steve keen political economy: critique of neoclassical economics wrong answers to the wrong...

Steve Keen

Political Economy: Critique of Neoclassical Political Economy: Critique of Neoclassical EconomicsEconomics

Wrong answers to the wrong questions: Wrong answers to the wrong questions: DemandDemand

2©Steve Keen 2005©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney

Why Political Economy?• Reject questions asked by mainstream

economics– Neoclassical economics asks the wrong

questions…•Assumptions of individual utility/profit

maximisation omit social interaction, social conflict, gender issues, etc.

•Equilibrium hangup ignores dynamic processes…

• Internally inconsistencies in mainstream economics– Provides wrong answers to questions it does

ask•Demand theory can’t derive downward

sloping market curve•Profit maximising firms don’t produce

where marginal revenue equals marginal cost

•General equilibrium can’t be in equilibrium…

– How do neoclassical economists cope?


Why Political Economy?• Ignore the problem!:

– Capital aggregation problem (Cambridge Controversies) ignored

– Income distribution adding up problem (Shaikh) ignored…

• Assume the problem away:– Assume identical

consumers to avoid demand curve aggregation problem (SMD conditions)…

• In a nutshell: “assume a miracle…”


• Great appeal of neoclassical economics: an apparently coherent picture of a complex system– Individual preferences generate demand

curves– Profit maximising generates supply curves– Intersection determines prices & outputs– Markets harmonise in general equilibrium– Welfare maximised by free market

• Great weakness of neoclassical economics– All steps in above process have logical flaws– Firstly, a recap of the neoclassical vision

•With this bloke turning up whenever the theory glosses over a crucial problem:

But it all looks so neat!…


Consumer demand• Consumer’s demand determined by

preferences– A rational consumer…

•Does not let income affect tastes;•Always prefers more to less;•Gets less utility out of each additional

unit (diminishing marginal utility);•Can always tell which bundle he/she

prefers– End result

•Tastes can be represented by indifference map;

•Prices & incomes determine budget;• Interaction of these determines demand

curve;•Fall in price necessarily increases

consumer’s welfare


• Hey presto:• downward

sloping demand curve!

• consumer welfare as P

Consumer demand• Indifference curves

show tastes

Bananas

Biscu

its

W

Y

XZ

q1 q2 q3

Bananas

Price

of B

ananas

p1

q1

p2

p3

q2 q3

I II III

• Prices & Income gives budget– Budget line II: banana

price p1 cheaper than p2 for line I;

• Points of tangency give maximum utility at given relative prices

• Price/quantity combos show the demand curve

– Points on Z preferred to X


Consumer demand• A caveat: income &

substitution effects– Can get upward-

sloping demand curve if (positive) income effect outweighs (negative) substitution effect

• Solution: “Hicksian compensated demand curve”– Notionally reduce

income back to original indifference curve…

• Hicksian demand curve necessarily slopes down

Bananas

W

Y

XZ

q1 q2 q3

Bananas

Price

of B

ananas

p1

q1

p2

p3

q2 q3

I II III


Consumer demand• Now add lots of consumers

together…• And we get a downward sloping demand curve

where consumer welfare rises as price falls:

Bananas

Price

of B

ananas

The dem

and curve

The dem

and cu

rve

• Now stage two: the upward-sloping supply curve


Supply• Producers are short run profit maximisers• Goods produced by combining factors of

production• In the short run, the quantity of one factor is fixed• Output is increased by adding more of the variable

factor (labour) to the fixed factor (capital)• Production function therefore displays diminishing

marginal productivity: output eventually rises at diminishing rate– Falling marginal product– Rising marginal cost:


Supply• Marginal product

can initially rise…

• But ultimately it falls…

• Falling marginal product mean rising marginal cost

Ban

an

a O

utp

ut

Labour InputA B

Marg

inal Pro

du

ct

Labour Input (capital fixed)A B

Ris

ing

mar

gina

l pro

duct

Maximum marginal product

Zero marginal product

• Divide cost of input (constant wage) by additional amount produced (falling) and you have rising marginal cost:

Lowest marginal costLowest marginal cost Infinite marginal costInfinite marginal cost

wmc q

mp q


• Marginal revenue falls with rising output for a monopoly

• But a competitive firm is so small that, as a price taker, it doesn’t affect market price. So its total revenue is a straight line

Supply• Firms profit maximise

by equating marginal revenue & marginal cost because that identifies the biggest gap between total revenue and total cost:

0 2000 4000 6000Quantity

0

100000

200000

300000

Tot

al r

even

ue &

cos

t

Total revenueTotal costProfit

Maximum profit

0 2000 4000 6000Quantity

0

50

100

150

PriceMarginal revenueMarginal costAverage cost

Pe

Qe

Ce

MC=MR<P

Qpc

Slope of TR=MR

Slope of TR=MR

Slope of TC=MC

Slope of TC=MC

Maximum profitMaximum profitwhere MR=MCwhere MR=MC


Supply• Since price is constant

for a competitive firm, marginal revenue equals price:

0 50 100 150 200Quantity

0

1800

3600

5400

7200

9000Total revenueTotal costProfit

Maximum profit

0 50 100 150 200Quantity

0

18

36

54

72

90 PriceAverage costMarginal costMarginal revenue

MC=MR=P

0i i ii

dPMR q P q P q P

dq

• Competitive firm maximises profit by supplying on marginal cost curve

• Marginal cost curve becomes firm’s supply curve

• Sum of all firms’ MC curves is industry supply curve:


Supply & Demand• “Houston, we have

equilibrium”…P

Q

PC=MC

QC

D

SConsumer SurplusProducer Surplus

• With maximum social welfare

MR

• But assuming all markets are competitive, we can have general equilibrium…

• Unless there’s a monopoly

QM

PM>MC


General equilibrium• All markets in instantaneous equilibrium• Complete coordination of all markets without

external intervention

• Social welfare maximised by the free market…• But now let’s check the fine print:

DemandSupply

Quantity

Pri

ce

Qe

Pe

DemandSupply

QuantityPri

ce

Qe

Pe

DemandSupply

Quantity

Pri

ce

Qe

Pe

DemandSupply

Quantity

Pri

ce

Qe

Pe


Consumer Demand• Adding lots of consumers together…

– With one individual•unambiguous link between preferences

(indifference curves) & demand curve•Fall in price unambiguously benefits

consumer

Bananas

Biscu

its

Y

X Z

Y

X Z

• “Houston, we have a problem…”

– With more than one individual:


Consumer Demand• Two different incomparable sets of

indifference curves– Point of tangency for one won’t be for the

other– Income effect may work in opposite

directions for two consumers (one might consume less as price falls, the other more)

• Income effects of changing prices– Change in relative prices changes

income/wealth•One-person analysis assumes prices can

be changed without affecting income;•Can’t assume same for 2 or more persons

– Can’t alter prices without affecting incomes


Consumer Demand• With one consumer,

no problem keeping prices & income/wealth separate:

Bananas

Biscu

its

W

Y

XZ

q1 q2 q3

Bananas

Price

of B

ananas

p1

q1

p2

p3

q2 q3

I II III

• With two consumers, even if their tastes are even if their tastes are identicalidentical, can no longer separate prices from incomes/wealth

q3

• E.g., banana price rise increases wealth…

• Demand rises as price rises

• Any shape of market demand curve can result…

• Two outcomes of these dilemmas:

q1


Consumer Demand• (1) Standard individual “law of demand” (that

demand rises as price falls) does not apply at market level– Market demand curves can have any shape

at all:•“…every polynomial … is an excess

demand function for a specified commodity in some n commodity economy… every real-valued function is approximately an excess demand function.” (Sonnenschein 1972: 550)

• (2) To guarantee that a market demand curve slopes down like an individual demand curve, consumers effectively need to be identical and have tastes that don’t change with income:


Consumer Demand• If

– (1) The marginal propensity to consume a good is the same for all consumers• i.e., you have the same marginal

propensity to buy Da Vinci’s original manuscripts as Bill Gates;

•Bill Gates has the same marginal propensity to buy methylated spirits as a derelict; AND

– (2) The marginal propensity to consume a good doesn’t change with income•When Bill Gates earned $100 a week, he

spent the last $10 on pizza•Now that he earns $100,000,000 a week,

he spends $10,000,000 on pizza…• Then the market demand curve will slope

downwards…


Illustration• Standard neoclassical “utility function” Cobb-

Douglas: , , 1U A B a A B • Add budget constraint:

a aY P A P B

• Yields individual demand curve:

BB

B P YP

Indifference Map for Cobb-Douglas Utility Function

U

• “Lagrange multipliers” to derive demand curve:

2 4 6 8 10

20

40

Demand Curve derived from CD

PB

B PB

• Add numerous identical consumers…


Illustration• So far so good…

B PB Y

PB

5000 1 104

50

100

PB

B PB

• But complications here for utility functions where Engels curves are not straight lines– Breaches “WARP”

• However so far Y treated as given

• But changing relative prices will change incomes

• Full illustration would require “GE” model, but…


Illustration• Consider Y which varies between 1 & 1000• Depends on relative prices of A & B

1000 1i i A i BY rand P P where 0,1i rand

• Sample demand curve for B:

8000 1 104

1.2 104

1.4 104

1.6 104

1.8 104

2 104

2.2 104

2.4 104

0

10

20

30

40

50

6050

1

P.B

2.296 1049.529 10

3

0

n 1

i

Y 1 P.B i( ) i

P.B ( )i

• Illustration only, but graphical simile for Sonnenshein’s “every real-valued function is approximately an excess demand function”


Consumer Demand• Conditions to avoid this outcome in effect

amount to:– All consumers are identical– All commodities are identical

• i.e., “model” only works with one consumer & one commodity

• When scaled to > 1 consumer and > 1 commodity, aggregation effects mean what applies at individual level doesn’t apply at aggregate

• Result is general:– Doesn’t depend on “perverse” utility

functions– Makes it impossible to derive meaningful

aggregate (market) “laws” from principle of individual utility maximisation


Consumer Demand• … market demand functions need not satisfy in

any way the classical restrictions which characterize consumer demand functions… The importance of the above results is clear: strong restrictions are needed in order to justify the hypothesis that a market demand function has the characteristics of a consumer demand function. Only in special cases can an economy be expected to act as an ‘idealized consumer’. The utility hypothesis tells us nothing about market demand unless it is augmented by additional requirements.’ (Shafer & Sonnenschein 1982: 671-2 [emphasis added])

• Ironically, neoclassical economics began in part as reaction to “class analysis” of classical school…


Consumer Demand• “If we are to progress further we may well be

forced to theorise in terms of groups who have collectively coherent behaviour. Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.” (Kirman 1989: 138)

• Ironically, neoclassicals have proven that class-based analysis is necessary!

• Post Keynesians & Marxists work in terms of groups (workers, capitalists, bankers) rather than individuals– Failure to derive aggregate demand function

from individual an example of “emergent property”


Consumer Demand• So rather than

this:

Bananas

Price

of B

ananas

The dem

and curve

The dem

and cu

rve

• In general market demand curves (derived from neoclassical theory) look like this:

• Even if consumers utility maximise!– Which they don’t…


Indifference Curves• “Seen any good indifference curves lately?”

– Dilemma: indifference curves play crucial role in theory, but unobservable

– Samuelson suggested a solution: “revealed preference”• Induce consumer’s preference map from

their purchasing decisions.•What we want to find is

Bananas

Biscu

its

W

Y

X Z


Indifference Curves• What we can know is what a consumer actually

buys at different prices:

q1 q2q3

Bananas

Biscu

its

P1P2 P3

W

Y

X

• Samuelson argued we can infer the indifference map from these…

• Using “revealed preference” & the axioms of rational behaviour– Consumer can rank all

bundles in terms of preference/indifference

– More preferred to less– If A pref B & B pref C

then A pref C


Indifference Curves• All points in

box preferred to A (non-satiation)

Bananas

Biscu

its

A

Bananas

Biscu

its

B

A

C

• If A preferred to B & C at one price, must be preferred at any price (completeness & transitivity; tastes independent of income)

• A must be on higher curve than B or C…

• Can build up “map” of consumer’s tastes by offering different bundles of goods at different prices, seeing which bundles chosen…

• “reveal” preferences


Indifference Curves• Sippel (1997) attempted to do just this:

“reveal” preferences of experimental subjects– 10 sets of Budget & relative prices

presented•Budgets/prices chosen to test aspects of

theory (e.g., “Homogeneity degree zero”—double prices & incomes, “should be” no change in consumption

– Choose from 8 goods at each budget/price combo

– Computer automatically calculated budget cost

– Consume choices in next hour from one of ten sets


Indifference Curves• Goods on

offer:

600gm-2 kilosPretzels, peanuts

400gms-2 kilosCandy

600ml-2 litresCoffee

400ml-2 litresOrange juice

400ml-2 litresCoca cola

30-60 minutesMagazines

27.5-60 minutesComputer games

30-60 minutesVideo clips

Max. Amount (if all budget spent on one good)

Good

• Unlimited amount of time to choose• 60 minutes to consume one choice set


Indifference Curves• Key propositions being tested:

– “Weak Axiom of Revealed Preference” WARP• If A B then never B A• If consumer chooses bundle A once when B

also affordable, then consumer will always choose A instead of B, regardless of relative prices

– “Strong Axiom of Revealed Preference” SARP• If A B & B C then never C A

– Formal definition of a utility maximiser– “Generalised Axiom of Revealed Preference”

GARP

• If A B & B C then pC * A pC * C

– If A B & B C then A more expensive than set C at prices when C declined in favour of B


Indifference Curves• Results first experiment (12 subjects)

– 11 of 12 subjects violated SARP & WARP– 5 out of 12 violated weaker test GARP

• Results second experiment (30 subjects)– 22 of 30 subjects violated SARP & WARP– 19 of 30 violated weaker test GARP

311321863.336.7GARP

3341-4773.326.7SARP

-1---1341.758.3GARP

1----3791.78.3SARP

> 20

11-20

9-10

7-8

5-6

3-4

1-2

Number of violations per person (max possible 45)

Inconsistent %

Consistent %Exp. 1 & 2


Indifference Curves• Sippel’s interpretation of results

– In general “not too favourable to the neoclassical theory of consumer behaviour…” (p. 1438); but•Low number of inconsistencies (median 2

out of 45—but average higher)•Subjects did try to “select a combination

of goods that came as close as possible to what they really liked to consume given their respective budget constraints” (1439)

•“They spent a considerable amount of time on their decisions (typically 30-40 minutes)”

– How serious are violations of axioms?…


Indifference Curves• Use waste of income from inconsistent choice

as guide to how significant were deviations from “rationality”:

– Afriat index: ratio (pB * A / pB * B) when (from previous experimental round) A B

– Where consumer chooses A when B affordable, use formula “A B if (e * pA * A) (pA * B)”

• Consumer deemed to prefer A over B if A (say) 11% more expensive than B & consumer still chooses A (here e=0.9)

•Like having “thicker indifference curves”


Indifference Curves• With thicker

indifference curves, more combinations are shown as “indifferent”:

BananasB

iscuits

• The “good” news: number of apparent violations of GARP dropped significantly for e<1

• The “bad” news: even “throwing a dart”—totally random choice—appeared rational for e<0.95!

• For e=.9, random choice appeared more rational than what human subjects did!

AABBCC

• e=1: C B A

• e=.95: C B & A but B A

• Choosing A or B appears “rational” for e=.95 but not for e=1


Indifference Curves

0.41.53.38.3.90

12.816.8108.3.95

65.246.826.725.99

97.361.363.341.71

Exp 2Exp 1Exp 2Exp 1e

% of times randomly chosen set violated GARP

% Experimental subjects violating GARP


Indifference Curves• Several other careful attempts to interpret

results• But overall judgment:

– “We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who do appear to be optimising, the majority of them do not… we … call the universality of the maximising principle into question.” (1442)

• So if people aren’t maximising their utility, what are they doing?– Are they being “irrational”?

• It’s the neoclassical definition of rational behaviour that is irrational!


How “rational” is optimising?• Neoclassical model a “toy” model of behavior

– Only 2 commodities, unspecified quantities• Let’s make it real:

– Shopping in a supermarket with 1,000 different commodities

– Decide whether to or not to buy one unit of each

• How many bundles do you have to consider?– For the textbook toy model, only 4:

• (0 bananas, 0 biscuits; 1 banana, 0 biscuits; 0 bananas, 1 biscuit; 1 banana, 1 biscuit)

– In the supermarket?


How “rational” is optimising?• Number of choices is:

– Number of units being considered + 1 (0 or 1)

– Raised to the power of how many goods•2 in textbook model—so only 4

combinations:• 2 goods, 2^2 = 4 combinations

• 3 goods, 2^3 = 8

• 4: 2^4 = 16• supermarket 1,000 goods• How many combinations?


• 21000, or roughly 10300.• So is that big, or what?

– Spelling it out in full, it’s:– 10,720, 000, 000, 000, 000, 000, 000, 000,

000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000, 000 combinations!

How “rational” is optimising?


How “rational” is optimising?• How big a brain would you need to remember

that many combinations?• Pretend each neurone could remember the

utility of 100,000,000,000 combinations• Your “grey matter” weighs about a kilo:

100,000,000,000 neurones, each weighing 1/100,000,000 grams

• Quick quiz: a brain this big would weigh…– (1) More than your brain?– (2) More than an elephant?– (3) More than the planet?– (4) More than the Sun?– (5) More than the Galaxy?– (6) More?


How “rational” is optimising?• (6) 10224 times as much as the entire universe!• If you could recall utility of each combination in

1/10,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000,000th of a second, how long would it take to remember the maximum?– 10200 seconds: 10180 times the age of the

universe!• What’s going on?

– The “curse of dimensionality”: number of combinations grows exponentially as more options considered• Impossible to consider even tiny fraction of

options in effectively finite time• Dimensionality overwhelmed Sippel’s

subjects, even with just 8 commodities & experimental setup replicating neoclassical theory


How “rational” is optimising?• Rational behavior is not considering all

options, but– Reducing number you do consider in a way

that•Makes deciding in finite time possible•Doesn’t obviously rule out good

combinations• We use “heuristics”: sensible “rules of thumb”

– We do consider our budgets when deciding tastes

– We use habit, convention, culture•Buy much the same combination each

week– We segment our purchases: x% on food, y%

on clothing…– Tastes evolve over time (with marketing

trying to manipulate development)


How “rational” is optimising?• These non-optimising behaviors make choice

possible• E.g., segmentation: rather than “optimise”

over everything in supermarket, segment into “fruit”, “meat”, “spices”, “hygiene”, etc.– Say 1000 products in supermarket, 100 in

each segment– Unsegmented optimising: “Buy/not buy”:

10300 combinations– Segmented optimising: “Buy/not buy”: 1031

combinations—10269 less: could remember everything with a brain weighing only… 1 million tonnes!

• More than segmentation needed! But optimising behaviour is clearly not rational


What should economists do instead?• Abandon ambition to build coherent model of

aggregate (market) behavior from isolated individuals

• Model “at some reasonably high level of aggregation” (Kirman)—classes (capitalists, bankers, workers…); or

• Model actual behavior at individual level– “Satisficing” (Herbert Simons) rather than

optimising; multi-agent modelling– Generate non-coherent model of aggregate

behaviour (waves of demand, non-equilibrium dynamics, co-evolution of products and demand)

• These approaches being taken by Marxist, Post Keynesian, Evolutionary economists; but not by neoclassicals (best offer “game theory”)


Political economy attitude• “Methodological individualism” of neoclassical

economics fails on own grounds– Internally inconsistent– Does not reach results they desire

• Socially coherent approach of Marxists, Post Keynesians, Evolutionary, Feminist economists superior

• Methodological individualism should be abandoned in favour of analysis of social groups/classes, income distribution between classes, etc.

• Next lecture, invalidity of theory of supply even if market demand curve exists; of theory of demand even if market supply curve exists; and of product…

steve keen political economy: critique of neoclassical economics wrong answers to the wrong...

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