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On Competition in Economic Theory

Posted by Alex M Thomas on 31st July 2014

The assumption of ‘perfect competition’ is central to marginalist (neoclassical) economics. In classical economics, a strand of non-orthodox economics, a seemingly similar but fundamentally different assumption of ‘free competition’ is made. This blog post is about the differences between classical and marginalist economics with respect to their definitions of competition. A further comment relating to the method of economics is also made in connection with this matter in the concluding paragraph.

In marginalist economics, under conditions of ‘perfect competition’, the demand and supplies of commodities and all factors of production are in equilibrium. There is no unemployment of labour or any underutilization of capacity (‘capital’). What are these conditions of ‘perfect competition’? A large number of firms is assumed to exist, each too small to be able to set the price. That is, all firms are price takers and they attempt to maximize their profits. There are no barriers to entry or exit. Further, it is assumed that whatever the firms supply, there always exists sufficient demand. One wonders whether there is any real agency to these price-taking firms and entrepreneurs. When questions are posed in classrooms about their correspondence with reality, the response provided is that such conditions do not actually exist but are a first and a necessary abstraction so as to examine conditions of oligopoly or monopolistic competition. So, what is profit in marginalist economics under ‘perfect competition’? It is the marginal product of ‘capital’, which is zero entailing that profits just cover the interest costs; that is, are no returns to entrepreneurs undertaking risk and uncertainty? Ignoring the capital theoretic problems faced by marginalist economics, underlying this conception is the view that capitalists and workers are (‘justly’) rewarded for their contribution to production.

On the other hand, classical economists, from Adam Smith to Karl Marx, and contemporary economists following the classical tradition, after its revival by Piero Sraffa in 1960, assume ‘free competition’. There is free mobility of labour and ‘capital’. Firms and entrepreneurs are profit maximizers as in marginalist economics. No restrictions are imposed on the number of firms or their ability to set prices. The process of competition – profit-maximizing behaviour plus mobility of factors – tends to make the market prices gravitate towards long-period normal prices and a uniform rate of profit is obtained on the capital advanced. Note that the rate of profit is not zero as in marginalist economics. Alterations in demand and supply affect the market prices. If market prices fall below normal prices, production is not profitable and depending on their permanence the affected firms might exit the industry. Alternatively, production may be cut down because of the lack of adequate demand. Moreover, real wages are determined by wider social and political forces. If real wages are given (and given technology), the rate of profit and the configuration of normal prices are determined. Or, if the rate of profit is determined via the rate of interest set by monetary authorities, the real wage and the set of normal prices are determined. That is, distributive variables are capable of being determined exogenously. This is in stark contrast with the marginalist theory – the marginal productivity theory of distribution, as it is called. Classical economics in contrast to marginalist economics has a logically consistent theory of value and distribution embedded in a framework of competition with realistic conditions. Also, classical economics is able to accommodate institutions, be it collective bargaining or monetary policy, within its framework without any difficulties.

To conclude, besides other logical problems marginalist economics faces, it also possesses a rather restrictive notion of competition. But, does economic theorizing require such an assumption? My answer is in the affirmative. To identify casual chains, however short they might be, an environment of ‘free competition’ must be assumed. With free mobility of labour and ‘capital’ – a genuine conception of a competitive economy, a uniform rate of profit is obtained. But, note that a classical competitive equilibrium does not entail full employment. [Non-competitive elements will generate differential profit rates.] So, should we abandon the study of economic phenomena under ‘free competition’? No, because it conveys to us tendencies in a competitive economy and non-competitive processes are conceptualised as a departure from competitive ones.

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Posted in Classical Economics, Economics, Employment, Marginalist economics, Markets, Neoclassical Economics | No Comments »

On the Determinants of Investment

Posted by Alex M Thomas on 30th June 2014

It is well known that an economy’s output levels and employment levels are determined by the level of investment. The popular story presented in mainstream textbooks and taught in conventional courses is that of planned saving adapting to planned investment, with the rate of interest as the equilibrating factor. This is the supply-side vision of the economy wherein demand can never be a constraint except temporarily due to frictions or imperfections. Additionally, this view reaches the conclusion that that there is a tendency to full-employment in capitalist economies. This blog post revisits the saving-investment relationship, the investment function and the link between the rate of interest and investment. Given the crucial role investment plays in an economy, it is important that we critically appraise its determinants.

By investment, economists mean the purchase of capital goods and not financial assets. Saving refers to the income that is not consumed. Saving is a leakage from the economy while investment is an injection. Marginalist (neoclassical) economics maintains that planned saving and planned investment are equilibrated through variations in the rate of interest which is assumed to be sufficiently sensitive to any saving-investment disequilibrium. Planned saving is a positive function of the rate of interest while planned investment is a negative function of the rate of interest. When planned saving is in excess of planned investment, there is excess savings which puts a downward pressure on the rate of interest and vice versa. However, is such an a priori functional link between the rate of interest and the rate of accumulation a correct one? The 1960s capital theory debate demonstrates the implausibility of an interest-elastic investment function on logical grounds. Also, in a world where the rate of interest is set by monetary policy (and therefore exogenous to the saving-investment process) it is unclear how it can play the role of an equilibrating force as suggested by marginalist economics.

The non-orthodox approach to activity levels and growth draws inspiration from the principle of effective demand of Kalecki and Keynes. The investment function is not interest-elastic in this theoretical approach, also called the demand-led approach. Here, investment depends on ‘the future expected level of effective demand (D+1), which tells us how much capacity firms will need, and on the current technical conditions of production (represented in this simple model by the normal capital-output ratio)…’ (Serrano 1995: 78; available freely here). In this simple model, note that production is assumed to be carried out with circulating capital only. So, I = aD+1 where a is the capital-output ratio. A change in technology will affect the capital-output ratio, which indicates how much of capital is required to produce one unit of output. Further, we make the realistic assumption that firms do not systematically err in their expectations. The expectations of firms of course depend on policy certainty. Policy uncertainty affects consumption and investment decisions in an adverse manner.

As a matter of fact, a recent IMF working paper on the situation of India provides partial support to the demand-led approach. They note: ‘Real interest rates account for only one quarter of the explained investment slowdown.’ For them, the key factor is policy uncertainty, but, the demand-led growth theorists, I think, will advocate the examination of the exact mechanisms through which monetary and/or fiscal policies have deterred investment. Without explaining further in this blog post, the answer might be found in the manner in which autonomous elements of demand such as autonomous consumption, research & development expenditures, government expenditures and foreign expenditures are affected by policy uncertainty. To conclude, it is time that the interest-elastic investment function is seriously questioned both on theoretical and empirical grounds, and subsequently discarded.

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Posted in Economic Growth, Economics, India, Macroeconomics, Marginalist economics, Michal Kalecki, Neoclassical Economics, Sraffa, Supply side economics | No Comments »

Towards an Objective Understanding of Scarcity

Posted by Alex M Thomas on 26th November 2013

When Henry Holt & Co. sent me an advance edition of Sendhil Mullainathan and Eldar Shafir’s Scarcity: Why Having Too Little Means So Much to review, I had presumed it to be another book on the ubiquitous nature of scarcity. However, their book, while acknowledging the phenomenon of scarcity to be omnipresent, argues, in a novel manner, the adverse effects scarcity has on the cognitive resources of individuals. In other words, scarcity (of money, time, etc.) forces people into a scarcity-trap: the poor stays poor; the busy remain busy; and the lonely remain lonely. For, ‘[s]carcity creates a mind-set that perpetuates scarcity.’ The aim of their book, writes Mullainathan and Shafir, is ‘to unravel the scientific underpinnings of scarcity’ in order to make more sense of ‘social and behavioral phenomena’ and is targeted at a ‘wide audience’. Their book is an attempt to present ‘the logic and consequences of scarcity.’

‘Scarcity captures our mind. … It changes how we think. It imposes itself on our minds.’ And, ‘scarcity’s capture of attention affects not only what we see or how fast we see it but also how we interpret the world.’ Hence the authors argue that scarcity ‘is not just a physical constraint. It is also a mind-set.’ The consequence of scarcity, according to Mullainathan and Shafir, is that it makes ‘us less insightful, less forward-thinking, less controlled.’ It reduces our ‘bandwidth’ – our cognitive ability. There is however a positive outcome of scarcity, the ‘focus dividend,’ which makes us more effective in the immediate period but ‘scarcity eventually ends in failure.’ They label the mechanism which reduces our cognitive resources ‘tunneling’. ‘Sometimes when we tunnel, we neglect other things completely.’ ‘Focus dividend’ is a short-term positive outcome of scarcity whereas ‘tunneling’ is a long-term adverse consequence arising from the tax scarcity imposes on our bandwidth. They are, in fact, interdependent phenomena. Based on their experiments, they observe that poor people ‘tunnel’ and therefore do not purchase insurance which would have helped them in the future. For, ‘scarcity taxes bandwidth’ and ‘generates internal disruption’ by lowering ‘fluid intelligence and executive control’. The authors acknowledge the role ‘self-control’ could play in overcoming scarcity, but they note that ‘will-power’ is something which is not yet fully understood. To summarise: ‘[t]he problem is not the person but the context of scarcity.’

Opposite of scarcity is ‘slack’ or ‘abundance’. ‘Slack’, writes the authors, ‘is a consequence of not having the scarcity mind-set.’ Those who have an abundance of resources (money or time) have the luxury not to make trade-offs. Additionally, ‘[s]lack gives us room to fail.’ Scarcity therefore not only leads to ‘greater errors’ due to the bandwidth tax, but also implies that there is ‘less room to fail.’ Marginalist economics treats any unused or underutilised resource as wasteful and inefficient and the authors follow this logic. Although, in the later part of the book, they distinguish between useful and useful slack. Of course, what is useful or wasteful depends on the goals or aims of the individual, organisation or government. The subjective assessment of physical/objective scarcity is also dependent on the goals, and the process of tunneling depends on this subjective measurement of scarcity and the goals. Therefore, the experience of scarcity is in itself conditioned by the goals and they affect each other in a dynamic fashion – reasoning is not limited to the means to achieve the ends, but it also can modify the ends. In the initial chapters, the authors, using results from experiments, quite convincingly argue that the subjective feeling of scarcity generates an objective result – it taxes the bandwidth and lowers the cognitive ability. In fact, the entire book can be seen as an attempt to provide an objective understanding of scarcity (which can be real or imagined or both).

Scarcity leads to borrowing. Borrowing, according to the authors, is a ‘simple consequence of tunneling.’ Although, it is conceivable that scarcity can lead to borrowing, it certainly cannot be maintained that all borrowing is because of tunneling. The phenomenon of a debt-trap is nothing new. ‘Scarcity leads us to borrow and pushes us deeper into poverty.’ Scarcity, writes the authors, causes the poor to focus more on immediate (short-term) goals and they overlook long-term goals. The focus on several short-term goals is termed juggling, and is a ‘logical consequence of tunneling.’That is, the poor resort to ‘short-term fixes.’ Can one get out of scarcity? Without some external intervention, the authors argue, it is highly unlikely. For, getting out of the scarcity-trap requires a (long-term) plan but since the goal is not immediate, the scarcity mind-set does not accommodate it. ‘Planning requires stepping back, yet juggling keeps us locked into the current situation.’ Also, ‘future planning requires bandwidth, which scarcity taxes heavily.’ To state the obvious, the authors note that ‘[a]ll this is complicated by the lack of slack.’ Scarcity implies a lack of slack. Similarly, slack implies a lack of scarcity. Owing to the objective effects of scarcity on cognitive resources, getting out of a scarcity-trap is extremely difficult, be it those who lack money or time.

Chapters 7 and 8 are devoted to understanding (income) poverty and some suggestions are offered for improving the lives of the poor. The authors rightly argue that the extant explanation of poverty is largely ‘piecemeal.’ Their major contribution, I think, to studies on poverty is that the poor ‘lack not only money but also bandwidth’ as a consequence of their income poverty. As they ask: ‘Why not look at the structure of the programs rather than the failings of the clients?’ This bandwidth tax is something the designers of social programmes ignore. Therefore, ‘strong incentives’ do not often function well. The authors call for social programmes which are ‘fault tolerant’ given the already taxed bandwidth of the poor. A limit ‘penalises but fails to motivate’ the poor and according to the authors such limits/penalties on incentives are flawed because they do not take into account the cognitive effects of scarcity. ‘Limits create scarcity, the logic goes, which might lead to better management of how the resource is “used.” This almost relies on the psychology of scarcity. But it is flawed.’ A better solution, according to Mullainathan and Shafir, would be ‘to create smaller but more frequent limits.’

A greater focus on the creation of dependable jobs and stable incomes for the poor across the world could be psychologically transformative.

All this is a radical reconceptualization of poverty policy. … Now, rather than looking at education, health, finance, and child care as separate problems, we must recognize that they all form part of a person’s bandwidth capacity.

A powerful and political conclusion emerges from the authors: social engineering should be built on better foundations, in this case, that of the psychology of scarcity.

Chapter 9 is titled ‘Managing Scarcity in Organizations’ wherein the importance of slack is stressed, in contrast to the views espoused by the ‘efficiency experts.’ Organizations should ‘explicitly manage and ensure the availability of slack.’ In other words, the quality of the workplace must be improved – less surveillance, adequate leaves, reduced working hours, etc. For, as the authors note:

Increasing work hours, working people harder, foregoing vacations and so on are all tunneling responses, like borrowing at high interest. They ignore the long-term consequences.

In line with the optimizing story told by marginalist economics, Mullainathan and Shafir emphasise the need to ‘maximize our limited cognitive capacity.’ They call for a greater focus on the ‘cognitive side of the economy’ and even go as far as to suggest the creation of a ‘Gross National Bandwidth’ index!

Despite the authors adopting some static concepts employed in marginalist economics of a very subjective nature, their research points towards a very dynamic and objective understanding of scarcity. Moreover, the adverse consequences of scarcity on cognitive resources highlight the extreme importance of careful social engineering, especially in the reduction of poverty.

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Posted in Behavioral Economics, Book reviews, Economics, Marginalist economics | No Comments »

Two Fundamental Objections to Marginalist Economics

Posted by Alex M Thomas on 31st October 2013

In the past, several posts on this blog have raised dissatisfactions and have expressed discontent with the prevalent orthodoxy in economics – neoclassical economics (more accurately, marginalist economics). This post is similar in intent as the previous posts, but it chooses to focus on, what I deem to be, the two most theoretically and empirically inadequate tenets of marginalist economics: (1) the marginal productivity theory of (income) distribution and (2) the supply-side growth theory.

Equilibrium prices and quantities of commodities and factors of production (such as labour and ‘capital’) are determined simultaneously in marginalist economics. Distribution is endogenously determined according to the relative scarcity of factors, i.e., based on the demand and supply of factors. Under conditions of perfect competition, in equilibrium, the wage rate equals the marginal product of labour and the profit rate equals the marginal product of ‘capital’. That is, there is no surplus in the marginalist theory of value and distribution. The origin of the marginal principle is to be found in Ricardo’s discussion of intensive rents. This principle has been illegitimately extended to labour and to ‘capital’. In marginalist production theory, labour is freely substitutable with ‘capital’. The famous Cobb-Douglas production function is based on the substitutability of the two factors of production. The use of the aggregate production function has been shown to be logically unsound (due to problems of not just measurement but also aggregation of ‘capital’) and therefore its applicability in empirical analysis is severely undermined. But, this logical critique, famously known as the Cambridge Capital Controversies, remains ignored.

Underlying the supply-side theory of growth is the marginal productivity theory of distribution. Relative scarcities of the factors induce changes in their prices such that the demand for factors equals their supply. This implies that, in equilibrium, all factors are employed. The real wages are assumed to be sufficiently sensitive to disequilibrium in the labour market such that they adjust in order to render the labour demand equal to its supply. And, the aggregate production function states that a growth in the factors will lead to a growth in output. In other words, if the labour and ‘capital’ endowments are increased, there will be higher growth. Aggregate demand adapts to aggregate supply and the possibility of an aggregate demand deficiency is ruled out. Slight modifications have been made to this theory in order to explain the presence of unemployment. These modifications take the form of rigidities of the real wage, which cause labour unemployment. In marginalist theory, one of the explanations for the presence of unemployment is labour market rigidities. If these rigidities are absent, labour will tend to be fully employed. Such theories have come under severe criticism and rightly so.

To conclude, marginalist economics is unsatisfactory on logical grounds. Moreover, it does not perceive the possibility of an aggregate demand deficiency. Lastly, unemployment is seen to be a consequence of imperfections or rigidities and not as permanent feature of competitive economies.

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Posted in Economic Growth, Economics, Marginalist economics, Neoclassical Economics | 1 Comment »