Theoretically wrong

Dr Geoff Davies, keen to crack on with solving the world’s problems, makes a critique of neoclassical economic theory, seeking to explain why the results of its application are so bad (see previous post on this subject). His second post is not as straightforwardly incorrect as the first in his series, because several of the criticisms he makes are ones with which I agree, or are true in a trivial sense, or are true but don’t have the significance he attaches to them. In addition, discussions about theory aren’t as amenable to simple refutation like his first post about empirical evidence.

“It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a ‘dismal science.’ But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.” -Murray Rothbard

That quote is simultaneously arrogant and elitist and true to some degree. I think anyone who can use basic arithmetic can have a valid opinion about economics, but I do find it frustrating when people don’t bother to inform themselves about the basic concepts in economic thinking, then proceed to dismiss centuries of thought on the subject. Unfortunately, Dr Davies is a member of the latter group.

To maintain mathematical tractability, the [neoclassical] theory makes simplifying assumptions about people and firms.

It would seem that Davies, “an experienced real scientist” (his words), chose to forget that all theories of complex systems make simplifying assumptions. In his own field of mantle dynamics, as in all physics, models based on simplifying assumptions are used as a matter of course. This isn’t a weakness, but a necessity. If one is concerned with understanding fundamental processes or dominant patterns, there is no point in developing a model that can mimic every eddy of molten rock, or every economic transaction. And that’s assuming it is even possible – such a fine-grained model would be mind-bogglingly complex, as convoluted as the real thing, and thus would defeat its own purposes as a model!

The misconceptions continue when Davies moves from the metaphysical level to the actual composition of the neoclassical model of economic decisions:

It assumes we are narrowly rational and that we can foretell the future. It assumes we have access to all relevant information for free, and can assimilate its implications immediately. It assumes we are brute materialists. It assumes there are no social interactions. It assumes there is a limit to economies of scale, based on constraints peasant farmers used to face.

Some of these I can map to genuine assumptions, others just seem to be made up on the spot, or are perhaps the result of a profound misunderstanding of economic principles (as per the Rothbard quote). Let’s take them one at a time.

  • The assumption of rationality is a perfectly reasonable starting point for a critique of economics. This is typically the first thing people object to, and you can see why – all of us perceive a multitude of seemingly irrational decisions by others, and might even acknowledge the occasional irrational decision by ourselves. However, it can be defended on two fronts. Firstly, the judgement call of ‘rational’ or ‘irrational’ is inherently subjective. What might be rational for you, might not be for me, because of our differing ideas about what methods and aims are appropriate for our circumstances. At its heart, the assumption of rationality is an assumption that people will pursue their self-interest, and that must perforce be individual in nature. Secondly, I will freely admit that people appear to behave irrationally sometimes, but even if they are indeed doing so, most of us are acting rationally most of the time. It is hard to imagine a society functioning where this was not so. For the purposes of modelling human behaviour, rationality (as opposed to antithetical options) would seem to be the only possible assumption to make.
    Further into Davies’ post, he expands on this critique, citing “herd behaviours” as one example of supposedly irrational behaviour. There will be plenty of “experienced real scientists” who would contest that claim, such as biologists and psychologists. In a world of limited information, paying attention to what other people are doing and following the crowd can be a successful strategy. Indeed, there is a lot of empirical evidence to suggest that aggregated knowledge can be more accurate than individual judgements.

  • “and that we can foretell the future” – this is flat-out false. In trying to understand where the heck Davies got this particularly bizarre idea, the only thing I can think of is rational expectations theory. Contrary to Davies’ laughable interpretation, all that this assumption says is that people will try to make predictions of the future, and in aggregate won’t be far off. That is very different to being able to “foretell the future”! I actually hope that I have misunderstood Davies’ meaning here, because otherwise it would mean that he is worse than ignorant.
  • ‘Perfect information’ is the typical way of describing the next assumption. Davies is right in this instance – it is assumed that all the actors in the model know all the prices (or whatever), and can access that knowledge at zero cost. However, this is only true of the more basic models. Apparently Davies is unaware that they do get more complex than the first-year undergraduate examples found in textbooks. It is the equivalent of the frictionless surface (or infinite plane, uniform density, perfect vacuum, etc) of physics problems. Transaction costs, as economists call them, are a prominent feature of the vast majority of models actually in use.
  • I don’t know why “brute materialists” merits an entry. It is true that economic models assume we want more for less (a corollary of the rationality thesis), but there’s nothing to suggest it must be money or material goods that are sought. Typically economists lump people’s preferences into a category called ‘utility’, which encompasses everything that humans might consider part of the Good Life, including social interactions. One need only read pop-economics books like Freakonomics to realise that economic tools can be applied to infinitely more things than just money.
  • The reference to economies of scale is particularly obscure. Reading further into Davies’ post, he alludes to the presence of “oligopoly or monopoly” as somehow proving an unspecified neoclassical assumption wrong. Without more detail about what his ideas really are, I can only surmise that he is referring to (and dismissing) the concept of diseconomies of scale.
    We are all familiar with economies of scale, the natural growth of the division of labour. We live it every day, by specialising in producing one set of goods (broadly speaking) and trading for others we need, and organising ourselves into groups that do the same thing. The efficiency gains are truly enormous, and are the basis of modern economies. Diseconomies of scale become evident when organisations get so large that counter-acting effects kick in – lines of communication multiply, slowing decision-making and response times; incentives change as people become more disconnected from what are supposed to be the central aims of the organisation; identifying necessary work from unnecessary work gets more difficult, leading to duplication of effort; and the phenomenon so well-known it has its own cliché – “too many cooks spoil the broth”.
    Dr Davies appears to suggest that these are not important effects, because… well, because large corporations exist. I’m struggling to come up with a generous interpretation of his proposition, but it’s not easy. To be clear, the existence of large corporations is not proof that those effects are negligible. Diseconomies of scale are only one of many factors influencing size and market power. Davies’ first example, Microsoft, essentially owes its dominant position to first-mover benefits due to the unique history of PCs, and network effects.

Thus, for example, in 1987 stock markets fell thirty or forty percent in a day, though thirty percent of the world’s factories had not been bombed overnight.

If stock prices were simply a measure of future company earnings, this would be a valid criticism. But they’re not. Dr Davies exhibits a perhaps wilful ignorance (for rhetorical effect) of the true nature of stock markets, which are primarily a measure of what people think other people think about future company earnings, a very important difference.

But this is a minor problem compared to what Davies is using stock markets as an example of – disequilibrium. If I may backtrack, Davies contends at the beginning of his post:

With enough assumptions like this, you can deduce, using clever mathematics, that a market will balance all supplies with all demands and the economic system will come to an equilibrium.

The simplest and most simplistic of economic models – graphs of supply and demand curves – do have an intersection that is the implied equilibrium. Rational market participants with perfect knowledge will inevitably drive supply and demand towards that point. However it would be a profound misunderstanding to think that this is the end of the story. If nothing else, economists emphasise the dynamic nature of economies. The static picture painted by that kind of abstracted models are in fact no more than a snapshot in time of an ongoing, ever-changing process. In reality (and in the models actually used by economists), the forces pushing demand and supply towards equilibrium are always over- and under-shooting it in a continuous off-kilter balancing act. Those forces have to contend with what are called frictional factors, which brings me to Davies’ last central claim.

If any one of those assumptions is violated you predict very different behaviour of the economy. If the behaviour is very different then the central theoretical conclusion, that a free-market economy comes to an optimal equilibrium, is lost. Lost with it is the basis for all the free-market rhetoric.

The concept of frictional factors is as old, if not older, than neoclassical theory, dating back to at least Walras. This fact is a blow to Davies’ assertion about simplifying assumptions, but let’s leave that for now. What I am concerned with is the total lack of evidence for his claim that the slightest deviation from the (supposed) assumptions means radically different outcomes. He does give a whole paragraph of possible reasons why equilibrium might be disturbed, all of which I have addressed earlier in this post, but he makes no attempt to either calculate the models with the deviations (very hard, so that’s understandable) or to find out if other people have done so (reasonably easy, so quite damning).
As it turns out, this is basically what economists do for a living. There are thousands of scholars, publishing in dozens of reputable journals, who – contrary to the insultingly dismissive opinion of Dr Davies – spend most of their time thinking about the sorts of problems that he apparently believes are devastating original insights. Their results show that modifying the underlying assumptions can change the output of the models, but most definitely does not invalidate the broader conclusions. The data gets messier, but the patterns stay the same.

Yet again Davies’ arguments share many characteristics with those of global warming deniers, something I’m sure he will be mortified to realise. It’s all depressingly familiar – the ignorance of basic concepts, the refusal to acknowledge that experts are aware of and grappling with the obvious concerns, cherry-picking, the danger of a little learning, and liberal doses of the Dunning-Kruger effect.

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15 Responses to Theoretically wrong

  1. db says:

    Tear him a new one! I know practically nothing about economic theory, but that made sense. But then you did con me out of that dollar that time… 😛

  2. Jarrah says:

    I’m glad someone waded through it, and thanks for saying it made sense – I’m never sure anything I write after midnight will make any sense.

    And I would have thought that your recent win would have healed that old wound 😉

  3. db says:

    I am, but I’m more disturbed by the fact I don’t remember it. That’s how canny you are!

  4. Geoff Davies says:

    Jarrah –

    I did not “choose to forget” that all theories are built on assumptions. I was merely noting the fact for this particular case. I am very well aware of the need to be aware of the limitations imposed by assumptions, in my science or anywhere else – far aware more than most economists it seems. See my discussion at
    http://betternature.wordpress.com/otherbooks/economia/neoclassical-scientific/

    Perhaps you could take your own advice about “a little knowledge” and learn more about the basis for my claims. I have written two books on the subject and studied it intensively since about 1998, so I am not the dilettante you assume.

    Taking your points –

    There is a large field called behavioural economics that begs to differ with the claim of rationality. Unfortunately the work hasn’t had a large effect on faith in free markets, as it should.

    Foretelling the future – yes, rational expectations theory claims “people will try to make predictions of the future, and in aggregate won’t be far off”. It’s the latter part that’s a fantasy. If it were true, financial market crashes would not happen. You may know about a currently popular book, The Black Swan, that says what most normal people know – sometimes something completely unexpected happens.

    Materialism – “utility” is such a nebulous concept it can’t be used in any useful quantitative theory. The fact is that economies are run to increase GDP, and in practice that means ever increasing material things, including per capita.

    Economies of scale are pervasive, substantially due to the learning curve effect, as I detail in Economia. If they apply, then the biggest firm can grow until it dominates its market segment. This negates the essential assumption that no-one is a price maker. The optimal equilibrium prediction is then lost.

    Stock markets – well, the theorists and apologists for “capitalism” claim the stock market assures “efficient allocation of capital”. Apparently you agree with me that they don’t do that.

    If the neoclassical general equilibrium applied, the 1987 crash could not have occurred. If you don’t understand that then you’re missing simple logic.

    The point of my focus on the neoclassical general equilibrium is that it is the basis of all the rhetoric about free markets being best. That claim has no basis in theory (nor in practice). You may contend that “economists emphasise the dynamic nature of economies”, but they don’t do that on the basis of a sensible theory of the dynamics of an economy. They are just making assertions with no more basis than, in effect “trust me, I’m an expert” – but an expert in something else.

    Perhaps you should acquaint yourself with Steve Keen’s work. He is a “real” professor of economics, and he is just as harsh as me about equilibrium. He is developing proper dynamic theories, but encountering severe resistance from those wedded to equilibrium. See http://www.debtdeflation.com/blogs/ and http://debunkingeconomics.com/.

    So Jarrah, as I said, perhaps you could educate yourself some more.

  5. Jarrah says:

    Dr Davies, I did not set out to make an attack on you, or review your life’s work. I only sought to show why people shouldn’t rely on the ‘Hopelessly wrong’ trilogy. Your books on the subject are essentially irrelevant, if you can’t make a reasoned or reasonable argument in a blog post after writing them.

    “If it were true, financial market crashes would not happen.”

    That’s not true. Even John Quiggin, in his recent book Zombie Economics, where he criticises rational expectations theory in no uncertain terms, can tell you that. Have you read Black Swan?

    “The fact is that economies are run to increase GDP”

    That is silly. Economies exist to serve human needs and wants. GDP growth is just what happens when capital produces more capital. That lets us provide for our needs and wants more easily, and is to be applauded, and it just so happens that freer markets do so better than less-free markets, certeris paribus. Feel free to peruse my blog if you want evidence to that effect.

    “If they apply, then the biggest firm can grow until it dominates its market segment.”

    So you’ve decided to completely ignore my substantive points about diseconomies of scale. OK, then don’t expect me to take your assertions seriously.

    “the theorists and apologists for “capitalism” claim the stock market assures “efficient allocation of capital”.”

    Again your misapprehension makes itself clear – all the market processes working together ensure an efficient allocation of capital (with caveats), and a stock market is just one manifestation of those processes.

    As for Keen, I’m well aware of his work, and I note yet another similarity between you and AGW sceptics – a reliance on fringe academics.

    In summary, you have presented assertion piled on assertion, ignored refutations of key parts of your argument, and exposed even more gaps in your understanding.

  6. Geoff Davies says:

    Jarrah,

    I write some summary articles on a big subject. You pick holes on the basis of points where you consider I haven’t provided enough evidence for my claims. I point you to where the further evidence is. You say you’re not interested in my “life’s work” and the books where I provide further evidence are “irrelevant”. I don’t think you’re arguing in good faith.

    The comments you are making here are at least as lacking in full, documented evidence, but apparently it’s OK for you to make summary comments.

    Just one point, before I stop wasting my time here. It’s true I should have said that market crashes in the absence of obvious external traumas would not happen if equilibrium applies. Many market crashes have happened without any obvious change in external conditions, so they must have happened through their internal dynamics – dynamics that would not exist if equilibrium applied. That was clear enough in what I originally wrote, but you don’t seem capable of understanding my words.

    My lack of response to your other points is because I will put my energy to a receptive audience, one interested in exploring alternative views, which you certainly are not.

    You continuing comparison of me to AGW sceptics is a cheap slur.

  7. Equilibrium is a tool for analysis, not an actual state of being. Economies evolve toward hypothetical equilibriums, but they never actually reach the equilibrium because the destination is always changing whenever knowledge or preferences change (which is every day). Comrade Geoff seems to have an amazingly shallow understanding of economics and markets, which probably explains why he hates them.

    Well written Jarrah.

  8. Omen says:

    Davis;

    You’re worse than a climate science sceptic, because you’re basically a leftwing crank dressing up garbage to make it look as though it’s scholarly. After reading your bilge I presume you’re also 1/32 Cherokee along with that other noted scholar Pocohantas Warren, who fits so-called research into a narrow leftwing perspective no matter the results.

    You grub Davis.

  9. John R Walker says:

    jarrah are you around?

  10. John R Walker says:

    have you read our posts on Troppo?

  11. Graeme Bird says:

    Geoff Davies is right to imply neoclassical economists are full of shit. The main intellectual fault they have is to never learn, or to forget, the implicit assumptions of their models.

    The best critics of the neoclassicals at the moment are Professor Keen and Professor Hudson. Both these guys however still cannot be quits with Keynesian error. But hey nobodies perfect. My economic understanding is perfect. But then I drink too much and have concentration problems. Perhaps if the excellent Professor Keen had more personal faults he could get rid of that last bit of Keynesian silliness.

  12. Graeme Bird says:

    I will explain what I mean by cross-posting the post I left at Geoff Davies blog.

    “Geoff one thing these Neoclassicals do is that they have assumptions to their models, and then they don’t learn or forget those models. So for example take banking. Their models assume that everytime a banker makes a loan the money is spent to buy machines that make workers more productive. That is the implicit assumption of their models. But we know that bankers borrow money to lend for land inflation, buying derivatives, takeover plays, consumer finance not excluding credit-card addiction, and this sort of thing.

    Worst of all you try and tell them where they are coming off the beam, they’ll think you are me and they’ll block you right away.”

    Now there is no denying the above is there? No there isn’t? You want to deny it Fatfingers? How about you Humphreys? Step forward.

  13. Graeme Bird says:

    The international banking and trade system these neoclassicals have bequeathed us is inherently unstable. Its set up to cause imbalances. There isn’t the move towards equilibrium as Humphreys implies. Rather there is the move away from equilibrium and then a rolling thunder of crises. The system is only lurched back towards equilibrium through periodic crises.

    The reason is that to have a system that works towards equilibrium you need a functioning price system. But our system is based on derivaties. Which means phantom supply. With phantom supply our price system is being screwed with. Hence there is no inherent balancing act in the system that the neoclassicals advocate.

  14. Graeme Bird says:

    I note that Jarrah is here defending the neoclassical economists. Doing so deriding the scientists motivation to make a better world. But this is very odd. To me Jarrah was always a lefty except in odd circumstances. Like when he wanted to gift the roads in front of properties to the property owner. Like when he wanted the fisheries auctioned.

    Though Jarrah can be a bit of a lefty, the fact is he is a Jew. And his views have to be seen in light of Jew tribal racism. So he’s big on neoclassical economics, as rotten as it is, because it favours the Jew tribe. And note the immense offense I took at his idiocy when it came to physics arguments. I need not have gotten so upset with his belligerence. Because he was only doing what a racist Jew does. He was sticking up for his tribe.

  15. David says:

    Hilarious as it is to watch grown men argue over ideals, you all seem to have missed the point.
    Ideals are intangible.

    Imagine for a moment that the Greens won the next election by a landslide and somehow controlled every state too.
    The country would be ruined in short order.
    While the Greens merely control the balance of power they get a few wacky ideas through but otherwise help to create an actual review of laws passed. Unheard of in a modern democracy.

    Arguing over who gets a bigger share of the cream and why is petty. It is inconsequential and basing your arguments over the worth of neoclassical or modernist or Doric or whichever architectural style of economic theory you subscribe to is surprisingly obtuse given the intellectual horsepower available.
    The reality is that you all provide puff pieces for a media so starved of genuine information that they take whatever you feed them and joyously broadcast the squabbles that follow.

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