Neoclassical Economics – Undergraduate Economist

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.”

The Macroeconomics Underlying the Economic Survey of India 2013-14

This blog post critically evaluates the first two chapters of the Economic Survey of India 2013-14 in order to get a sense of the macroeconomic theory underlying it. [This blog has assessed previous ones for the years:2012-13,2009-10;2010-11;2011-12.] What conceptual framework does the Economic Survey adhere to, implicitly and/or explicitly’ This is of significance not just for those interested in theory but also for those who want to understand how economic policies are formulated. Attention will be mainly divided among the following macroeconomic themes: (1) role of investment in economic growth, (2) labour market flexibility and economic growth, (3) policies emanating from (1) and (2), and (4) the overarching aim of economic policy.

It is well-known and widely accepted that investment, be it private or public, is necessary for economic growth. By investment, we primarily refer to additions to fixed capital ‘ machinery, tools, storage facilities, transport equipment, etc. Investment in education, health and environment should also be included, for they expand the productive capacity of the economy in the long term. Two questions may be posed now. First, what is the source of investment’ Second, what ensures that the growth in productive capacity will be matched by an equivalent growth in demand’

Prior to the path-breaking work of Keynes, it was widely believed that investment is savings constrained and that saving and investment are equilibrated through variations in a sufficiently sensitive interest rate. Keynes convincingly argued that investment is not savings constrained, rather, it is finance constrained. Moreover, he demonstrated that it is activity levels (output and employment) which equilibrate saving and investment, and the causation runs from investment to saving. This is the principle of effective demand, also to be found in the work of the Polish economist Kalecki. The Economic Survey adopts the pre-Keynesian view, which, not surprisingly is still around, embedded in the neoclassical school of economics ‘ the dominant school in economics teaching and publishing. This marginalist idea of saving-investment equilibrium is mirrored by the market equilibrium for ‘capital’ ‘ the demand for and supply of capital is brought into equilibrium by variations in the interest rate; this is nothing but the marginal productivity theory of distribution.

Implicit in the Economic Survey is the pre-Keynesian view, an essential part of neoclassical economics. ”higher investment required for raising growth had to come from higher domestic savings” (p. 9). However on p. 11, the slowdown in investment growth is attributed to policy uncertainty, sluggish demand and high interest costs. Despite the reference to demand deficiency on the same page (on p. 13, it is acknowledged that an increase in aggregate demand has a positive impact on economic growth), the conclusion on the same page supports ‘structural reforms’ and the elimination of ‘supply-side bottlenecks’. Also, Keynes’s finance-constrained investment view is expressed when the ‘bank credit flow to industry’ is briefly discussed (p. 25); due to sluggish demand, the demand for credit was lower. [See an earlier post on the determinants of investment.]

Income earners make saving decisions (commonly referred to as households or wage earners) whereas it is the firms and entrepreneurs who make investment decisions in a decentralized economy as India. Firms also make use of their retained earnings for purposes of investment (p. 14). The intermediation of saving and investment is carried out via the banking and financial system ‘ the suppliers of credit, so to speak. The point I wish to highlight is this: abundant savings or a low rate of interest is not sufficient for (physical) investment. There should be demand for the commodities and services produced. Also, there are no mechanisms which ensure that supply will create its own demand, famously known as the Say’s Law. At various points, it appears that the architects of the Economic Survey believe in the Say’s Law. In other words, they do believe that a growth in productive capacity will engender an equivalent growth in demand.

Policy uncertainty & investment

Policy uncertainty emanates from ‘difficulties in land acquisition, delayed environmental clearances, infrastructure bottlenecks, problems in coal linkages, ban on mining in selected areas, etc.’ (p. 11; also see p. 33). This particular statement is reflective of a view which does not take common property resources, ecosystems and environmental sustainability seriously and with caution. The uncertainty in policy vanishes when the government is clear, transparent and committed to socio-economic and environmental justice. Policy uncertainty arises from vague, untimely and arbitrary policy decisions. In fact, this approach to securing higher economic growth is inconsistent with the position adopted in the Economic Survey on sustainable development and climate change which, on paper, appears committed to environmental justice and inter-generational equity. And it is such inconsistencies which cause confusion and policy uncertainties for firms wishing to invest in India.

The marginalist growth theory (Solow’s growth model being the exemplar) makes use of the marginal productivity theory of distribution. Put simply, a growth in the factors of production (or factor endowments) is sufficient for economic growth. And, supply creates its own demand. According to this view, widely taught in macroeconomics courses, growth is supply-side. The impediments to growth then become imperfections in the factor markets, particular labour markets. Consequently, policy is supposed to make labour markets flexible/free/perfect so that the economy can gravitate towards the full-employment position. But, this theoretical view has been shown to be unsatisfactory given the logical problems associated with the marginal productivity theory of distribution. In addition, the creation of a just society must necessarily ensure a minimum wage for all workers sufficient for a decent living, the scope of which ought to widen as societies progress.

According to the Economic Survey, ‘[t]he inflexibility of labour markets have prevented high job creation’ (p. 30). For those brought up in the marginalist tradition, the usual culprit is the labour market. Of course, labour laws, like any other law, should be just and provide opportunities for workers to support each other given that the employers are more powerful than the workers. Also, working conditions, social security, equal opportunity across gender, caste and class and so on must be provided to the workers. This is the responsibility of institution builders ‘ the government together with the civil society. Yes, labour market reforms are necessary: ‘changes in the legal and regulatory environment for factor markets’ (p. 31).

Reforms, unfortunately, have come to possess a single meaning in economics and politics. Reforms have come to refer to policies which make markets more free. There is no reason why reforms need to be thought of in this manner. Politics is about possibilities, and economics suggests some ways of engineering these possibilities in order to provide a decent life to all. There is nothing intrinsically good in any economic or political sense about reforms. The efficacy and goodness of reforms lies in its details.

‘Factor markets such as those for labour, land, and capital, however, remained largely unreformed. This has proved to be a constraint for growth and employment generation’ (p. 48). This statement also is very marginalist or neoclassical in nature. Moreover, one has to be cautious for the three factors of production are very different from one another. Capital refers to produced means of production ‘ commodities and services. Barriers to entry and exit need to be reduced and firms need to operate in a competitive environment. Land is a resource which needs to be treated very carefully and on a case-by-case basis; it has immediate impacts on livelihood as well as on the natural environment. Labour market constitutes people, and there should be strong social security for workers and good working conditions.

III

Policy prescriptions include primarily supply-side measures. This is not surprising owing to the Economic Survey being fundamentally neoclassical. Investment, a component of aggregate demand, is rightly considered crucial. But, public investment is not much favoured. Investment, as noted in section I, will be revived if supply bottlenecks are removed ‘ that is, projects get easily cleared. Policies are targeted at boosting productivity. Provision of physical and social infrastructure is of utmost importance. A market for food (reducing distortionary interventions in agriculture) needs to be created. Manufacturing must be improved.

What is the central aim of these economic policies’ Repeatedly, in these two chapters, the objective is to create a ‘well-functioning market economy’ (p. 29; also 26, 46). This is much needed, but the ‘reforms’ need to be socially and environmentally sensitive. Also, just as with reforms, many different configurations of a market economy are possible. This must not be forgotten, and nor should social, economic and environmental justice be overlooked. To conclude, I would add a few words to the first sentence in chapter 2: ‘The defining challenge in India today is that of generating employment and growth’ (p. 29) which is economically, socially and environmentally inclusive. These additional words make all the difference, both in terms of economics and politics.

Economics: The Study of Commodities

The study of commodities has been central to economic theory. Mercantilists considered gold, a commodity to be wealth. Later economists argued that an increase in commodities, both agricultural and manufactured, implied an increase in wealth. The increase in the production of commodities is still the most widely used indicator of economic growth/progress. This indicator is none other than the real GDP. In 1985, Amartya Sen published a book titled Commodities and Capabilities. In this work, Sen challenges the dominant view in economics regarding the role of commodities, i.e. he maintained that an increase in commodities cannot be taken as the sole factor in assessing economic development. Sen emphasised the importance of examining capabilities, which subsequently led to the creating of the Human Development Index (HDI). This post discusses the rationale behind economists’ obsession with commodities. It also examines Sen’s critique of commodities and how his (Aristotelian) concept of capabilities differs from it. This post concludes by arguing for a strengthening of classical economics, which studies the production, distribution, exchange and consumption of commodities, for the considerations of ethics can be easily integrated into this approach.

Economics as a distinct form of inquiry begins with the works of Sir William Petty in the 17^th century. Petty was interested in assessing the comparative wealth of England and Ireland. Some of the indicators he chose were the number of houses and population. The idea behind this being that a surplus of food results in more population and therefore more houses. Having a large population was considered to be beneficial to the state. His successor, Richard Cantillon, an economist par excellence, pointed out that wealth of a state is reflected in the quantity and nature of commodities it produces ‘ necessities, comforts and luxuries. This brief historical excursus is to point out the nature of economic inquiry, which is essentially an analysis of quantities and prices. Examples of quantities are employment, income, exports, investment, money supply, etc. Examples of prices are WPI, interest rates, foreign exchange rate, commodity prices, share prices, etc. That is, an analysis of commodities is an examination of quantity and price at the same time. Therefore, an analysis of commodities subsumes an examination of their production, distribution, exchange and consumption. Production includes the structure and relations of production; distribution pertains to the process and mechanism through which the incomes/surplus from production is divided among its participants; exchange refers to the mode and institution through which commodities are sold; finally, consumption illuminates the channels through which consumption of commodities aid production in the next period and how production in the current period aids current consumption. Thus, classical economists such as Petty, Cantillon, Quesnay, Smith and Ricardo were interested in the theory of production, distribution and exchange of commodities. Their interest was motivated by the need to find out ways of improving the general well-being of their respective societies.

According to Sen, the kind of analysis posited above looks at opulence as the sole indicator of economic development. A shift in economic analysis came about in the 1870s with the emergence of marginal analysis, independently developed by Jevons, Walras and Menger. Terms such as utility, choice, scarcity, margins, etc made inroads into economics. In fact, standard microeconomics texts are nothing but a combination of Walrasian and Marshallian economics. In any case, the maximization of utility began to be seen as the objective of individuals, for attaining economic progress. The internal justice of free markets was imbued to this form of economic analysis. Based on utilitarian principles, the maximization of utility by individuals was seen as a way to improve human well-being and welfare. This conception of development, according to Sen, emphasised the role of utility.

Both the above mentioned analyses, according to Sen, deal with ‘the relation between commodities and people’ (p. 1). The former approach argues for more commodities which leads to more production, which raises the incomes of the people and hence their consumption. The latter analysis points out that ‘more is better’ and hence availability of more commodities imply more utility. The idea of ‘more is better’ is intricately connected with their idea of economics, as a science of choice. Economics, for marginal/neoclassical economists, refers to the allocation of scarce resources amongst alternative uses, as Lionel Robbins points out. For Sen, both these analyses are limited, since they do not address the heterogeneity in the capabilities of different people, which leads to ‘a confounding of the state of a person with the extent of his or her possessions’ (p. 16). It is precisely this argument of Sen developed in his 1985 book which widened the scope of mainstream economics. I write mainstream economics because for classical economists, economics or political economy formed only one way of looking at growth/progress/development. For classical economists, as pointed out earlier, an analysis of production included the state or condition of the producer. The best example of this form of theorising can be found in Marx, the last of the early classical economists. However, with the advent of marginal analysis, the analyses of the structure of production took a backseat. The sphere of exchange came to the forefront and along with it the explanation of the formation of all kinds of prices and quantities through the apparatus of demand & supply.

It is interesting to note that the idea of capabilities has been intrinsic to classical economics. As mentioned earlier, an increase in the production of commodities translates into an increase in income generated. In contrast with neoclassical economics, the economic processes is visualised in a circular way as opposed to a one-way street. One needs to look into the structure of production to find out to whom (which class) this increase in income accrues (theory of distribution). However, the manner in which Sen develops his capabilities approach is rooted in mainstream/neoclassical economics ‘ via the sub-domain of welfare economics (See Benicourt 2002 and Omkarnath 2007). Although, Sen deserves credit for bringing back humanitarian concerns into the discourse of neoclassical economics. Omkarnath further points out that the capabilities approach rooted in the Walrasian tradition is static in nature, for it mainly concentrates on the formation of capabilities. Whereas, classical economics has numerous insights on the relation between capabilities and commodities. This sort of analysis calls for a careful examination of the structure of production, distribution and exchange present in various economies in the classical political economy tradition, which has more scope for including social, cultural and political factors as well as ethical concerns.

References

Benicourt, E (2002), ‘Is Amartya Sen a Post-Autistic Economist”, post-autistic economics review, issue no. 15, September 4, 2002, article 4. http://www.paecon.net/PAEReview/issue15/Benicourt15.htm

Omkarnath, G (2007), ‘The Formation of Capabilities’, Indian Journal of Human Development, Vol. 1, No. 2, pp. 389-399.

Sen, Amartya (1985) [1999], Commodities and Capabilities, Oxford University Press: New Delhi.

Krishna Bharadwaj: The Ideal Economist

Krishna Bharadwaj is an economist who made lasting contributions to economic theory. She is especially known for her understanding of the classical theories of value and distribution. In particular, she has successfully traced out the history of classical as well as neoclassical economics. This kind of conceptual history writing is important, especially for the economist who wants to apply these theories in understanding the socio-economic reality. And because of her firm grasp of various theoretical approaches in economics, she was able to judiciously analyse problems of the Indian economy. She was, in fact, the first economist to point out the exploitative nature of inter-linked markets which are prevalent in Indian agriculture. She also placed emphasis on the power relations which dominated the production structure of agriculture in India.

Apart from struggling to show the distinct and superior nature of classical economics over neoclassical economics, Bharadwaj also relentlessly worked on Indian economic issues. In particular, Bharadwaj analysed the structural linkages between agriculture and industry in India and also examined the production conditions which characterise Indian agriculture. In her latter study, she pointed out the inadequacies of neoclassical economics in understanding Indian agriculture. She particularly criticised the application of production functions. In addition, Bharadwaj explained the origin of neoclassical economics and how it suffers from various logical as well as other methodological issues.

For Bharadwaj, theory was only a tool to understand the questions and problems which arose from the social reality. This is why, she promoted the teaching of different economic approaches in Centre for Economic Studies and Planning (CESP) at Jawaharlal Nehru University (JNU), such as classical, Marxian, Keynesian as well as Walrasian. As Prabhat Patnaik writes in a foreword of The Krishna Bharadwaj Memorial Lecture, ‘according to her [Bharadwaj]…we had to evolve a research-cum-teaching agenda of our own. No centre in India could flourish, by international standrads, merely by mimicking what was happening abroad, merely by showing proficiency in solving problems which were posed abroad. The problems has to be rooted in the social reality of our own country, and the effort to grapple with them had to be, very consciously, located within the intellectual endeavour of our country…[However] Her emphasis on taking up problems rooted in the Indian social reality was not a plea for turning one’s back upon theory or theoretical struggles. On the contrary, her plea for investigating our real problems, was simultaneously a plea for a richer theory, a theory with a body to it, one which is all the more powerful because it has been used for investigating real problems facing economies like ours.’

From her work on economic theory and its applications to the Indian economy, what becomes clear is her philosophy that economic theory should be based on concepts which can be observed and be amenable to measurement in reality. This is one of the reasons why she criticised the demand and supply theories; for, values were determined by subjective utilities. Another quality worth mentioning is her firm belief that economic theories are not mere intellectual constructs; rather, they arise out of a particular socio-historical situation, often to promote a certain ideology. In her R C Dutt Lecture, which was later published as a book in 1986, she makes it clear that the emergence of demand and supply theories were primarily a reaction against Ricardo and Marx. For, in both Ricardo and Marx, a conflict of interest is visible between social classes. In order to promote the ‘idea’ of a just and harmonius system, the theories (especially the labour theory of value) of Ricardo and Marx were criticised as being limited, and an alternative was proposed. This new theory completely did away with social classes. Individuals were chosen as the primary unit of analysis. Social classes, actually was modified into ‘factors of production’. A very interesting and important methodological shift, with powerful political implications! All the factors of production were assigned equal importance, and it was also shown how both labour and capital recieved incomes according to their contribution to the production process. That is, a capitalist system, with free mobility of labour and capital and with clear property rights (contracts), is essentially a just and stable system.

To conclude, the following are the reasons why Krishna Bharadwaj is an ideal economist. (1) She had an in-depth understanding of the various theoretical approaches in economics, be it, Marxian, Classical, Neoclassical, Austrian or Keynesian. (2) She did not blindly apply these theories (mainly Classical and Marxian) to understand the Indian economy; instead, her inquiry was based on extensive empirical observations, which made the theory richer. (3) She considered it very necessary to understand the history of economic theory, especially because of the historical specificity of all theories. Also because, most theories are responses to certain socio-political events or interests. (4) Lastly, she applied all her experience in setting up a new centre, which paid close attention to both economic theory and its application to the Indian economy, in close connection with other disciplines.

References

Bhaduri, Amit (1992), Krishna Bharadwaj, Economic and Political Weekly, Vol. 27, No. 10/11 (Mar. 7-14, 1992), p. 490.

Bharadwaj, Krishna (1963), ‘Value Through Exogenous Distribution’, The Economic Weekly, August 1964.

Bharadwaj, Krishna (1986), Classical Political Economy and the Rise to Dominance of Supply and Demand Theories, Calcutta: Universities Press.

Harcourt, G C (1993-94), ‘Krishna Bharadwaj, August 21, 1935 – March 8, 1992: A Memoir’, Journal of Post Keynesian Economics, Vol. 16, No. 2 (Winter, 1993-1994), pp. 299-311.

Patnaik, Utsa (1991), ‘Krishna Bharadwaj: 21 August 1935 – 8 March 1992,’ Social Scientist, Vol. 19, No. 12. (Dec., 1991), pp. 63-67.

Patnaik, Prabhat (1996), Foreword, in Time as a Metaphor of History: Early India, by Romila Thapar, The Krishna Bharadwaj Memorial Lecture, New Delhi: Oxford University Press.

Roncaglia, Alessandro (1993), ‘Krishna Bharadwaj, 1935-1992. In Memoriam’, Metroeconomica, Vol. 44, No. 3, pp. 187-194.