Tag Archives: economic methodology

On Competition in Economic Theory

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.

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-à-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?