbon, Mandeville, Quesnay.

(Capital, vol. 1, Ch. 25: The General Law of Capitalist Accumulation)

Marx describes Mandeville as ‘an honest, clear-headed man’ in volume 1 of Capital and writes in part 1 of Theories of Surplus-Value that ‘Only Mandeville was of course infinitely bolder and more honest than the philistine apologists of bourgeois society.’

 

 

 

The Character and Role of Economic Theory

Over the years, much has been written about the methods employed in economic theory. The recent financial crisis and the ongoing economic crisis in Europe have resulted in a marked increase in criticisms directed at mainstream economic theory ‘ neoclassical economics (more precisely, marginalist economics). Internal critics of neoclassical economics have been modifying certain assumptions of marginalist economics and have ‘developed’ new forms of economic knowledge such as law and economics, welfare economics, neuroeconomics, new institutional economics and so on. Critics external to marginalist economics, often known as heterodox economics (examples include Classical/Sraffian economics, Post-Keynesian economics and Marxian economics), have provided compelling logical critiques of the theory. Additionally, they also supplement their analysis with empirical and historical details (which is not uncommon in neoclassical economic either). This post is reflective in nature and tries to comprehend the character of economic theory along with a commentary on its contemporary function in the form of questions, thereby reinforcing the reflective nature of this blog post.

First, the definition adopted has a critical influence on the aims and scope of economic theory. For instance, the definition of economics as a study of reproduction and accumulation of wealth/income (characteristic of the heterodox economic theories mentioned above) is qualitatively different from a definition which views economics as a study of allocating scarce resources among competing ends (characteristic of neoclassical economics). The former definition is more modest in scope and seeks to provide answers to a limited number of questions vis-‘-vis the latter one which encompasses any and every issue where human decisions are involved. Examining the causes of accumulation and growth warrant the following theories: a theory of value and distribution; a theory of activity-levels (at times, this is absent); and a theory of economic growth. While examining the causal connections within these theories, some features of human behaviour are taken as given. The most important, perhaps, is the human propensity for self-betterment in material terms. Such a limited domain enables these economic theories to be more specific and definite thereby improving their explanatory power in the analysis of economic growth, unemployment, technical progress, wage dynamics and so on. An extremely wide scope is entailed by the definition of economics present in neoclassical economics; consequently, we see the emergence of sub-fields such as: cognitive economics, neuroeconomics, economics of philosophy, experimental economics, evolutionary economics, cliometrics, etc. The questions addressed in many of these sub-fields often have nothing to do with the generation of income or its distribution. The questions being asked are different, and quite relevant in understanding various aspects of human behaviour and institutions. However, if the aim of economic policy and economists is to improve material well-being, neoclassical economics and its sub-fields are not entirely satisfactory, primarily for logical reasons. The two most dangerous tenets of marginalist economics are the marginal productivity theory and the tendency to full employment.

Second, economic theory, I think, has two broad functions. One is to explain the logically necessary connections which exist between various economic variables, and the direction of causation. Usage of terms such as exogenous, endogenous, dependent and independent variables convey the direction of causation. For example, classical/Keynesian theory argues that activity levels and economic growth is demand-led whereas marginalist economics posits that activity levels and economic growth is supply-driven. This is a theoretical debate, which cannot be resolved by recourse to empirical data given the high degree of correlation present among (macro)economic variables such as income, investment, saving, etc. Another reason for the debate being unresolved is the incommensurability of the two kinds of economic theory involved ‘ classical/Keynesian vs. marginalism. The other broad function of an economic theory is to provide an explanation for the manner in which these (marco)economic variables grow over time; strictly speaking, the dominant economics influences the way in which data is collected and presented and the explanation for the data is also provided by the dominant economics. (A chief, although not very reliable, exception to this is the econometric technique known as VAR which attempts to undertake ‘measurement without theory’.) Much of these numbers will need to be supplemented with contextual and historical details. Also, in economics, one needs to be careful about assigning too much ‘reliability’ to data so much so that they are considered ‘adequate’ to overturn a particular economic theory. This is not to say that data does not matter, but that it should be treated with significant caution.

Third and finally, it is of great practical importance to know what economic policies can be advanced based on economic theory, supplemented by data or not. In other words, what conditions must a particular theory fulfil in order for it to be reliable’ Is an empirical assessment necessary or is it sufficient’ How sound must the logic be’ To what extent must the assumptions be scrutinised’ Can econometric analysis provide conclusive evidence’

Kaushik Basu’s Economic Methodology and the Economic Survey of India 2011-12

As the title suggests, this blog post examines a couple of policy recommendations made in Chapter 2 (Micro-foundations of Macroeconomic Policy) of the Economic Survey 2011-12. This examination is carried out in conjunction with Kaushik Basu’s economic methodology which is scattered across the Economic Survey and very visible in his 2011 book Beyond the Invisible Hand: Groundwork for a New Economics (Princeton and Oxford: Princeton University Press). Note that we are making an assumption, albeit very plausible, that Basu authored and/or significantly influenced the contents of Chapter 2 of the Economic Survey. On the basis of these two texts ‘ Chapter 2 and his 2011 book, this blog post evaluates (1) Basu’s method of doing economics, (2) his affinities towards the micro-foundations approach and (3) his (select) macroeconomic recommendations. The blog post concludes with a critical look at the role of economics as espoused by Basu.

Basu writes in the Economic Survey that ‘monetary and fiscal policies are part science and part intuition and common sense’ (p. 24). This statement reflects the openness to knowledge possessed by the author. However, owing to his role as the Chief Economic Advisor of India, he is an economic architect. Therefore, at a deeper level, one wonders whether he is talking about the ‘intuition and common sense’ of a particular individual (himself’) or a certain group of individuals. We get to read more of his thought on ‘intuition’ in his 2011 book. Some priceless extracts are reproduced below:

‘My view is that in economics, the need for intuitive understanding is much greater than most economists would have you believe. Good economic policy requires a ‘feel’ for things over and above the knowledge of theorems and regression coefficients’ (p. 14).

‘Both interventions and noninterventions have too often been left to the ideological whims of believers. They need to be founded on analysis and reason, not faith’ (p. 23).

‘What we so often take to be features of the world are actually propensities of the mind’ (p. 51).

‘My belief about the puzzle of knowledge lies somewhere between the skeptical and evolutionary claims. I have faith in our intuition’ (p. 53).

‘Causality lies in the eyes of the beholder’ (p. 54).

‘To sum up, scientific knowledge has to be combined with intuition and a shot of skepticism for it to be useful’ (p. 54).

On p. 23, he argues that policy interventions should be based on reason and not faith. However, on p. 53, he asserts that he has faith in (his’) intuition. Most of his comments seem to indicate a certain sense of confusion on what the scientific method entails and the role of economic theory in particular. This is quite unfortunate, since it comes from the pen of the current Chief Economic Advisor of India. If it is not confusion then it seems to be a proposal that ‘any idea goes’ wherein obviously the ‘idea’ is decided by those in power. Whatever happened to reason’ At the risk of repetition, let me state that this is an extremely dangerous outlook to possess because bad economic policies have devastating implications for majority of the population.

Basu rightly points out in his 2011 book that ‘the economy must be viewed as embedded in society and politics’ (p. xi). No one disputes this fact of reality. A worthwhile digression follows. Classical economists such as William Petty, Adam Smith, David Ricardo and Karl Marx in their contributions to political economy, as it was called then, never said otherwise. They stressed the need for proper social and political institutions. Coming back to Basu, he further writes: ‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104). Based on this premise, he criticises neoclassical microeconomics for restricting individual choice to their budget sets for, in reality, they make choices outside their budget sets. In other words, there is a wide range of behavioural options which cannot be captured by the budget set and therefore Basu arrives at the conclusion that traditional microeconomic theory is very unqualified to deal with human behaviour. But, isn’t the aim of microeconomics to explain (economic) prices and quantities’ Or, should we consider microeconomics as the study of human behaviour’ Basu seems to think of the latter when he discusses economics. For him, economics is primarily the study of human behaviour and actions and not primarily a study of incomes and prices (on this, see Economics: The Study of Commodities). It also must be kept in mind that Basu’s scientific strengths lie in game theory, behavioural economics and related fields. In his 2011 book, he himself states that his analysis ‘belongs predominantly to positive social science’ (p. 98).

Since his objective is to study human behaviour, he proposes that we expand the scope of economics. This proposal, as we all know, has important repercussions on economic theory and eventually on economic policy. As Malthus pointed out, to study wealth and its distribution, one needs depth and not breadth; in short, the boundaries or scope of economics must be clearly outlined, however limited they might seem. Introducing several aspects of culture as Basu suggests will only make the explanatory and causal content of economic theory very weak. In fact, it might make economic theory too open that it can be used to explain everything. This must be resisted at all costs for it is knowledge that is at stake here (see also Malthus: The Scope of Political Economy). Basu therefore hopes to expand the scope of economics by altering and widening its foundations in order to usher in the micro-foundations approach in macroeconomic theory as well as in policy making. One glance at the title of Chapter 2 of the previous three Economic Surveys is sufficient for this purpose – 2009-10: Micro-Foundations of Inclusive Growth; 2010-11: Micro-foundations of Macroeconomic Development and 2011-12: Micro-foundations of Macroeconomic Policy. The mark of Kaushik Basu is indelible.

Basu seems to be doing exactly what Gary Becker did when he applied microeconomic tools to a variety of human behaviour around the 1970s. Although, things have improved since then and research in game theory and behavioural economics have been reasonably successful in dispelling the very nice-to-hear qualities of the individual/agent in the economy. Cooperation, reciprocity, trust, etc have once again (Adam Smith talked about a lot of this in his Theory of Moral Sentiments; although he believed that it was necessary to assume certain behavioural propensities when studying the generation and distribution of wealth) begun to play an important role in economics. Basu does provide the reader with many such insights in his 2011 book by drawing upon his earlier research. As a consequence, he criticises the manner in which mainstream neoclassical/marginalist economics employs methodological individualism, especially the textbook version of it. Basu is unhappy because the agent in mainstream economics still does not carry out identity-based behaviour (p. 49). He demands an agent who is more social which does not imply a complete rejection of methodological individualism. Basu is candid about this: ‘It is not within my ability to break away from methodological individualism to the extent that we will eventually need to in order to have a more powerful social science and at the same time retain rigor’ (p. 101). He wants an increased role for identities in economic theory ‘ caste, gender, race, language, etc. As pointed out earlier, bringing too many variables when studying a specific problem often muddies and obfuscates the phenomenon under study. Moreover, the cognizance of such identity-based behaviour can easily be taken into account while formulating policies without having to call for an overhaul of economic theory. Therefore, Basu calls for widening the scope of economics:

‘A fundamental step in broadening the scope of economics is to recognise that the feasible set of actions open to individuals is much larger than our models make it out to be’ (p. 27).

‘Minimally, a proper understanding of economics requires recognizing that our economic relations are a part of a larger sphere of social and cultural interactions and institutions’ (p. 104).

‘How a nation functions at the level of macroeconomic aggregates depends a lot on the nuts and bolts of the economy. In our concern with managing the large and attention-catching variables, it is easy to let attention slip on the small, which may be vital’ (p. 39, Economic Survey 2011-12 ).

Given Basu’s view about the scope of economics, it is easy to understand why he promotes the micro-foundations approach in macroeconomics. This is undertaken in a manner which shows complete disregard for alternative/heterodox macroeconomic schools such as the Post-Keynesians, the Sraffa inspired Classical/Keynesians, the Marxians or the Kaleckians. These schools of thought are built on the belief that the economy is a system which has a logic and working distinct to itself. They criticise the neoclassical/mainstream economists of committing the fallacy of composition when they conceptualise the economy as an aggregation of individuals (see Some Logical Fallacies in Economics). Basu strongly advocates using the micro-foundations approach to macroeconomic issues in the Economic Survey. He writes:

‘The error has usually been in misreading the incentives and behavioural traits of the individuals who are to benefit from the policies and those who are supposed to carry out their day-to-day functioning. Fortunately, this is beginning to change both in the discipline of economics as well as in the design of policies in India. There is increasing recognition that flawed micro-foundations can devastate the best of macro intentions’ (p. 24).

‘Macroeconomic policymaking entails a mix of science and intuition. To ignore either of these would be a mistake. We need to marshal the best scientific knowledge available and study the microeconomic foundations of these macroeconomic concerns and then blend them with intuition and commonsense to craft policy’ (p. 25).

In short, according to Basu, micro-foundations is THE way forward both of economic theory and for policy.

His macroeconomic policy recommendations are problematic because of two reasons. First, his method of doing economics seems to be lack focus on the issues at hand ‘ unemployment, poverty, inflation, agricultural growth and so on; instead, his entire focus is on human behaviour and micro-foundations. Second, he appears to lack a solid understanding of macroeconomics, especially its alternative schools. In any case, let us take a look at two of his major macroeconomic proposals ‘ on fiscal deficit and Government as an enabler.

‘In the interest of medium- to long-term growth, it is important for us to bring the fiscal deficit down. While an expanded deficit can boost consumption and economic growth, this is medicine akin to antibiotics. It is very effective if properly used and in limited doses, but can cause harm if used over a prolonged period. Hence, government’s aim must be to effect rapid fiscal consolidation. A large deficit over a long period tends to squeeze out the private sector from the credit space. This dampens private investment and productivity and, more significantly, worsens the options of the inflation-growth mix available to government’ (p. 27).

‘This is what is meant by the enabling role of government. It should create a setting where it is in the interest of private agents to deliver on what needs to be delivered’ (p. 28).

As long as the economy is not at the full-employment level of output, crowding-out can never happen. Moreover, Basu forgets that the economy is not a stagnant organism; instead it is a growing one. The idea that government investment crowds-out private investment precariously hinges on the notion of scarcity in the economy. In a setting where the Central Bank controls interest rates so as to maintain price stability, it is difficult to see how crowding-out occurs as a result of government expenditure (see Introductory Macroeconomics: On Crowding Out). As for the enabling government, Basu seems to forget that India requires significant government expenditure/intervention in the form of Right to Food, Right to Education, Right to Employment, Right to Information, etc so that a dignified ‘setting’ can be constructed for everyone.

To conclude, it appears that as a game theorist who has important socially relevant insights, Basu is well on the mark. However, his macroeconomics, unfortunately, is grounded on extremely weak foundations and therefore is well off the mark.