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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 »

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 »

Misunderstanding Economic Growth and Development

Posted by Alex M Thomas on 25th August 2013

If two previous posts dealt with trying to understand how economic growth may or may not translate into development, this post goes a step behind and discusses what economic growth means. More importantly, this post examines what economic growth does not mean. The motivation for this blog post comes from Jagdish Bhagwati and Arvind Panagariya’s 2013 book titled Why Growth Matters: How Economic Growth in India Reduced Poverty and the Lessons for Other Developing Countries. Note that the following paragraphs are not intended to be a detailed review of the book; only their central premise – ‘the centrality of growth in reducing poverty’ (p. 4) – will be engaged with. The blog post, however, ends with a critical commentary on the authors’ methodology (focusing on authors’ engagement with opposing views, presentation of authors’ own arguments and referencing), as contained in the Preface, Introduction and the first three chapters. Also, no comments are offered on the data analysis present in their book.

A premise is ‘a statement or proposition from which another is inferred or follows as a conclusion.’ Bhagwati and Panagariya start with the premise that economic growth entails increase in employment opportunities and an improvement in income per person. This is also their conclusion, and forms the title of their book. They write:

Bhagwati argued nearly a quarter century ago that growth would create more jobs and opportunities for gainful improvement in income, directly pulling more of the poor above the poverty line and additionally would allow the government to pull in more revenues, which would enable the government to spend more on health-care, education, and other programs to further help the poor. Growth therefore would be a double-barrelled assault on poverty. (p. xix)

Further, they write: ‘growth helps by drawing the poor into gainful employment’ (p. 23). A simple question is sufficient to negate this view. Does the market create jobs after taking into account the abilities and skills of the poor? Of course not! If so, there would not be any unemployment or underemployment. A well-educated (and healthy) workforce is necessary so as to actually ‘gain’ from the newly created employment opportunities. [Not to forget the hardships involved in deskilling and reskilling.] And, it is not logically necessary for employment opportunities to increase when the economy grows. Jobless growth is a possibility where the surplus is not used to create further jobs; more often, it is a question of whether jobs are being created at the same pace as at which the economy grows.

By definition, economic growth entails a rise in income. But whose income? Economic growth can co-exist with the rich getting richer. Or, economic growth can give rise to stagnant wage shares amidst productivity rises. Growth can be export-led. It can be service-led. It might favour capital-intensive over that of labour-intensive technology. A rise in real GDP can happen because of a variety of reasons. It is these ‘reasons’ that one must investigate. For, it is here that we will find answers as to who the beneficiaries of economic growth are. It is to the mechanisms or processes which generate economic growth that we must attend to in order to comprehend which sector/classes/groups are losing out. For example, the nature and consequences of service-led growth will be very different from that of growth that is manufacturing-led. Bhagwati and Panagariya repeat the same fallacy, pointed out in the previous paragraph, in the following passage.

Conceptually, in an economy with widespread poverty, labor is cheap. Therefore, it has a comparative advantage in producing labor-intensive goods. Under pro-growth policies that include openness to trade (usually in tandem with other pro-growth policies), a growing economy will specialize in producing and exporting these goods and should create employment opportunities and (as growing demand for labor begins to cut into “surplus” or “underemployed” labor) higher wages for the masses, with a concomitant decline in poverty. (p. 23; see p. 43 as well)

Conceptually, in an economy with excess labour supply, labour is cheap. Bhagwati and Panagariya argue that a growing economy with cheap labour will adopt labour-intensive techniques. This reasoning assumes that an unemployed farmer or school teacher can easily and naturally be employed in a firm which exports computer parts. The authors’ views seem to indicate a gross misunderstanding of the actual economic dynamics of any society (see below as well). Moreover, one is not just concerned with mere employment, but with employment that provides good working conditions – including sick leave, maternity leave, overtime wages, etc.

‘The pie has to grow; growth is a necessity’ (p. xx). Yes, a larger surplus makes it feasible for each claimant to get a greater share, including the government. The contention is with respect to the feasibility and who these claimants are. According to Bhagwati and Panagariya, growth automatically and naturally generates higher incomes per person thereby ‘directly pulling more of the poor above the poverty line.’ Growth is not manna from heaven which everyone gets in equal amounts. It is based on definite political, economic and social institutions/processes – wage bargaining, possibilities of reskilling, mobility of labour, gender, caste, family structure, social security nets (family based or from the government) and so on. In this context, the authors rightly note the negative effects excessive licensing, government monopolies and protectionism can have on the growth of an economy (p. xii).

Given the authors’ belief in a strict one-way causation running from economic growth to development, they argue for carrying out growth-enhancing reforms first, which they refer to as Track I reforms. Subsequently, the surplus can be redistributed by the government to achieve development; this can be through transfer payments of various kinds. These are known as Track II reforms. They argue:

Track II reforms can only stand on the shoulders of Track I reforms; without the latter, the former cannot be financed. (p. xxi)

Of course, they can be financed through government borrowing and there is ample literature on the issues surrounding debt-sustainability in relation to achieving full employment. One wishes to see a more nuanced understanding of such matters.

This separation of growth from development is not just illogical and untrue, but also dangerous to public policy. Often, for purposes of economic theorising, in order to carefully study the causal relations between variables, some boundaries are drawn and certain assumptions are made. But, an import of this technique into the domain of public policy is methodologically flawed, where the abilities of individuals to seek jobs and actually work and earn (higher) incomes crucially depend on their social, cultural and economic backgrounds. In other words, while the distinction between economic growth and development might be reasonable for some purposes, in practical politics, they go together. Moreover, if the policy objective is to ensure good quality of life for all, then it must be the case that, to use the authors’ terminology, both Track I and II should be undertaken at the same time, with perhaps a greater emphasis on Track II reforms.

A fundamental error underlies the authors’ belief that ‘growth’ is an automatic process which takes place when the government lets the private players have a completely free hand, international trade is free, and capital can freely flow in and out of the country. It is this notion which makes the authors’ note that ‘Track II reforms involve social engineering…’ (p. xxi). That is, in their view, Track I reforms require no ‘social engineering’. Nothing could be farther from the truth! A ‘market’ is an engineered institution. The belief that ‘free markets’ will deliver both economic and social justice is quite easily discernible from their statements. Making commodity markets free (from both government and private monopolies) is certainly beneficial for economic growth as well as for wider socio-economic development. But, given the (historical or otherwise) arbitrariness (as opposed to ‘merit’) involved in the ownership of various forms of assets, and the tendency of markets to favour the powerful, there is always a crucial role for the government and civil society to intervene in order to ensure social justice (especially in the arenas of education and health). After all, is this not what we mean by participatory democracy?

The preceding commentary is based on a partial reading of Bhagwati and Panagariya’s book, as noted in the introductory paragraph. Their conception of growth, at best, seems superficial and at worst, they misunderstand the dynamics of economics growth as well as development. The view of ‘free markets’ generating growth with rising incomes per person is never an automatic process. It requires visible hands and is indeed social engineering. We end with a few observations on their methodology. For them, all that their critics say are myths; Part I of their book is titled ‘Debunking the myths.’ On one occasion, some of the critics, who are hardly ever named (and therefore not cited), are accused of being ‘intellectually lazy’ (p. 25; also see p. 32, p. 34, p. 35 for the unnamed critics). On the other hand, the following phrases are used for arguments in their own support: ‘state-of-the-art techniques’ (p. 31), ‘detailed state- and industry-level data’ (p. 31), ‘compelling nature of evidence on the decline of poverty under reforms and accelerated growth’ (p. 33), ‘irrefutable evidence’ (p. 37), ‘evidence…is unequivocal’ (p. 38) and ‘these authors’ superior methodology’ (p. 43). Out of the total number of references excluding data sources and reports (around 125 in number), about 37% (around 47 in number) are references to the authors’ work, either as a sole author, a co-author or as the editor of the volume. This is very striking. And, out of citations to Panagariya’s work (about 27 in number), 14 of them are newspaper articles published in the Times of India or Economic Times. It is indeed unfortunate to come across so many fundamental errors in a book like this, because growth does matter, although not at all in the way Bhagwati and Panagariya expound in their book!

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Posted in Book reviews, Development Economics, Economic Growth, Economics, Education, Employment, GDP, Government, India, Labour Economics, Macroeconomics, Markets, Neoclassical Economics, Poverty, Unemployment | No Comments »