To the Defence of the Practical Use of Neoclassical Economics

In political-economy fields, the issue of states and (or versus) markets is widely debated. Some argue that markets should be left alone without governments distorting their functioning, thinking which is often connected to authors such as Adam SmithMilton Friedman and Friedrich Hayek; others emphasise the role of the state and the failures of the market, linked to authors as different as Karl Marx and Joseph Stiglitz. In this debate it has now been acknowledged that the original, strict divide between markets and states is useless: markets and states are strongly interrelated and both necessary. In a world without some sort of state, property rights cannot be assured and enforced, which is why markets will not flourish. In a world without markets (unless we speak of an extremely simple, static, and thus predictable world), standards of living cannot rise in a durable manner. This is showcased by the inevitable demise of communism, where innovation was largely ruled out, and all necessary information could not be collected and centralised. But even if it could have been, it could then not have been processed, thus posing insurmountable allocation problems. It has been recognised that markets can lead to higher standards of living for society as a whole on the longer term, when the state is there to ensure property rights, to smoothen its hardships and to step in when it fails too badly. This implies a combination of roles for markets and states.

Related to the markets versus states issue is the narrower debate surrounding neoclassical economics, which has many interpretations, but in which a lowest common denominator seems to be that welfare is maximised if individual human beings are left free to maximise their individual utilities by making rational decisions based on complete information sets. There exists a broad consensus in academic circles that neoclassical economics has failed. Its assumptions have clearly been proven to be oversimplified, if not plainly wrong, whereby recently references are made to the financial crisis. I will argue that one should consider neoclassical economics in a similar way as markets in the markets versus states debate: ‘pure’ neoclassical economics, in assuming that it does or should describe reality perfectly, is useless. However, so is totally ignoring it, because it contains crucial suggestions as to when and how markets can improve the living standards of society as a whole.

Since this is not an essay that will be assessed such that it might result in me failing a desired degree, my structure will be rather loose. You can, however, rest assured that I will say a few things in the order in which they are introduced in this paragraph. I will first briefly discuss the practice of modelling. I will explain why and how rationality is often misunderstood, and argue that when perfect information is assumed, subsequently assuming rationality is redundant. This is a clue to understanding that they are never both perfectly satisfied. I will argue that disproving the (mathematical) assumptions that can be found in neoclassical economic thinking does not mean that the underlying ideas lose their power and relevance. Finally, I will argue that markets are crucial in achieving long-term economic growth and rising livings standards, and that the controversial assumptions of neoclassical economic ideas can actually be used as instruments in achieving this.

Let us first, very briefly, discuss modelling. Modelling corresponds to the simplification of reality by way of the determination of assumptions. Models allow for increased understanding, because one cannot understand reality by holistically observing everything in a single instant. Werner Heisenberg pointed out that this is not even possible – the observer always and inevitably influences the observed.

Modellers are very well aware that their assumptions are (over)simplifying. This is why they are assumptions and not axioms in the first place. In a sense, the assumptions are the most important elements of the modelling process, since in one way or another, the assumptions imply the following model. They determine the model that, often, approximates reality. Accusing modellers of believing that their assumptions describe truth or reality in full is silly: They acknowledged it the moment they called them assumptions.

Rational behaviour or rational choice theory involves modelling as well. It helps to explain humans’ decision-making processes. According to some, rationality often enters decision-making processes through the usage of utility functions. The decision-makers are believed to maximise their utility subject to a set of constraints. This set of constraints often comprises the endowments with which the decision-makers are provided. In critiques it is often stated that utility functions and the set of preferences of a single decision-maker cannot be perfectly constant over time. Naturally, if a credible person would assume so, this must be a modeller. He knows it not to be true, but for his purposes it might provide explanatory power.

Why must this be the case? Just consider a bottle of water and the value that a certain person attaches to it, right after this person consumed some other, big bottle of water. Subsequently, we deprive this poor fellow of water for two consecutive days. Obviously the value attached to the bottle of water has increased dramatically, and therefore the utility function must have changed. You will not find any credible person, who approves of the usage of utility functions, and opposes such a line of reasoning.

This oversimplified example indicates that rationality relates to needs. Needs are crucial to rationality. The creation of utility, or welfare for that matter, through the fulfilment of needs, subject to constraints, is central to rational behaviour. Utility functions symbolise the relationship between an additional unit of a certain something and the increase or decrease in utility its consumption or experience would create. The optimisation of the decision-making process symbolises rationality.

In the term rationality, we find the term ‘ratio’. Ratio refers to (the ability to) reason, a term that refers to the capacity human beings possess to find causational relationships, to establish and verify facts, and to the use of logic. That human beings use ratio does not make them infallible. This is where another misunderstanding kicks in. Often, and especially in critiques of capitalism and neoclassical economics, the ‘rationality assumption’ is criticised together with the complete and perfect information assumptions. Actually, if we take the information assumptions as they are often voiced in critiques, they would make a rationality assumption redundant. If you know all utility functions including your own, and if you know everything that is available to you to consume or experience to fulfil your needs within the boundaries of your constraints, you do not need ratio anymore. You then know how to maximise your utility.

Likewise, rationality neither implies nor needs the information assumptions. This is where rationality is most misunderstood. Rational behaviour does not imply that those using it cannot be wrong. To the contrary, the acknowledgement that one might be wrong, that we do not have every possible bit of information, that even if miraculously we would have every possible bit of information available to us we would not be able to process it perfectly, that we do not know how the future will unfold, and that we do not precisely know how utility or welfare is maximised, fuels the very need to apply reason – to apply ratio. We use ratio to help us with the decisions that would otherwise be plain guesses. The oft-sounded argument that rationality was falsified at the moment a presumably rational agent failed in his or her decisions, simply because he or she made the wrong decision, is false. A rational decision does not imply that a decision is right – it implies that reason is applied to it.

Many have attempted to falsify the validity of rational behaviour, and utility functions in particular, with the example of the irrational decision-making individual in a supermarket. It is reasoned that (part of) the behaviour in a supermarket is irrational in the sense that the decisions are to a large extent influenced by the powers of advertisement. The observation that we just pick ‘this and that’ product and that we throw products in the cart that we did not need when we stood outside the supermarket a few minutes ago, would evidence irrational behaviour. I think the example is misleading, for the following reasons. To argue that for all individuals in a supermarket elaborate cost-benefit analyses would be worthwhile would be to discard the constraint that relates to the ‘resource’ that might be the scarcest of all: time. It can be perfectly rational to ‘quickly’ visit the supermarket, because time might be spent more efficiently at work, with your children, or in my own case, in the university library. In fact, in most cases elaborate cost-benefit analyses in supermarkets would be irrational given that time is more effectively spent doing something else, and whether you buy milk or orange juice, in a week you will most likely neither remember nor care about it anymore.

And this is what brings us back to what rationality is all about: needs and their fulfilment. For the greatest part of our lives, we use rationality to fulfil the needs that we think will yield us the most incremental utility or welfare, even if we are not aware of it. Often it does not seem this way, because rationality in a lot of more or less inevitable daily activities seems missing, but that is because it is no longer needed there. Supermarkets these days are safe environments, with products that need to satisfy many conditions before they can be put on the shelves (observe the role of ‘the state’). Decisions around which study to choose, which house to buy (or to rent), or which job to take have a far greater impact on our welfares or utilities, and therefore require our ratio. But at the moment that our needs shift, because we have become very poor or the supermarkets are no longer safe environments, the need for rational behaviour in supermarkets will resurface.

Much of the critiques of neoclassical economics have focused on the abovementioned rationality and information assumptions. What is striking is that there seems not to be a strong voice defending rationality or ‘pure’ neoclassical economics in a more general sense. Claims that rational agents make wrong decisions, often involving the concept of bounded rationality, have not been met by opposing voices repudiating these claims. Moreover, the assumptions that are so massively criticised are hardly ever connected to an author. This is because there is no-one that is of any importance or credibility to be found that ever believed that all the assumptions of neoclassical economics always hold and explain the whole of human behaviour. Similar to the case of ‘pure markets’ in the markets versus states debate, the critiques are therefore useless; they hit nothing and no-one. To take a small example, Milton Friedman states in the very paper that proved so influential for the development of rational expectations and choice theory that it would take actors years to find out about and react to inflationary monetary policies by demanding (over)compensating higher wages. This, as you can see, is already very different from the often attacked notion that rational actors can immediately change their behaviour based on the information set they possess.

The general message here is that one should not be distracted too much by the mathematical frameworks that are often understood to form the foundations of neoclassical economics when one takes an actual look at reality. For all the reasons mentioned above, it is and has always been crystal clear that the assumptions are simplifying. This, however, does not mean that the original ideas that underlie much of the later-developed (mathematical) frameworks lose their power. As Deepak Lal puts it: “To compare competition in any actual market economy with an unattainable ideal, is, to use Demsetz’s (1969) useful phrase, a form of ‘nirvana economics’. For it is child’s play to show that because of incomplete markets, external effects, and the existence of public goods, ‘market failure’ defined as deviations from the perfectly competitive norm is ubiquitous, but the corollary that this then requires massive corrective public action is highly dubious.”

One can just take a look at the ‘real world’ to see the clear evidence of the practical power of neoclassical economic concepts and ideas. The states that have more prominently allowed markets to develop where individual actors may act freely to respond to their own interests are characterised by a deeper specialisation of industries, a higher efficiency, increased trade, and a rise in living standards in general. This can be partially explained by observing that the critiques focus on the static mathematic models of neoclassical economics, whereas it is the dynamic efficiency that makes that competition and markets are so successful. It is in the latter idea where Adam Smith is misunderstood most, according to Mark Blaug.

Even though some refer to China as some kind of evidence to the contrary, I would argue that in total size the Chinese economy might indeed rival those characterised by free markets, but they are nowhere near in doing so on a per capita basis. Actually, one might argue that even the very steps the Chinese have made in economic development have been caused, or at least enabled, by economic liberalisation.

Next to such evidence that states with free markets, in which individual actors can make informed choices, perform better in an economic sense, are free markets also supportive of what one may call ‘Western’ ideals and values such as freedom and diversity. For example, Friedrich Hayek, when stating his case for free markets, does not so much emphasise the guaranteed economic success of free market countries (although he does argue that on a longer term the economic success will be greater compared with centrally planned economies), as he does underscore that every other alternative will jeopardise values (that are not particularly ‘economic’ in nature) like freedom because it would lead to the ‘serfdom’ of individuals.

So now we find ourselves on a point where we accept that on the one hand neoclassical models often (over)simplify and are somewhat incongruent with reality. On the other hand, we observe that markets are crucial to sustained economic development and rising living standards. It is my assertion that neoclassical ideas, and especially their highly controversial assumptions, are key in finding the right balance between and combination of the market and the state.

The power of neoclassical models is that they indicate in a highly transparent way when and how markets will or can be efficient and welfare-enhancing. By formulating the assumptions, they provide policy-makers with criteria to evaluate the usefulness of markets and indications of how to improve their functioning. One can distinguish here a positive and a normative use of the assumptions.

The positive use is relevant for determining whether or not a market might serve society well for a specific industry, by checking whether the relevant models correspond strongly enough with reality. One can take the ‘checklist of assumptions’, including externalities, completeness of markets, availability of information, diminishing returns, free entry to the market, and public goods, and use it to evaluate whether or not a market would be a good idea. Hence, it is nonsense to argue that neoclassical economic ideas always favour competition and the establishment of free markets; they argue that when the assumptions as stated above are too severely violated, it might actually not be a good idea.

The normative use is relevant for the design of markets. As argued above in reference to the markets versus states debate, in the ‘market extreme’ it is not the case that there is no role for the state, if only because of the minimal reason that property rights need to be ensured. In a broader sense, Karl Polanyi and Gøsta Esping-Anderson, among others, convincingly argue that well-functioning markets do not just spontaneously come into being – they are planned and organised. For a market to be efficient and as welfare-enhancing as possible, one can once again take the checklist of assumptions to improve them. If the use of markets has been deemed useful and beneficial, government intervention might be directed towards fulfilling the assumptions as much as possible. So, even if the original market does not meet such assumptions, government intervention might correct this.

Such ideas are of course not new. Indeed, a growing and almost infinite amount of government interventions have already been used to do exactly this: responding to the neoclassical economics assumptions, such that individuals can make informed (‘rational’) choices that would actually improve their welfare. As regards foodstuffs, which seems a very ‘free’ market, strict regulations enforce suppliers and producers to state the necessary information about the contents in an understandable way on labels and by requiring a ‘use before date’. As regards pensions, governments have recognised that making informed choices is only reserved for a few individuals since information is lacking or too complex to process, which is part of the reason why universal minimum pension schemes are prevalent in many European countries. As regards national defence, which comprises a public good, government financing is used.

One may even turn this argument around: as regards the 2008 financial crisis, one can argue that it was because the government did not ensure that these assumptions were satisfied enough that it could be as severe as it was. Actors on financial markets could not make informed choices because they did not know the underlying product they were buying or trading in well enough. Traders were allowed to maximise their utility (with short-term trading profits) by putting excessive risks on others (hence creating negative externalities and decreasing these others’ utility). Households were lured into mortgage contracts that were too complex for many of them to understand, and that, with hindsight, were quite clearly not in their best interest.

Public and academic discussion should therefore not be focused on whether the assumptions are perfectly satisfied, because we already know they are not, but on whether they are or can be satisfied enough to preclude public production, and on how government intervention can be used to satisfy them even more. So-called neoclassical ideas about economics have therefore not played their role just yet. They remain crucially important for the design of markets, and, if anything, the recent crises emphasised this once more.

This was posted earlier here.

2 comments on “To the Defence of the Practical Use of Neoclassical Economics

  1. […] ‘market versus the government’ perspective and argues that one is better than the other. As argued before, such framing is pointless. States cannot sustainably increase living standards without markets […]

  2. […] The discussion seems settled. Only a very myopic mind would still claim that a fully socialist state would result in a somehow desirable society. Even self-proclaimed socialist parties aren’t really that socialist anymore. They take the market mechanism as their foundation – they only see a bigger role for the government in curbing its demerits. Not one single significant political party would still want to dismantle the markets as we know them today. The time of central planning has gone. […]

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