Blog-Reference
Most non-economists are not fully aware that economists do not understand how the market economy works. The designation economist includes here all economists and in particular the adherents to the Walrasian, the Keynesian, the Marxian, and the Austrian approach as well as the Pluralists. This embarrassment is due to the scientific incompetence of the representative economist who stands henceforth for the personified synthesis of the familiar sects.
Most non-economists tend to think that economists know exactly what they are talking about when they use economic terms like income, profit, capital, market equilibrium, GDP, and so on. This is not the case. As the Palgrave Dictionary summarizes with regard to profit “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10)
What follows from the well-documented fact that the representative economist has no idea of what profit is? Quite simply, if the core concept of profit is false then the whole economic theory/model is false. Every non-economist can check it out for himself that neither the Walrasian, Keynesian, Marxian, nor Austrian sect understands what profit is. There is no need at all to study the whole corpus of an approach in detail. If profit is ill-defined the whole theoretical superstructure falls apart. It is as simple as that. Profit is the key to all of economics.
For more than 200 years the representative economist has achieved nothing of real scientific value. Of course, this failure has often been noticed: “Thousands upon thousands of scholars, as well as thousands of statesmen and men of affairs, have contributed their efforts to the attempt to understand the course of events of the economic world. And today this field of investigation is being cultivated more extensively, than ever before. How is it, then, that in all these years, and with all the undoubted talent that has been lavished upon it, the subject of economics has advanced so little?” (Schoeffler, 1955, p. 2)
The answer is that the representative economist does not understand the pivotal phenomenon of his subject matter. Note well that this has nothing to do with political differences. Both, the defenders of capitalism and the followers of Marx have no idea of what profit is. Thus, neither the capitalist nor the communist economic system (nor their countless variants and combinations) has a sound theoretical foundation. What economists have produced so far are elaborate social belief systems but nothing of any scientific value. Economics looks like science but is storytelling on a level with myth or religion. Economic policy advice or institution-building never had a sound theoretical foundation.
“In order to tell the politicians and practitioners something about causes and best means, the economist needs the true theory or else he has not much more to offer than educated common sense or his personal opinion.” (Stigum, 1991, p. 30)
Economists have as many opinions as non-economists but no true theory. Because of this, one always has to bear in mind the crucial distinction between political economics and theoretical economics. The main differences are: (i) The goal of political economics is to push an agenda, and the goal of theoretical economics is to explain how the actual economy works. (ii) In political economics anything goes; in theoretical economics, scientific standards are observed.
Theoretical economics has to be judged according to the criteria true/false and nothing else. The history of political economics since Adam Smith can be summarized as a perpetual violation of well-defined scientific standards. Economics as it actually presents itself to the general public is essentially political economics, which is synonymous with being scientifically worthless. This verdict applies to Walrasian, Keynesian, Marxian, and Austrian economics. Policy proposals of all these sects have no sound theoretical foundation because theoretical economics in the strict sense is virtually non-existent. Seen from the genuine sciences economics is a proto-science or what Feynman called a cargo cult science.
Has the non-economist any chance to understand what economists do not understand? Yes, of course. All that is needed is one iota of scientific instinct. As we know by now, the representative economist lacks this essential mental catalyst.
We take the simplest of all cases as the point of departure. The most elementary economic configuration is the pure production-consumption economy. It is defined for one period by three rather straightforward equations. Note well that no green cheese assumption like constrained optimization or equilibrium is put into the premises.
(A1) Yw=WL wage income Yw is equal to wage rate W times working hours L, (A2) O=RL output O is equal to productivity R times working hours L, (A3) C=PX consumption expenditure C is equal to price P times quantity bought/sold X. For the graphical representation see Wikimedia AXEC31
At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of budget balancing, i.e. C=Yw, and market clearing, i.e. X=O. Note that the ray in the southeastern quadrant is not a linear production function; the ray tracks any underlying production function. Note also that the wage rate W is an average if the individual wage rates are different among the employees, which is normally the case.
Under the conditions of market clearing and budget-balancing in each period, the price is given by P=W/R, i.e. the market-clearing price is always equal to unit wage costs.
If the wage rate W is lowered, the market-clearing price P falls. If the number of working hours L is increased the price remains constant, provided productivity R does not change. If productivity decreases the price P rises. If productivity increases the price falls. In any case, labor gets the whole product, the real wage W/P is invariably equal to the productivity R, and profit for the business sector as a whole is zero. All changes in the system are reflected by the market-clearing price.
We know, of course, that the firm sets a price that is different from the market-clearing price. This case has to be treated separately on another occasion.
In the next period, the households save. The result is shown on Wikimedia AXEC33
Consumption expenditure C falls below Yw and with it the market-clearing price P. With perfect price flexibility, there are no unsold quantities and no change of inventory. The product market is always cleared and there is no such thing as an inventory investment. So we have household sector saving but no business sector investment, that is, monetary saving which is given by Sm≡Yw−C is not equal to investment.#1
The crucial conclusion is that the business sector makes a monetary loss that is exactly equal to the household sector’s saving, i.e. Qm≡−Sm. Therefore, loss is the exact counterpart of saving; by consequence, profit is the exact counterpart of dissaving, that is, of the growth of the household sector’s debt. This is the most elementary form of the macroeconomic Profit Law. It follows directly from the profit definition Qm≡C−Yw and the definition of household sector saving Sm≡Yw−C. The sector balances always add up to zero, i.e. Qm+Sm=0.
Note well that profit for the economy as a whole has nothing at all to do with productivity or the wage rate. And this is why all stories that economists tell about the functioning of the market system and the price mechanism are false (2014). For an individual firm, there is indeed a relationship between productivity or wage rate and profit. But this relationship cannot be generalized to the economy as a whole. This logical mistake is known since antiquity as the Fallacy of Composition. This methodological blunder is the defining characteristic of microeconomics, so much so that the representative economist could well be characterized as a Fallacy of Composition on two legs.
The Profit Law for the investment economy reads Qm≡Yd+I−Sm (2014, eq. (18)). Legend: Qm monetary profit, Yd distributed profit, Sm monetary saving, I investment expenditure.
The Profit Law gets a bit more complex when foreign trade and government are included.
The Profit Law contains nothing but measurable variables, which means that its empirical fit can be readily established. This ultimately leads from the worthless political economics and the silly model bricolage of the representative economist to economics as a science.
The most valuable contribution to science the non-economist can actually make is to bring in his circle of influence an end to the incompetent waffling of Walrasians, Keynesians, Marxians, and Austrians. Peer-reviewed journal articles, standard textbooks, debates between the sects, and Dani Rodrik’s recent junk recycling are wasteful in all material and intellectual dimensions. To expect New Economic Thinking from people who have demonstrated over two centuries that they can not think is futile.
Egmont Kakarot-Handtke
References
Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, 1–11. Palgrave Macmillan, 2nd edition. URL
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Schoeffler, S. (1955). The Failures of Economics: A Diagnostic Study. Cambridge: Harvard University Press.
Stigum, B. P. (1991). Toward a Formal Science of Economics: The Axiomatic Method in Economics and Econometrics. Cambridge: MIT Press.
#1 For details of the I=S blunder see cross-references Refutation of I=S
Related 'How economists became the scientific laughing stock' and 'Scientific Cavemen with a daunting message' and 'The ur-blunder of economics and its rectification' and 'Profit and the collective failure of economists' and 'Free academia from economics' and 'First Lecture in New Economic Thinking' and 'The Profit Theory is False Since Adam Smith. What About the True Distribution Theory?' and 'Essentials of Constructive Heterodoxy: Profit' and 'Your economics is refuted on all counts: here is the real thing'.
A PDF version of this post is available on EconoPhysics posted on 17 Dec 2015 and on SSRN posted 20 Dec 2015