Adventures in Debunking Economics

Perhaps the most surreal moment in Debunking Economics – Professor Steve Keen’s broadside against mainstream economic theory – comes when he proves that a functioning “free market” would require a “benevolent dictatorship”. In reality, the proof is not his: astonishingly, he takes it from “a neoclassical textbook … used in the training of virtually every American PhD student since the late 1990s”. According to conventional economic theory, we all buy more of something the cheaper it gets. To reach this conclusion, economists constructed a model of a single individual – Robinson Crusoe on his desert island – worked out that the theory holds (given some reductive assumptions about human behaviour), then extrapolated it to the whole of society. Hey presto!

For a while, this economic orthodoxy went unchallenged. The trouble started when economists decided to try and demonstrate that the theory held. The results proved rather unnerving: as soon as you added another individual, the model collapsed. Robinson Crusoe alone would buy more as biscuits or bananas got cheaper (exchanging money with himself somehow), but once “Man Friday” gets involved, the results become “an unholy mess”. Together, the two will sometimes spend more as the price of bananas goes up, sometimes less. The first reason is that one person must be producing the bananas. If that person is Crusoe, then Friday’s spending on bananas becomes Crusoe’s income – and, like most of us, Crusoe’s spending patterns will change as his income changes. Second, since economists assume these biscuits and bananas get more and more difficult to produce and therefore more expensive, the first banana Friday buys both knocks down his income and kicks up the price of bananas. Third, Crusoe gets richer every time a banana is sold, but makes them more expensive every time he buys one (because they get harder and harder to produce). Add up all these effects and who knows where you’ll end up.

How do economists get from this “unholy mess” to the assumption that we all buy more as stuff gets cheaper? For the seminal PhD textbook by Mas-Colell and colleagues, there must be an imagined “representative consumer”; in other words, let’s just pretend. But we can’t stop there, the textbook goes on – because, for the market to function as it should, the choices of this lone consumer must “maximize welfare”. That means we must imagine a “benevolent central authority” that redistributes wealth to an ideal level where what people choose to buy makes them as well-off as possible. Not exactly an “invisible hand”, then.

But Mas-Colell’s is only the most honest treatment of the issue, Keen points out. On discovering the existence of irrational numbers, he recalls, the Pythagoreans drowned the discoverer, Hippasus of Metapontum. Faced with their own uncompliant data, economists went one better and drowned the result. That everyone buys more as prices fall only holds given two conditions, they worked out: first, if the proportion of your income you spend on each good remains the same even as your income rises – in other words, if you’d spend a tenth of your income on pizza whether you earn $100 or $100,000 a week. That’s effectively the same as saying that only one commodity exists. Second, if we all have identical tastes – in other words, if only one person exists. Economists then either assumed these conditions held, or simply ignored the problem.

Neoclassical economic models also provide no grounds for thinking that a multitude of small firms behaving as selfishly and competitively as possible behave any differently from a monopoly, Keen points out. Monopolies will keep producing to the point where they maximize profits: where the quantity supplied produces a price high enough to produce the biggest revenue. But so will an industry full of tiny, profit-maximising firms – if they didn’t, the industry as a whole would be behaving irrationally, producing part of its output at a net loss. This pulls apart the neoclassical idea that perfect competition drives down prices to a level that only just covers companies’ costs. The mistake is assuming each firm is so small that it cannot affect prices, Keen points out – rather like “proving” the earth is flat by dividing it into “flat”, one-square-metre segments, noting the “flat” angle between adjacent segments, then continuing until you’d covered the entire world.

Keen then turns his attention to the idea that costs of production rise the more you produce. In theory, a company will have lots of productive stuff it can’t change in the short term (such as machinery or land) and lots it can (such as people it can hire). It’ll have already paid for the machinery, though, so if it hires only one worker and produces (say) one packet of crisps, the worker will not be as productive as possible and that packet of crisps will cost a fortune. As it produces more and more, though, it’ll hire more people to operate its machines more productively, the costs of machines and staff will be spread over more and more packets of crisps, and costs will come down. In theory, though, costs will eventually start rising again: in the short term you can’t bring in more machines, so your factory floor will become more and more crowded. Eventually, workers will cost more to hire than they produce, and at that point the company will stop hiring.

That’s the theory, at least. But, by drawing on economist Piero Sraffa’s seminal critique, Keen shows that it does not hold water. If an entire sector – such as agriculture – needs more land and workers, it will need to take them away from (say) manufacturing and tourism, and this will be difficult and expensive. But drawing workers away from other industries will also affect wages, and trying to get hold of land will affect its price. That in turn will end up changing the incomes of all manner of people, and therefore the kind of stuff they want to buy. So while it might be true that stuff that’s hard to get hold of gets more expensive and pushes up an industry’s costs, in doing so we’ve shifted the rest of the economy so much that we don’t know where agricultural prices or output will actually end up.

For single industries rather than sectors, productive stuff is not normally that hard to get hold of. Wheat farmers can start using fallow fields, or barley farmers convert their own fields to wheat; manufacturers can bring new machinery online, and so on. Since there are no longer too many or too few workers crowding the factory floor, a company’s average costs will generally remain the same, however much it produces. The first priority will be breaking even; everything after that point it takes as profit. Rather than compete on price, then, firms simply try and grab as much of a market as they can.

The implications of these revisions, Keen points out, are rather stark. Take employment: in mainstream theory, it gets less and less productive to hire people, so companies keep hiring until the next employee wouldn’t produce enough to justify their wage. Workers set wages themselves: they decide, in effect, how much to get out of bed for. And this puts a cap on the amount the company produces. This is why so many mainstream economists demand we boost productivity by lowering wages. Yet if every extra worker hired is as productive as the last one, there is no “equilibrium” point where wages equal productivity. Using neoclassical tools, we can no longer explain what sets output, employment or wages at all.

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