1. Steve Keen Political Economy: Critique of Neoclassical Economics Wrong answers to the wrong questions: Demand

2. 2 ©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?

3. 3 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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…”

4. 4 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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!…

5. 5 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

6. 6 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Hey presto: downward sloping demand curve! consumer welfare  as P  Consumer demand Indifference curves show tastes Bananas Biscuits W Y X Z q1q1 q2q2 q3q3 Bananas Price of Bananas p1p1 q1q1 p2p2 p3p3 q2q2 q3q3 I II III Prices & Income gives budget –Budget line II: banana price p1 p1 cheaper than p2p2 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

7. 7 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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 X Z q1q1 q2q2 q3q3 Price of Bananas p1p1 q1q1 p2p2 p3p3 q2q2 q3q3 I II III

8. 8 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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 Bananas The demand curve Now stage two: the upward-sloping supply curve

9. 9 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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:

10. 10 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Supply Marginal product can initially rise… But ultimately it falls… Falling marginal product mean rising marginal cost Banana Output Labour Input A B Marginal Product Labour Input (capital fixed) A B Rising marginal product 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 cost Infinite marginal cost

11. 11 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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: Slope of TR=MR Slope of TC=MC Maximum profit where MR=MC

12. 12 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Supply Since price is constant for a competitive firm, marginal revenue equals price: 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:

13. 13 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Supply & Demand “Houston, we have equilibrium”… P Q P C =MC QCQC D S Consumer Surplus Producer Surplus With maximum social welfare MR But assuming all markets are competitive, we can have general equilibrium… Unless there’s a monopoly QMQM P M >MC

14. 14 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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: Demand Supply Quantity Price QeQe PePe Demand Supply Quantity Price QeQe Pe Demand Supply Quantity Price QeQe Pe Demand Supply Quantity Price QeQe Pe

15. 15 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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 Biscuits Y X Z Y X Z “Houston, we have a problem…” –With more than one individual:

16. 16 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

17. 17 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Consumer Demand With one consumer, no problem keeping prices & income/wealth separate: Bananas Biscuits W Y X Z q1q1 q2q2 q3q3 Bananas Price of Bananas p 1 q 1 p2p2 p3p3 q2q2 q3q3 I II III With two consumers, even if their tastes are identical identical, can no longer separate prices from incomes/wealth q3q3 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: q1q1

18. 18 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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:

19. 19 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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…

20. 20 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Illustration Standard neoclassical “utility function” Cobb-Douglas: Add budget constraint: Yields individual demand curve: “Lagrange multipliers” to derive demand curve: Add numerous identical consumers…

21. 21 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Illustration So far so good… 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…

22. 22 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Illustration Consider Y which varies between 1 & 1000 Depends on relative prices of A & B where Sample demand curve for B: Illustration only, but graphical simile for Sonnenshein’s “every real- valued function is approximately an excess demand function”

23. 23 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

24. 24 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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…

25. 25 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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”

26. 26 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Consumer Demand So rather than this: Bananas Price of Bananas The demand curve In general market demand curves (derived from neoclassical theory) look like this: Even if consumers utility maximise! –Which they don’t…

27. 27 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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 Biscuits W Y X Z

28. 28 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Indifference Curves What we can know is what a consumer actually buys at different prices: q1q1 q2q2 q3q3 Bananas Biscuits P1P1 P2P2 P3P3 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 C then A pref C

29. 29 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Indifference Curves All points in box preferred to A (non-satiation) Bananas Biscuits A Bananas Biscuits 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

30. 30 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

31. 31 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

32. 32 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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 p C * A  p C * C –If A  B & B  C then A more expensive than set C at prices when C declined in favour of B

33. 33 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

34. 34 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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?…

35. 35 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Indifference Curves Use waste of income from inconsistent choice as guide to how significant were deviations from “rationality”: –Afriat index: ratio (p B * A / p B * B) when (from previous experimental round) A  B –Where consumer chooses A when B affordable, use formula “A  B if (e * p A * A)  (p A * 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”

36. 36 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney Indifference Curves With thicker indifference curves, more combinations are shown as “indifferent”: Bananas Biscuits 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! A B C 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

37. 37 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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

38. 38 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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!

39. 39 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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?

40. 40 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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?

41. 41 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 2 1000, or roughly 10 300. 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?

42. 42 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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?

43. 43 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney How “rational” is optimising? (6) 10 224 times as much as the entire universe! If you could recall utility of each combination in 1/10,000,000,000,000,000,000,000,000,000,000,000,00 0,000,000,000,000,000,000,000,000,000,000,000,000,0 00,000,000,000,000,000,000,000,000 th of a second, how long would it take to remember the maximum? –10 200 seconds: 10 180 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

44. 44 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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)

45. 45 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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”: 10 300 combinations –Segmented optimising: “Buy/not buy”: 10 31 combinations—10 269 less: could remember everything with a brain weighing only… 1 million tonnes! More than segmentation needed! But optimising behaviour is clearly not rational

46. 46 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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”)

47. 47 ©Steve Keen 2005 Advanced Political Economy, Economics & Finance, University of Western Sydney 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…