May 4, 2015

Economics is not what most economists think it is

Comment on 'Coase and Reality’


Imagine for a moment a rather elementary economy. Total employment is L and there are two firms. The wage rate W is equal and fix. So total income Y=W(L1+L2) is fix. The household sector spends this total income, hence total consumption expenditures C are equal to Y and fix. No saving/dissaving. The productivities R1, R2 are fix in both firms. Under the condition of zero profit the respective market clearing prices are equal to unit wage costs, i.e., P1=W/R1 and P2=W/R2. Labor can be shifted between the two firms at short notice, so the only question that is open from the viewpoint of the business sector is how will the households split consumption expenditures C between the two goods? As soon as the firms know this they will allocate total labor input accordingly. As a result, consumers get exactly want they want, markets are cleared, all budgets are balanced, labor is fully employed and gets the whole product.

How does standard economics answer this elementary question? The partitioning of C is defined by the equality of the marginal rate of substitution MRS and the price ratio.

Seems to be a sensible answer. We have the price ratio — but how exactly do we get the MRS?

This is the moment of truth. In this way, nobody can ever answer the most elementary question of consumer theory because MRS is a nonentity.

This, though, is not the end of the story. Now phantasy gets busy. Can you imagine a set of preferences? Yes, I can, but then the MRS follows from my definition of the set. That is, I put the answer in the hat in the form of well-defined preference curves and then pull it out as MRS. Obviously, this is scientifically illegitimate. End of story. Nice try. Orthodoxy is gone.

Not yet, because now the heterodox economist steps in and tells us:
“The consumer in economics is not a life form, for life forms have to realize their needs for real and measurable benefits from consumption, rather than maximize their so-called preferences, if they to survive.” (See previous post of Larry Motuz)

Very true, nobody can say much against survival. But, wait a minute! The question was how do the households partition the total consumption expenditures C?

Heterodoxy is correct in pointing out that the introduction of preferences is a methodologically unacceptable move. But frankly, is the waffling about life form, benefits and survival one iota better?

Actually, it is worse. Because now we are entangled in a discussion about the motives of the consumers. And, clearly, this is psychology, sociology, politics, and what you have, but it is not economics. Economics is first and foremost about how the economy works* and not about how people tick.

Egmont Kakarot-Handtke

* For the correct approach see cross-references