June 10, 2016

Fatal defects of profit and market theory

Comment on Menzie Chinn on ‘Thinking about Wages, Inflation and Productivity… and Capital’s Share’

Blog-Reference and Blog-Reference

Economists are groping in the dark with regard to the two most important features of the market economy: (1) the profit mechanism, and (2), the price mechanism. The fault lies in the fact that economists argue from the micro-level upwards to the economy as a whole. And here the Fallacy of Composition regularly slips in. To get out of failed standard economic theory requires to move from microfoundations to macrofoundations. In other words, the faulty axiomatic foundations of standard economics have to be fully replaced.

In the following, a sketch of the formally and empirically correct price, employment, and profit theory is given. The most elementary version of the objective structural Employment Law is shown on Wikimedia AXEC62a

From this equation follows:
(i) An increase in the expenditure ratio ρE leads to higher employment (the letter ρ stands for ratio). An expenditure ratio ρE>1 indicates credit expansion, a ratio ρE<1 indicates credit contraction.
(ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite.
(iii) An increase in the factor cost ratio ρF≡W/PR leads to higher employment.

The complete and testable Employment Law is a bit longer and contains in addition profit distribution, public deficit spending, and import/export.

Item (i) and (ii) cover Keynes’ arguments about aggregate demand. Here, the focus is on the factor cost ratio ρF as defined in (iii). This variable embodies the price mechanism which, however, does NOT work as the representative economist hallucinates. As a matter of fact, overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R.

For the relationship between real wage, productivity, profit, and real shares see (2015, Sec. 10)

The correct macroeconomic Profit Law reads Qm≡Yd+I−Sm (2014, p. 8, eq. (18)).#1 Legend: Qm monetary profit, Yd distributed profit, Sm monetary saving, I investment expenditure

The Profit Law gets a bit longer when foreign trade and government are included. The equation says:
(iv) Strong growth = high investment I is good for the overall monetary profit of the business sector as a whole.
(v) Strong consumption expenditures = low saving Sm or even dissaving −Sm = growing consumer debt is good for profit.
(vi) By implication, high government deficit spending = growing public debt is good for profit.
(vii) Profit distribution Yd is good for profit if spent on consumption goods.

Profit and profit distribution constitute a self-reinforcing feedback loop. The same holds for profit and investment. The crucial point is that the market economy is inherently unstable.

Note that OVERALL profit and by consequence, the income distribution has NOTHING to do with productivity or low wages, or market power. These and other factors affect only the DISTRIBUTION of overall profit BETWEEN firms. What holds on the firms’ level does NOT hold for the economy as a WHOLE. Not to realize this is the fatal standard error of standard thinking about wages, distribution, inflation, productivity, and employment.

The ultimate cause of unemployment is the proven scientific incompetence of economists for more than 200 years.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL

#1 Wikimedia AXEC09 or Wikimedia AXEC08 or Wikimedia AXEC42.