Economics and the Real World

Of all the social or human sciences economics might claim to be the one most immediately concerned with the actual condition and life of mankind. Although many might think that anthropology or sociology are irrelevant to their lives or interests, and that political science is only of indirect importance to them, probably few would think the same about economics. Every day we must eat and otherwise consume, most of us have jobs, and participate in other kinds of economic activity regularly. Thus would not economics be the social science most adapted to actual life in the real world?One would hope that this might be the case, but here I want to examine some of the statements made by Paul Samuelson in his text Microeconomics, which seem to me to put the lie to the claim that mainstream neoclassical economics is actually engaged with the real world. Rather, it inhabits a fantasy world, a world of graphs and equations, with slight attachment to the way things really work. And I propose to do so using the statements of Samuelson and his associates, letting them be witnesses against themselves, as it were.[note]References are to Paul Samuelson and William Nordhaus, Microeconomics, 17th ed, 2001, and Laurence Miners and Kathryn Nantz, Study Guide for Use with Microeconomics, 2001.[/note] Paul Samuelson's economic textbooks, which have been in continual use since the late 1940s, are probably the most-used economics texts throughout the world. They have been translated into many languages and probably represent the consensus of the neoclassical outlook in economic thinking.In the first place, to grasp the conception of economics that Samuelson and the vast majority of professional economists champion, we must recognize that they want to make economic behavior as much like the behavior of physical objects as possible. Just as you can drop a stone of a certain weight from a certain height and measure how fast it falls, how big an impact it makes on what it hits, etc., and create graphs and equations based on this behavior, so these economists want to make the economic behavior of human beings as much like stones as possible. Are these economists successful in this? Let us look at some examples.The fundamental principle of market behavior, according to mainstream economists, is to maximize our economic satisfaction or utility, in fact, to buy cheap and to sell dear, as Adam Smith expressed it. Now while I certainly do not deny that in general there is such a desire on the part of human beings, it does not follow either that this desire is always the strongest influence on human behavior or that other forces, e.g., economic power or cultural and legal norms, do not significantly modify how this works out in the actuality. But let us now look at some statements made by our texts.In explaining market behavior Samuelson gives pride of place (chapter eight) to an explanation of perfectly competitive markets.He defines this type of market in these words. "Perfect competition is the world of price-takers. A perfectly competitive firm sells a homogeneous product (one identical to the product sold by others in industry). It is so small relative to its market that it cannot affect the market price; it simply takes the price as given".[note]Ibid., 148.[/note]A common example of this type of producer (firm) is a small farmer who grows a crop, say tomatoes, essentially identical with the crop of other tomato farmers. Each individual small tomato farmer must simply accept the going price. There is nothing he can do to change that price as long as his output remains small and his product undifferentiated from that of other tomato-growers. The problem arises because Samuelson and his school consider this type of competition as the norm, ignoring the fact that even in a market dominated by such small producers, other factors may make the market far from perfectly competitive in the sense that Samuelson indicates. For example buyers of farm products, or shippers or processors may control the market in such a fashion that market forces are distorted in ways that Samuelson does not readily recognize.But there is another and much more important criticism of making perfect competition the paradigm of economic behavior. This is that even by the standards of neoclassical economic analysis, perfect competition is rare. At the beginning of the next chapter, chapter 9, Samuelson says: "Perfectly competitive markets are the ideal in today's economy. In fact, while often looked for, they are seldom found".[note]Ibid., 166.[/note] In other words, the sort of market condition that is presupposed, explicitly or implicitly, by the neoclassical model hardly exists. Instead there are markets dominated in one way or another by large firms, firms moreover that use their economic power to affect prices for both consumers and suppliers, market share, the price of labor, and so on.Now it is true that economists have come to recognize the existence of imperfectly competitive markets. My complaint is that, even while they do so, the model of perfect competition is the paradigm, the "ideal" as Samuelson terms it, always lurking at the back of the whole myth of the market, the myth that the individual's desire to maximize his economic gain is the means by which the various measures in the economy, such as prices, wages, etc., are set, and which, moreover, produces the maximum benefit to society as a whole. On the other hand, were imperfect competition recognized as the norm, and were factors such as power and legal or cultural norms recognized as prime determinants of economic outcomes, then the utility of the neoclassical graphs and equations would be severely compromised--indeed the whole market myth would be called into question.Let us examine another of Samuelson's economic relations. The concept of the marginal, or the additional unit produced, sold or consumed, is of great importance in neoclassical economic doctrine. Marginal cost (MC), for example, "denotes the extra or additional cost of producing 1 extra unit of output." This, he says, "is one of the most important concepts in all of economics" (p. 126). Rational firms, that is, the kind of economic actors that the graphs and equations so beloved by Samuelson and so many other economists presuppose, always seek to equate their marginal cost with their marginal revenue (MR), "the change in revenue that is generated by an additional unit of sales".[note]Ibid., 175.[/note] Samuelson includes a great many charts and graphs illustrating this wonderful discovery.  But let us bump up against the real world. On page 192 he blithely admits that most firms do not even bother to set their production by the MC=MR rule. "For example, it is common practice for companies—especially ones in imperfectly competitive markets—to set prices on a 'cost-plus-markup' basis.... Instead of setting prices by an MR and MC comparison, companies take the calculated average cost of a product and mark it up by adding a fixed percentage..." So it turns out that "one of the most important concepts in all of economics" has hardly any application in the real world, which is characterized largely by imperfectly competitive firms largely ignoring MC, as Samuelson admits. So if this is so, why go to great lengths to discuss concepts and formulas which have mostly no application to reality? Such graphs and formulas do have a purpose, however. That purpose is to fix in the minds of students the myth of the self-regulating market, so that however much they may admit that the ideal world of rational actors in perfectly competitive markets, carefully calculating their marginal costs and revenue, does not exist, still they will conduct their analyses and deliver their policy advice with such a model always subconsciously lurking at the back of their minds.I mentioned that Samuelson and his school assume that individuals and firms are rational economic actors. That is, everyone is out to maximize profit, minimize expenses, and seeks after these ends in a rational and consistent manner. Without such an assumption the ideal world of neoclassical graphs and equations would vanish. But is this the real world? In the Study Guide that accompanies Samuelson's text, the authors make an interesting admission:

In this discussion, we assume that the firm's objective is to maximize profits. Note that there are other perfectly reasonable objectives that firms might have. For example, many not-for-profit organizations, such as hospitals, churches, and even many universities, exist in a market economy; the goals of these firms might be to serve the community or provide for social welfare. In other cases, firms aggressively market their products and try endlessly to increase sales and market share, seeming to maximize revenues or production rather than profits. In some cases, CEOs of companies seem to be interested in maximizing their own salaries rather than the profitability of the enterprises that employ them.[note]Ibid., 105.[/note]

One wonders how many for-profit firms actually do try to maximize profits. Either because of ignorance, carelessness, difficulty of calculation, or other goals—such as maximizing CEO compensation or sometimes pride of workmanship—even occasionally because of good will toward employees and customers, perhaps a sizeable number of firms do not try to maximize profits, at least not in a sustained and careful way. Would not economic analysis better describe the actual workings of the economy if it discussed all this first and at greater length instead of adding it as a kind of afterthought? Moreover, if our culture and laws did not encourage maximization of profits as the only rational purpose of a firm, then perhaps even fewer firms would aim at this goal.Economists such as Samuelson seem to want to make their subject as much like physics as they can, but in dealing with a real world of men and power, they would do better, I think, in looking at the many different ways in which people relate to each other and use their power, and even sometimes their good will, toward each other. The economy is not a self-regulating mechanism whose operations can be neatly captured by graphs and equations. Human motivations are many and vary widely between different times and places. Market forces, such as the desire to buy cheap and sell dear, certainly exist, but they never operate in a vacuum. They are determined and shaped by many forces, especially their cultural context and by the legal system, whose sanctions have immense influence on economic behavior. For example, the limited liability conferred on corporations is a creation of civil law, and could be changed at any time. If corporate directors, still more shareholders, were made potentially criminally liable for misbehavior on the part of corporations, think how much this would change the actions of corporations. In addition, raw power, exercised either directly via economic means, or indirectly via politics, greatly shapes economic outcomes, for example, as corporations strive to control legislative and regulatory bodies on behalf of their interests and profits.I anticipate that some might object that the texts I am dealing with here are meant for beginners, often college freshmen. As students progress in the study of economics their concepts and analytic tools become more complex and sophisticated. This is all true, but not of great importance. For, as I said above, by treating perfect competition and rational economic actors as the "ideal," everything else is rendered an exception, an afterthought, something to be explained with constant reference to an economic world that does not exist. Moreover, why would beginners in any subject be taught a paradigm that does not exist? If the real world of economic behavior is complex and is always influenced by non-economic factors, why not make that clear to students at the outset? The grasp of the simplistic formulas of neoclassical economics will do little to help students sort out and make sense of the actual economic behavior of real people. Rather it will make them more likely to attempt to fit their understanding of actual economic behavior into the neat formulas, graphs and equations taught to the neophyte. There will always be a bias in the mind of the economist toward attempting to understand economic behavior according to an ideal that does not exist.The attempt on the part of economists to emulate the physical sciences has not helped us in our understanding of how economies actually work. But it has done considerable damage by helping to spread the notion that economic outcomes are in great measure determined by impersonal market forces, beyond the ability of man to shape or change. For example, the steady increase in the amount of wealth and income obtained by the richest in the United States since about 1980 is hardly an accident or the result of impersonal and competitive economic forces. It could more accurately be called a conspiracy, although a conspiracy largely conducted in public view. The changes in law or regulations regarding taxation, labor unions, investments, the environment, and many other social and economic matters have together created a situation in which income and wealth have flowed to the richest, while the wages of everyone else have mostly remained flat or even declined. But mainstream economics tends to explain this in impersonal terms, rather than as an outcome of the use of political, economic and media power. If economics is to be of benefit to the human race, instead of serving mostly as a rationalization of capitalist wealth and power, it must take account of the actualities of economic life. Economic activity does not exist in a vacuum, a vacuum in which detached rational actors interact among themselves with little reference to the rest of human affairs. Only economic schools which actually look at the totality of human social life and seek to account for all their multiple and interrelated causes and effects have a right to consider themselves as engaged with the real economy. Thus we would do well to look at such schools as the original Institutionalists or the German Historical School, both of which have important insights to offer in this regard. I am not claiming that either of these has the last word, but their insights and findings can hardly be ignored by anyone who wants economic analysis to correspond to what goes on in the actual economy of real people. And this, after all, is what economists claim to be concerned with.