Capitalism with friends like these, you don’t need enemies part 2

Steve Keen

This is the second part of a chapter from Prof Steve Keen’s book Rebuilding Economics from the Top Down, scheduled to be published in 2024. The first part appeared in the previous issue of ERA Review.

The Neoclassical theory of profit maximisation that a firm maximizes profit by equating marginal cost and marginal revenue applies if firms have rising marginal cost. However, the papers that Milton Friedman advised economists not to read revealed that, for the vast majority of firms, marginal cost did not rise, and for the reasons given by Eiteman earlier: factories are designed by engineers to be most efficient at maximum output. As the mathematics in Chapter 5 showed, in this realworld situation, marginal revenue is always greater than marginal cost, and the sensible profit maximisation strategy is to sell as many produced units as possible. Making the domain assumption that real-world factories experience diminishing marginal productivity (and therefore rising marginal cost) is a domain assumption which leads to a false theory of profit maximisation for the real world.

This is why the results of Blinder’s survey were, as Alan Blinder put it, “overwhelmingly bad news … (for economic theory)” (Blinder 1998, p. 102), because the theory of supply and demand falls apart:

(a) There is no supply curve: as Blinder acknowledges, rising marginal cost is “enshrined in every textbook and employed in most economic models. It is the foundation of the upward-sloping supply curve” (Blinder 1998, p. 101).

Though sales necessarily equal purchases, this is not a point of equilibrium: the sellers have excess capacity and could sell more units if they could find buyers.

The welfare-maximising conclusions of Neoclassical economics also fall by the wayside: rather than the market equating marginal revenue and marginal cost, thus maximising consumer utility subject to the constraints of producer cost, there is a gap between the two that explains the evolutionary competitive process we actually see in the real world.

That competitive struggle leads to a power law distribution of firm sizes which again, we see in the real world (Axtell 2001, 2006). Perfect competition is not a desirable state, but a myth. A very different (and much richer) theory is required to understand actual

competition and actual microeconomic behaviour than the toy models of Neo-classical economics.

In other words, acknowledging this empirical research into actual firm costs requires a revolution in economic thought, just as Galileo’s experiment led to a revolution in scientific thought. And just as other intellectuals and the Catholic Church resisted the findings of Galileo, because they overturned the beliefs that they had held for millennia, Neoclassical economists resisted these findings, because they overturn the Marshallian paradigm to which they are wedded.

This reflects the phenomenon noted by the philosopher of science Thomas Kuhn (Kuhn 1970) and the physicist Max Planck (Planck 1949), that most scientists, once they are committed to a paradigm, continue clinging to it, even after encountering contrary evidence.

Blinder’s own reaction to his own research is both instructive and pathetic. A decade after he found that diminishing marginal productivity does not apply to real-world firms, Blinder continued to teach in his textbook that realworld firms are subject to diminishing marginal productivity, and experience rising marginal cost (Baumol and Blinder 2011, pp. 127-133). In fact, Blinder’s discovery clearly disturbed him so much that the explanation he gives for diminishing marginal productivity, and one of the examples he gives of it, are both wrong, even from the point of view of Neoclassical economics.

Blinder’s behaviour is evidence of how disturbing the results of his own research were to Blinder himself, and is also a vivid example of the mental gymnastics that believers in a failed paradigm are willing to undertake to avoid abandoning the paradigm. If Blinder acknowledged his own research and followed through its consequences as I did in Chapter 5, then he could no longer be a Neoclassical economist. So instead, he ignored his own results, and does not even mention his own research into this topic in his own textbook!

Blinder’s reaction to his discovery is not an exception: it is the norm. When Neoclassical researchers find results that contradict Neoclassical theory, they almost always make outrageous assumptions to cover them up, and so persuade themselves that they haven’t broken the paradigm. They then describe these outrageous propositions as simplifying assumptions. Here is a byno-means complete selection of such assumptions:

(i) In 1953, William Gorman considered the question of whether a country could have its tastes represented by a single “community preference field” which is a common assumption in the Neoclassical theory of international trade. He concluded that:

“there is just one community indifference locus through each point if, and only if, the Engel curves for different individuals at the same prices are parallel straight lines. (Gorman 1953, p. 63)“.

This amounts to the assumption, not merely that all individuals have the same tastes (otherwise “Engel curves” would intersect), but also that all commodities are identical (otherwise they would not be straight lines). He then commented as I noted earlier that:

“The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given. (Gorman 1953, p.63)”.

This is not a simplifying assumption: it is an insane, false assumption constructed in order to cling to the belief that Neoclassical trade theory is valid.

(ii) In 1956, Paul Samuelson, considering a related problem whether a downward sloping market demand curve could be derived from summing individuals who all had downward-sloping individual demand curves and concluded that this could be done for a family:

“if within the family there can be assumed to take place an optimal reallocation of income so as to keep each member’s dollar expenditure of equal ethical worth, then there can be derived for the whole family a set of well-behaved indifference contours relating the totals of what it consumes: the family can be said to act as if it maximizes such a group preference function. (Samuelson 1956, p. 21)”.

He immediately generalised this to the whole of society:

“The same argument will apply to all of society if optimal reallocations of income can be assumed to keep the ethical worth of each person’s marginal dollar equal.” (Samuelson 1956, p. 21. Emphasis added)”.

So, a downward sloping market demand can be derived if we’re willing to assume that someone—“a benevolent central authority perhaps” (MasColell, Whinston, and Green 1995, pp. 117. Emphasis added), to cite a textbook that teaches this result to students reallocates income before consumption “to keep the ethical worth of each person’s marginal dollar equal”.

This is not a simplifying assumption: it is an insane, false assumption constructed in order to cling to the belief that the Neoclassical theory of demand is valid.

(iii) In 1964, William Sharpe tried to construct a theory of asset pricing by firstly building an elaborate model of a single individual allocating his investments between a risk-free interest paying bond and a spectrum of risky assets. Having built this model of a single individual, he extended it to a model of all investors by assuming:

“homogeneity of investor expectations: investors are assumed to agree on the prospects of various investments-the expected values, standard deviations and correlation coefficients described in Part II. (Sharpe 1964, pp. 433-34)”

Not only that -as Fama confirmed when reporting on the (surprise, surprise!) empirical failure of this theory forty years later:

“And this distribution is the true one that is, it is the distribution from which the returns we use to test the model are drawn. (Fama and French 2004, p. 26)”.

It is little wonder that a theory of stock market prices that assumed all investors were able to accurately predict the future failed!

This is not a simplifying assumption: it is an insane, false assumption constructed in order to cling to the belief that the Neoclassical theory of asset prices is valid.

None of this, nor the myriad other examples I could cite, represents the behaviour of a scientific community. It is instead the behaviour of a cult that is hanging on to its core beliefs despite repeated contradictions of those beliefs by reality.

Ironically, this is not unique to Neoclassical economists Marx did the same thing when he developed a philosophical explanation for the source of value which contradicted his “Labour Theory of Value” (Keen 1993a,b). Nor, even, is it unique to economists alone. Max Planck, the brilliant physicist who ushered in the era of quantum mechanics, lamented in his autobiography that:

“It is one of the most painful experiences of my entire scientific life that I have but seldom in fact, I might say, never succeeded in gaining universal recognition for a new result, the truth of which I could demonstrate by a conclusive, albeit only theoretical proof. (Planck 1949, p. 22)”

What is unique to economists is that the anomalies in science which show that a dominant paradigm say, the Maxwellian one about the nature of energy is false are permanent. Once the anomaly has been discovered, it can be recreated at any time by anyone with the necessary equipment.

Therefore, even if existing scientists refuse to abandon the falsified paradigm, they are ultimately replaced by new scientists who, as students, know that the anomaly exists, and that they will make their intellectual mark if they can resolve the anomaly with a new paradigm. Planck’s explanation for how sciences advance was paraphrased as “science advances one funeral at a time”, but what he actually described was generational change:

“A new scientific truth doesn’t triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it. (Planck 1949, p. 23)”

These mechanisms of change do not exist in economics. Firstly, anomalies in economics are transient. If the anomaly is an event like, say, The Great Depression then it can be forgotten as new events take its place. If the anomaly is a theoretical result like the “Cambridge Controversies” over the nature of capital, which Samuelson conceded that Neoclassicals lost, ending his paper “A summing up” with this poignant concession:

“If all this causes headaches for those nostalgic for the old-time parables of neoclassical writing, we must remind ourselves that scholars are not born to live an easy existence. We must respect, and appraise, the facts of life. (Samuelson 1966)”

This can be forgotten by later Neoclassical economists if those economists including Samuelson himself continuing to behave as if they in fact won the debate, by continuing to teach the concepts, such as the marginal productivity theory of income distribution, which this debate has proven to be false, and in which he conceded defeat. Consequently, later Neoclassicals can think that they actually won arguments that Neoclassical participants at the time actually conceded that they lost. This is Paul Krugman, writing in 2014:

“And what’s going on here, I think, is a desperate attempt to claim that the Great Recession and its aftermath somehow prove that Joan Robinson and Nicholas Kaldor were right in the Cambridge controversies of the 1960s. It’s a huge non sequitur even if you think they were indeed right (which you shouldn’t). But that’s what seems to be happening.”

This unscientific behaviour by Neoclassical economists have several consequences that have enabled the dangerous nonsense to be published.

Firstly, they have been raised in a virtual ocean of unrealistic domain assumptions, while at the same time these false assumptions are essential to the Panglossian vision they have of capitalism. That makes them almost blind to the assumptions in a Neoclassical economics paper: they read the method by which the results were derived from the assumptions, rather than casting a critical eye over the assumptions themselves.

Secondly, the essential role of these assumptions is to preserve the Neoclassical vision of capitalism, and not to preserve capitalism itself which they innately believe is indestructible anyway. They become zealots for market solutions above all other approaches to remedying society’s ills.

Thirdly, the inability to understand the role of energy, and raw materials in general, in enabling human society to evolve, has led to a training of economists devoid of any real knowledge of the biophysical nature of existence.

This combination of foibles accepting almost any assumptions, so long as they preserve the vision of capitalism as a self-regulating system, believing that capitalism can in fact survive any threat, and having virtually no knowledge of the physical nature of production has had the fatal result that they could not accept that climate change could be a serious threat to capitalism. So when William Nordhaus “proved” this result, subject of course to some “simplifying assumptions”, he accepted such assumptions without even considering that they were absurdly false assumptions about the nature of the biosphere.

References:

Axtell, Robert L. 2001. ‘Zipf Distribution of U.S. Firm Sizes’, Science (American Association for the Advancement of Science), 293: 1818-20.
Baumol, W. J., and Alan Blinder. 2011. Economics: Principles and Policy.
Blinder, Alan S. 1998. Asking about prices: a new approach to understanding price stickiness (Russell Sage Foundation: NY).
Gorman, W. M. 1953. ‘Community Preference Fields’, Econometrica, 21: 63-80.
Keen, Steve. 1993a. ‘The Misinterpretation of Marx’s Theory of Value’, Journal of the history of economic thought, 15: 282-300.
Keen, Steve. 1993b. ‘Use-Value, Exchange Value, and the Demise of Marx’s Labor Theory of Value’, Journal of the history of economic thought, 15: 107-21.
Kuhn, Thomas. 1970. The Structure of Scientific Revolutions (Univ of Chicago Press).
Mas-Colell, Andreu, Michael Dennis Whinston, and Jerry R. Green. 1995. Microeconomic theory (Oxford University Press: NY).
Planck, Max. 1949. Scientific Autobiography and Other Papers (Philosophical Library; Williams & Norgate: London).
Samuelson, Paul A. 1956. ‘Social Indifference Curves’, Quart J Economics, 70: 1-22.
Samuelson, Paul A. 1966. ‘A Summing Up’, Quart J Economics, 80: 568-83.
Sharpe, William F. 1964. ‘Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk’, The Journal of Finance, 19: 425-42.

This article is based on a chapter from Prof Steve Keen’s book Rebuilding Economics from the Top Down, which is scheduled to be published in 2024. Reference: Keen, S. (2024), Rebuilding Economics from the Top Down; Budapest Hungary (Budapest Centre for Long-Term Sustainability and Pallas Athene Publishing House).

Republished with the permission of the author. If you like Steve’s economic analysis then you are invited to support his work by signing up to either of the following networks: (a) Patreon (https://www.patreon.com/ProfSteveKeen minimum $10 per year) or (b) Substack (https://profstevekeen.substack.com/ minimum $5 per month).