Economics

From Hobson's Choice

A branch of the social sciences devoted to the analysis of production and distribution, reduced to a generic set of phenomena.

1 Schools of Economics
2 Orthodoxy: Economics as Celestial Mechanics
3 Countervailing Trends: Economics and Institutions
4 From the Industrial Firm to Industrial System
5 Keynesianism
6 Dynamic General Equilibrium Theory
7 Notes
8 See Also
9 Additional Reading/External Links

[edit]

Schools of Economics

The following is a loose breakdown heavily influenced by the College for Economics & Public Administration (CEPA) economics website (which supplied nearly all external links).

Ancient (Kuan Chung; Aristotle, Thomas Aquinas)
Mercantilists (Richard Cantillon, William Petty, Charles Davenant, James Steuart)
Enlightenment (Adam Smith, François Quesnay, Cesare Bonesana di Beccaria)
Classical (Jean-Baptiste Say, Nassau Senior, David Ricardo, Nassau Senior, Jules Dupuit, John Stuart Mill, Karl Marx)
Marginalist (Carl Menger, Leon Walras, William Stanley Jevons)
Historicist School (British Historicists: Richard Jones, J.A. Hobson; German: F. List, G. von Schmoller)
Neoclassical (Alfred Marshall, John Neville Keynes, Vilfredo Pareto, Maurice Allais)
Institutionalism (Thorstein Veblen, John Commons)
Keynesianism (John Maynard Keynes, Joan Robinson, Abba Lerner Franco Modigliani, James Tobin)
DGE (Robert Lucas, Neil Wallace)

[edit]

Orthodoxy: Economics as Celestial Mechanics

Economists of the late 19th century developed a view of the world that was isotropic; they were determined to find a general system of laws that applied the same way in all places. Their forebears tended to notice patterns, but the marginalists, for the most part, were determined to find a Cartesian system of rules that transcended, or anticipated, the laws of nature. They wanted to show that economics was almost a parallel of physics. The relations between persons, represented by their wills and endowments, could be deduced endlessly to explain reality, provided one had the proper disciplines of mind, and had a perfect knowledge of initial endowments.

For such an outlook, there could be no such thing as an industrial system. There was only the economy. It was more or less without boundaries. It was like the ether of space, in which the laws of Newtonian physics and Maxwell's equations operated smoothly and infallibly.

In developing countries such as the USA and Germany, economics tended to split ideologically, with some—like John Bates Clark—favoring laissez-faire, and others—like Gustav Schmoller—sided with the historicist school, which argued that affluence required a policy of state management. The coexistence of these rival social sciences led to a division of labor between them, with the neoclassicists of North America tending to be polemical (as, for example, Simon Newcomb and Frank W. Taussig), and the historicists tending to go into social research. Since historicism is prescriptive, and a true federal republic is unlikely to ever be capable of embracing any such prescription, the North American historicists—led by Richard Theodore Ely and Henry C. Adams—turned to empirical research in the social sciences. As a result, we call this group of heretics institutionalists." Their special attention was directed at the nature of institutions that carved out economic space within the economy.

Because the neoclassical school of economists was at once caught up in an academic struggle with the historicists/institutionalists, they were determed to deny institutions any determining role in the form the economy could take. Rather, the neoclassical economists insisted that economic institutions themselves (viz., corporations) sprang from economic efficiency. As an example of this, consider Ronald Coase's "The Nature of the Firm"

, 1937. Coase's paper is a microcosm of classical economic thought (albeit, partly because of his citations). Herewith is the neoclassical vision:

Let us consider the description of the economic system given by Sir Arthur Salter. "The normal economic system works itself. For its current operation it is under no central control, it needs no central survey. Over the whole range of human activity and human need, supply is adjusted to demand, and production to consumption, by a process that is automatic, elastic and responsive." An economist thinks of the economic system as being co-ordinated by the price mechanism and society becomes not an organization but an organism. The economic system "works itself." This does not mean that there is no planning by individuals. These exercise foresight and choose between alternatives.

Coase, himself later regarded as the neoclassicists's neoclassicist, outlines the contrast between the economy and institutions operating within it:

Sir Arthur Salter's description, however, gives a very incomplete picture of our economic system. Within a firm, the description does not fit at all. For instance, in economic theory we find that the allocation of factors of production between different uses is determined by the price mechanism. The price of factor A becomes higher in X than in Y. As a result, A moves from Y to X until the difference between the prices in X and Y, except insofar as it compensates for other differential advantages, disappears. Yet in the real world, we find that there are many areas where this does not apply. If a workman moves from department Y to department X, he does not go because of a change in relative prices, but because he is ordered to do so. Those who object to economic planning on the grounds that the problem is solved by price movements can be answered by pointing out that there is planning within our economic system which is quite different from the individual planning mentioned above and which is akin to what is normally called economic planning... As D.H. Robertson points out, we find "islands of conscious power in this ocean of unconscious co-operation like lumps of butter coagulating in a pail of buttermilk." But in view of the fact that it is usually argued that co-ordination will be done by the price mechanism, why is such organization necessary? Why are there these "islands of conscious power"?

[edit]

Countervailing Trends: Economics and Institutions

The notion that the firm, rather than individual owners of capital endowments, was the real agent of decision in the capitalist system might have appeared to have been a tip of the hat to the institutionalists. In fact, "The Nature of the Firm" was an attempt by Coase to prove that economics, as understood by the neoclassicists, could indeed supply an explanation for the firm's emergence as "an organism rather than an organization," i.e., something that evolved without any relevant human agency. This does not mean that Coase was so extreme a skeptic as to deny the existence of Henry Ford or John D. Rockefeller. It meant that Coase (and neoclassicists in general) would take the position that the markets had favored Ford Motor Company and Standard Oil taking the form they did. Had Ford or Rockefeller died in childhood, then some other entity would have furnished the automobile or refined petrochemicals in a similar way. Given the available technology and the nature of the market for these items, it followed that there was an ideal size of the firm for a particular product. The firm would require persons of peculiar abilities, and someone would necessarily emerge to fill the bill.

Economics is full of hypotheses like this one: substituting universal laws for conscious agency, and beyond the realm of testing. Not only is there no means of testing to see if the auto industry would be materially different if Henry Ford had died in childhood, or if it emerged in Canada instead of the USA, the concept is essentially meaningless. By insisting that the laws of economics determine the optimum size of a firm for any given sort of business, amounts to a tautology. Of course they do do. Even if I manage to decisively prove that, say, General Motors is far larger than the optimum size for a firm,^[1] Coase might object that other Japanese and European firms operate under different constraints, and represent essentially different enterprises with different outputs. But that's my point. Most industries will have a cluster of firms ranging in size from small to large, with the medium either more, equally, or less, profitable than those at either extreme.

I could spend a far longer time than I have examining the profits over different time horizons, different capital market structures, or different corporate law regimes; examine the returns on equity (ROE) over different time horizons; or contrive any comparison you like. The fact that firms do exist with performance varying widely, sometimes over very long periods of time; or else, a firm's performance over time may vary when its size does not, or a firm's performance over time may be consistently excellent while its size is not, are all outcomes that Coase must have known about.

Coase was not claiming to devise a theory that would predict the exact size of a firm given readily available information about the industry in which it operated. In fact, his paper was mainly intended to attack Frank H Knight's theory of uncertainty. Coase, in other words, wrote his paper as a salvo on behalf of the apologetics. Knight, while generally siding with laissez-faire, denounced the Panglossian claims made for it by the apologetic school. There were consequences, Knight declared, to defending free markets with a bodyguard of humbug. Coase manfully rose to strike a blow for humbug.

The humbug that Knight scoffed at, and Coase defended, was the absence of any sort of political or institutional role in the free enterprise economy. We may find it odd that Coase had a beef with Knight's perfectly plausible concept of uncertainty playing a role in the size of the firm. The ability of an entrepreneur to shield himself from unquantifiable risks associated with increases in costs of production by buying out suppliers, is an imminently compelling reason for expanding the size of a firm. However, not being quantifiable, it is political. That, Coase cannot accept.

Risk is an economic matter. Uncertainty—unquantifiable risk—is a political one. A random incidence of property crime, with minor variations over time, can be factored into the costs of doing business. The possibility of public resentment at a monopolist giving way to nationalization of the firm, cannot be. If the possibility is real, it must be eliminated. If the monopolist absolutely positively cannot install a falangist regime in the country he operates out of, then he will stew about it and become obsessive. The notion that a firm is the size it is to suppress the consequences of the manager's own incompetence, and not to maximize shareholder ROE, is a grave and fundamental challenge to the apologist's position. The moral virtue and historic inevitability of the capitalist system's behavior is called into question; it is contingent upon results. Knight favored laissez-faire because it was the least bad system. Coase championed it as definitionally, immutably optimal. Oddly, it was fairly exotic to point out it didn't exist.

[edit]

From the Industrial Firm to Industrial System

Main article on Industrial System

While an economy represented the space in which transactions and production occurred, a corporation is a planner whose size is determined by politics rather than by economics. It takes its size partly in response to uncertainties, such as the unknowable possibility that its suppliers or retailers will gain an advantage over it. The risk of one's customers being engulfed by a monopsonoid retailer, if plausible, will very likely trump comparative transaction costs when considering a merger. Another consideration is the expected future costs of transactions: if superior industrial technologies requires massive investments in new plant and equipment, then the entrepreneur will be seeking an optimal path, rather than an optimal state.

Choosing an optimal path involves planning for a future under certain assumptions about trends in costs and prices. Over the period being planned, it may be expected that there will be years in which the firm is losing money, since it is operating at an excessively large size; at the end of the period, the firms profits (in the aggregate) will be, or have been, greater than if it had optimized from quarter-to-quarter. Different management teams might choose different assumptions about trends, or different time horizons, leading to historic (institutional or personal) peculiarities in the composition of the economy.

While these aspects are both decisive and outside the scope of purely economic theory, they do not refute it. They merely impose limitations on its applicability, much the way psychology does not necessarily predict the behavior of a person held at gunpoint (rather, the gunman does).

However, an industrial firm is only a part of an industrial system, which is also peculiar to prevailing technological, historical, and personal conditions. We usually think of industry as either the business of manufacturing and construction; an industrial system, however, is a process of converting available factors of production into goods, and using the goods to obtain further factors of production. "Using the goods to obtain further factors of production" may include selling the goods to a population of grateful customers for money, but it may also include pointing the "goods" at fearful natives and extorting factors of production from them; or combinations of the two (selling extorted goods for money to buy goods like rifles and gunboats).

[edit]

Keynesianism

Main article on Keynesianism

Keynesianism is the casual term used to refer to some economic theories and policy methods that were widely used between 1946 and 1980. These theories are named for John Maynard Keynes (1883-1946), although Keynes was actually the manager of the research group that developed Keynesianism.

Keynes' role was to summarize the findings of the Cambridge Circus into the famously well-written, if a bit ambiguous, General Theory of Employment, Interest and Money (complete text). The General Theory incorporated acceptance of market imperfections, such as sticky prices and corner solutions in factors markets, that had been growing for some time. The crucial departure of Keynesianism can be summarized as "imperfect markets," which meant,

prices may "never" adjust to reflect the intersection of supply & demand;
money is not neutral (i.e., disinflation or deflation has a serious impact on economic conditions; the available money supply, accompanied by a distinct market for cash balances, has an impact on real output);
factor markets, such as for labor, land, and capital, may sometimes not clear;
state intervention may sometimes cause more good than harm.

The last proposition is a bit difficult for some people to understand. Keynes had sought to establish a macroeconomic role for the state precisely so it could avoid a microeconomic (i.e., socialistic) one, and he attempted to establish clear, immutable boundaries for the state under conditions of economic emergency. These borders were not crossed by Keynes; for example, the Royal Commission on the Poor Laws (UK-1905-1909) examined mainly employers and economists, before setting up a system of compulsory unemployment insurance.^[2]

However, there are essentially two key features of Keynesian economic policy that were widely adopted everywhere for many years: fiscal policy and monetary policy. Fiscal policy was based on a crucial term of art coined by Keynes, the "theory of effective demand," which acknowledged that supply did not create its own demand, and on occasion it was necessary for the national treasury to step into the breach with deficit spending. This could be achieved with public works spending of various kinds, or it could be accomplished by slashing taxes. Monetary policy consisted of influencing liquidity preferences, or the demand for cash, through shrewd manipulation of interest rates. In later years, it was understood that major national governments had significant, but limited, power to influence interest rates; and the tools for influencing them tended to be fairly blunt.

[edit]

Dynamic General Equilibrium Theory

The dynamic general equilibrium (DGE) model of economic behavior is the one that has prevailed in public policy analysis for about 30 years now. In its early form, it tended to use, and was known as, the "rational expectations hypothesis" (REH) ; and a money-neutral version of the business cycle, or "real business cycle" (RBC) theory. In the years since, there has been a shift of emphasis away from REH and RBC, towards the design of the model itself (DGE). Hence, DGE methodology can specifically exclude some of the early assumptions, and incorporate their converse.

In general equilibrium, all of the determinants of economic equilibrium are considered at once. This can be gone though a system of linear equations. The equations incorporate the utility functions of representative consumers, prior endowments of capital and labor, production functions (i.e., equations that provide the maximum output of commodities for an economy, given available labor and capital; see Egwald), and so on. The object is to create a mathematical representation of how an economy works.

The dynamic component comes from the use of mathematical models to simulate the behavior of such an economy over time (an innovation of Edward C. Prescott's "Time to Build" paper, cited below). In such a model, the economy has predictable responses to various kinds of external shocks ("technology shocks"), each of which corroborate the others.

[edit]

Notes

↑ GMC has annual sales of about US$192.6 billion (2005), and lost $10.6 billion. Moreover, its products are generally either poorly designed, or else poorly made, and usually both. In contrast, Renault S.A. has annual sales of about $55.5 billion and profits of $4.8 billion. Like GMC, Renault makes trucks as well as a wide range of motor vehicles. Subaru (Fuji Heavy Industries) is smaller yet: at $13.5 billion in sales, and $581 million in profits, it has 7% of GMC's revenues, superior products, little (if any) government subsidies, and outstanding ROE. FHI's mix of products is somewhat different, but clearly the automotive division is far superior in efficiency and financial performance than giant GMC; medium-sized Renault, in turn, is more profitable than either, has a product mix more like GMC's, and (for 2003) had a better ROE than either.

From this, one might conclude that Renault is Goldilock's preferred automaker: firms bigger than it suffer from excessive impedence of market forces, while smaller firms like FHI suffer from excessive transaction costs. But Toyota ($178 billion sales/11.7 billion profits) is 3.2 times the size of Renault, more consistently profitable, and in between Renault and GMC in size. Porsche is smaller than FHI ($7.8 B/$949 M), and Daihatsu's ($10.9 B/$240 M) auto division is bigger than Subaru (i.e., FHI's auto division).
↑ Timothy T. Hellwig "[http://ssh.dukejournals.org/cgi/reprint/29/1/107.pdf The Origins of Unemployment Insurance in Britain: a Cross-Class Alliance Approach]" , Social Science History (Spring 2005)

[edit]