Naive Experts: Economists and the Real World

by John Médaille on July 27, 2010 · 19 comments <span>Print this article</span> Print this article

in Economics & Empire,Politics & Power

how markets work

A review of Robert E. Prasch, How Markets Work: Supply, Demand, and the ‘Real World’ (Edward Elgar: Northhampton, MA, 2009).

It is considered something of a rude question, nevertheless I think it fair to ask why 90% of all economists missed the coming of the current disaster. One doesn’t wish to judge too harshly. After all, everyone makes mistakes, even scientists. And if economic science missed this one, it wouldn’t be fair to use such a mistake to call into question the whole science. None of us would wish to be judged by one mistake. Should we not extend the same courtesy to economic scientists?

The problem, however, is that the same 90% of all economists also missed the last crises, and the one before that as well, and before that, and so on. In fact, their record of being able to diagnose and treat economic problems is about zero. And their prescriptions always seem to be counterproductive: the recommendations to limit government always make it grow, their advice on limiting taxation always makes it more, their prescriptions on growing the economy only leads to the illusory growth of bubbles, etc. Put it this way: If your doctor had this same track record of diagnosing and treating disease, you’d be dead by now.

Obviously, there is some deep problem at the heart of economic science which prevents it from being a useful analytic or prescriptive tool. Let me suggest that the problem lies in the very name of that discipline, which is a new name, only about 100 years old. The study of economic systems is as old as Aristotle, but this study was always considered to be a branch of ethics, and the proper functioning of any economic system was believed to be dependent upon proper ethical arrangements. Adam Smith, for example, was himself a professor of Moral Theology. Through most of the 19th century, the science was known as political economy. As the name implies, an economic system was always viewed as something embedded within—and dependent upon—particular political and social institutions, and could not be studied apart from them. Further, political systems cannot be viewed apart from ethics. It was this connection with ethics that made the new “economists” uneasy. As one wag put it, they suffered from “physics envy,” and wanted to divorce their “science” from any moral considerations, making it solely a matter of pure calculation (as with the neoclassicals) or of pure deduction (the Austrians.) By the start of the 20th century, the term political economy disappeared from common usage and was replaced by the new “science” of economics, a “science” divorced from the moral world.

However, the elimination of ethics could only be accomplished by a ruthless reductionism: man was reduced to an “economic calculator” capable of acting only in self-interest, while all markets were reduced to a single model of supply and demand curves with a single, well-defined equilibrium points. The new homo oeconomicus was conceived as a pure individual with no natural ties and was no more than a collection of unfulfilled desires, always waiting for the entrepreneur to fill them up, while creating new wants. Thus, it is an economics designed for an alien race, built on markets of a single type. But are all men like this new creation, and are all markets like the one they modeled? In other words, does current economic theory bear any relationship to the real world?

These questions are at the heart of Robert Prasch’s book, How Markets Work: Supply, Demand, and the ‘Real World’. This book is comprised of nine brief lectures that challenge the market fundamentalism which has come to dominate the economics profession, whether of the Austrian or more mainstream neoclassical economists. Dr. Prasch first deals with property, contract law, and a theory of exchange, which is the proper place to begin any study of the markets. He concludes that, “[T]he social institution that we term ‘the market’ is a complex construction, based on an evolving system of rights, property law, and contract law,” all of which depend on the political and social environment. Hence,

[T]he social scientific and policy question is not whether the law or the state is involved in the market. Rather the correct question is just how it should be involved, and what laws and regulations make the most sense. In short, “regulation” is not necessarily in conflict with “the market.” On the contrary, the social arrangement that is conventionally called a “free market” has been built upon a long and evolving tradition of legally framed rights, distinctions, and prohibitions that is continually interacting with an equally long history of evolving ideas, legislation, and court rulings on property and contract law (27).

Prasch next turns his attention to commodity markets, which form the model for standard economic theory. The problem with this theory is not that it doesn’t work, but that it does work, and works rather well, but only for certain kinds of commodities under certain conditions. This model works for non-status, man-made, reproducible, highly elastic commodities for which many substitutes and complete information is available and which are supplied by a vast number of firms such that no firm has any pricing power; they are all price-takers rather than price-makers. Such “spot markets” can easily be modeled on relatively simple supply and demand curves with a single equilibrium point. This is the “self-correcting” market model which requires little government regulation.

Nearly everyone is familiar with the operation of markets of this type because it is the market model deployed in arguments about government regulation of credit and asset markets, labor markets, environmental and safety standards, etc. But these other markets do not look at all like the simplified commodity market model. They have completely different supply and demand curves. At this point, economics and reality go their separate ways. Prasch takes us on a journey through markets which have completely different characteristics, specifically credit, asset, and labor markets. These markets have complex supply and demand curves which are completely different from simple commodity markets.

Credit market, for example, exhibit “backward-bending” supply curves. As interest rates rise, the quality of borrowers falls, and banks are less willing to provide the loans. The good borrowers get out of the market when the rates rise; they defer their plans or seek other sources of credit. So as demand rises, the interest rate rises, but so do the risks. As Adam Smith noted, with high rates, “the greater part of the money…would be lent to prodigals and projectors, who alone would be willing to give this high interest.”

Asset markets are peculiar in that while a commodity price is based on the “history” of a product, an asset price is based on its future. That is, the price of a commodity must in general recover the costs of that commodity, or it will cease to be produced. But costs have little to do with asset prices; they are based solely on the expected revenue stream of the equity. But a history can be known, the future cannot; it can only be discovered. These markets are highly emotional and are subject to all sorts of information asymmetries (where one party knows more about the asset than the other), speculation, arbitrage, uncertainty, etc. There is simply no simple model of their behavior.
Prasch’s most interesting work concerns labor markets, and here he parts company with the standard theory in the most radical way. The standard theory treats labor as just another commodity with a “normal” supply and demand curve. Looked at in this way, all government interference in such a market, such as minimum wage laws, would be counterproductive. But labor is not a commodity manufactured for the market. Labor, of course, is human beings, and since most people must live from their labor, they cannot substitute some other “commodity”; this is a market which is driven by necessity rather than choice.

Standard theory contrasts “work” with “leisure,” and all that is not (paid) work is leisure. But it is a travesty of language to say that people living on the streets are enjoying leisure. Further, much of the time spent apart from paid work is given to other kinds of work, such as that necessary to maintain a family and a household. Leisure, properly considered, is a joint product of free time and purchasing power, and only those with sufficient purchasing power can “substitute” leisure for work. Therefore paid work is balanced against leisure and other forms of work. This gives the supply curve for labor a serpentine form with four equilibrium points, two of which are stable and two unstable. The stable points occur near subsistence,where people must give more hours just to live or to maintain an acceptable lifestyle, and at a higher point where work may be freely traded for leisure. The result is a dual labor market, one which is low wage-high hours, and the other high wage-low hours.

Although standard theory denies the possibility of multiple equilibrium points in one market, Prasch’s description matches more closely the labor markets we actually see in the real world. The problem with the standard theory is that it doesn’t account for the dual market (“work” and “leisure”) represented as one supply curve. In such a case, a supply curve can be serpentine with multiple equilibria.

Is the existence of a low-wage equilibrium point a problem? Yes, and for several reasons. The first is that people who must work at low wages can only get out of poverty by giving more hours to work. But as they give more hours, thereby increasing the supply, they further lower the wage. Thus low wages lead to even lower wages if a significant number of people try to escape from poverty. This is called a “poverty trap,” where any attempt by a group to escape poverty leads to more poverty. But this is just the beginning of the problems. The next difficulty is that low wage workers have less time to devote to family work, to the serious job of raising families and maintaining homes. Thus family structures are weakened, often fatally. But the whole point of a sane economy is to strengthen the family and provide the material basis for the stable family structures upon which any stable society must rest.

We can expand on Prasch’s analysis by pointing out that as bad as the low-wage market is for workers and their families, it also posses a dilemma to investors. The entrepreneur may believe that he is being clever by depressing wages and increasing profits. However, the wage bill for one firm is also the primary component of the demand curve for every other firm. By depressing wages, the entrepreneur lowers demand in every other sector. If this is widespread (e.g., when there is a lot of outsourcing) consumer markets are under-supplied with purchasing power, while capital markets are over-supplied. The entrepreneur makes more money, but he finds there is less opportunity to invest it, because the very success of his strategy has narrowed demand. Since the productive economy offers less opportunity for the excess capital, the investor turns to purely speculative gambling instruments such as the synthetic CDOs and CDSs with which we have become all too familiar.

Understanding the labor market leads to better policies. For example, a minimum wage set below the low-wage equilibrium point will have little effect on the market, but one set above it will tend to drive the market towards the higher equilibrium point. Workers with some excess over their perceived needs will be freer to enter the “leisure” market and thus give more time to family work and actual leisure.

Prasch also analyzes the social effects of markets. Standard theory proposes that the market by itself, and without the aid of government rules, is capable of solving social problems such as discrimination. Prasch shows why this is naïve, and why such problems can persist no matter how free the market.

These nine lectures are easy to read yet not lacking in sophisticated analysis. Both the amateur who wants an introduction to the laws of supply and demand and the economist looking for better analytic tools will find this text useful. But most importantly, Prasch provides a technical analysis of ethical issues in economics. Too often, those who wish to re-establish the ethical pole of the debate cannot do so in technical terms. Thus their arguments come off as mere bromides or preaching and fail to persuade the economist. It is not enough to merely insist on a connection between ethics and economics; one must demonstrate the connection at a technical level, or the two sides will simply be talking past each other.

It should be clear by now why economists have failed, by and large, to anticipate the recurring disasters or to proscribe effective remedies. You cannot predict the course of a system if you cannot accurately describe it, and the simple models simply fail to account for the realities. Unless and until economists get better models, they will continue to be naïve experts, skilled at discussing highly artificial systems that have little real world applications.

{ 19 comments… read them below or add one }

avatar Robb July 27, 2010 at 10:40 am

Dr Médaille – You have just added to my summer reading list. Thanks for this review. Your quote about the problem with low wage equilibrium points clarified something I had been wondering about: what drives the search for ever emerging (and arguably riskier) investment instruments. You wrote:

“The entrepreneur makes more money, but he finds there is less opportunity to invest it, because the very success of his strategy has narrowed demand. Since the productive economy offers less opportunity for the excess capital, the investor turns to purely speculative gambling instruments such as the synthetic CDOs and CDSs with which we have become all too familiar.”

One question: Do you REALLY expect that economists will ever “get better models” given the number of markets, actors, and political realities that make up the global (or even a local) economy?

Thanks again. Very useful… Still looking forward to your review of James Davison Hunter’s “To Change the World”.

avatar Bruce Smith July 27, 2010 at 3:27 pm

Should it surprise us that brutal and short-sighted alpha ape acquisitiveness attempts to justify itself with ethics free Neo-classical economic theory? As Phillip Blond and Patrick Deneen have shown us the same attempt is made in political theory with Libertarianism. In both justifications the attempt is made to argue against the ethical implementation of collective association involving capital for the majority of the population. Egoistic individualism must rule the day.

avatar Valerie Shepard July 28, 2010 at 3:02 am

Umair Haque’s recent blog post touches on some of the same themes:

http://blogs.hbr.org/haque/2010/07/a_deeper_kind_of_joblessness.html

And it was published at the Harvard Business Review!

avatar D.W. Sabin July 28, 2010 at 9:06 am

But wait, the Government trotted the term “moral hazard ” out for a brisk spin while it orchestrated the public bail out of some firms and pressured other private firms to make “too big to fail” firms into “bigger too big to fail” firms because it did not want to “hurt the little guy”.

For a few weeks in September of 08, The Fed and Treasury were a chop shop, helping the still wobbling Financial firms in the stripping of dented Mercedes and Ferraris of the sub-prime fiasco and overseeing their re-emergence as part of the fleets of those left standing…or wobbling…. bigger and no less failure prone given the rot afoot.All, of course, to “help the little guy”.

Meanwhile, the Government and Business fail to recognize that one can just change a single word in the phrase “too big to fail” in order to arrive at the truth of our moment in time:

“Too Big to Succeed”. Bureaucracy and its conventional pieties has infected Business and Government with a fatal dose of consumption and “fresh air” is the last thing you’ll see emanating from the corridors of Big International.

avatar John Médaille July 29, 2010 at 9:33 am

Robb, it’s “Mr.,” not “Dr.” I am but a simple master the theological arts. There is no reason that social scientists can’t have better models; they just aren’t purely mathematical models. They involve a high degree of judgment. In fact, they are more similar to narratives rather than models.

Bruce, “individualism” was the old liberalism but is now the new “conservatism.” This means that the purpose of modern conservatism is to regulate the rate of surrender to liberalism.

Valerie, the failures of economics are being evident; the solutions are not.

DW, spot on. Since helping out the “little guy” by giving money to the big guy, the little has become smaller and the big bigger. Quelle Surprise! There are at least a few economists of my acquaintance who would have reversed the procedure.

avatar Bruce Smith July 29, 2010 at 4:56 pm

Meanwhile contrary to the United States the epiphany for some conservatives continues on the other side of the pond :-

http://www.opendemocracy.net/ourkingdom/jonathan-rosenberg/if-thou-wouldst-what-true-freedom-is-thou-shalt-see-it-lies-in-take-bi

avatar John Ryan July 31, 2010 at 10:21 pm

I seriously have to read this before the semester starts and I am drowning in Early Political Theory. It is refreshing to know that a Social Democrat (such as myself) has a lot in common with Conservatives, when it comes to the economy. Nobody outside the Front Porch Republic seems to realise it, but American conservatives are in the liberal tradition. The merely slap conservative notions about sex onto their classical liberal beliefs.

And, this article makes me feel a little safer on my plans to do a Ph.D in Political Economy.

avatar Bruce Smith August 1, 2010 at 9:50 am

Robert Heilbroner in his 1985 book “The Nature and Logic of Capitalism” describes the minority controlled, or elitist, capitalism we currently have as an exclusionary (denial of choice or undemocratic) capitalism which has the power to deny human flourishing through the denial of access to resources using such devices as leonine employment contracts where you either work, subsist or starve. Downward pressure on wages also takes place through the manipulation of externalities (for example, outsourcing of jobs to low wage and currency manipulating economies like China) cyclically resulting in lack of demand such as the current recession. The cycles occur because of the periodic fight back against this repression such as the New Deal, wars, Keynesian economic policy or the doomed to failure Greenspan and Bush “Let Them Eat Credit” policy of recent times. There is no reason why this exclusionary process cannot be permanently moderated in the interest of the common good using majority association with others at a grass roots, or civil society, level to utilize resources in private enterprises. This would produce the better type of conservatism within society.

avatar Rob G August 1, 2010 at 11:08 am

“American conservatives are in the liberal tradition. They merely slap conservative notions about sex onto their classical liberal beliefs.”

Part A of that quote is correct, with some significant qualifiers. Part B is true only of some American conservatives, certainly not all of us.

avatar Fred August 1, 2010 at 11:25 pm

As a PhD student in economics, I’m of course open to critiques and criticisms of the discipline. In fact, I believe that there are many valid ones to be made. Often, though, these critiques often reveal that their authors do not even have a vague idea of what economists believe, or what standard economics says. If Mr. Medaille has accurately represented Dr. Prasch’s arguments, that is the case here.

As my training is in labor economics, it seems most fitting to address the comments about labor supply. There are so many errors that I cannot address them in full, as this post itself constitutes procrastination from studying for my exams. Prasch doesn’t seem to even have a passing familiarity with the theoretical and empirical research in labor economics.

Medaille says “Prasch’s most interesting work concerns labor markets, and here he parts company with the standard theory in the most radical way. The standard theory treats labor as just another commodity with a “normal” supply and demand curve. Looked at in this way, all government interference in such a market, such as minimum wage laws, would be counterproductive.”

This is not true on multiple levels. It is true that the simplest possible toy model of markets will say that the minimum wage increases unemployment. It is also the case that some economists believe that the minimum wage is counterproductive under certain circumstances. But you can open up any standard graduate labor economics textbook and read reasons why the minimum wage makes sense. In fact, I just did. You can read why perfectly orthodox, neoclassical economics can justify a minimum wage here: http://bit.ly/c61Xef.

I’m not sure what is meant by a “normal supply and demand curve”, but judging from the following paragraphs, I think we are meant to understand that labor supply should be upward sloping in wages. We can deal with that after we tackle the argument about leisure.

Medaille: “Standard theory contrasts “work” with “leisure,” and all that is not (paid) work is leisure. But it is a travesty of language to say that people living on the streets are enjoying leisure. Further, much of the time spent apart from paid work is given to other kinds of work, such as that necessary to maintain a family and a household. Leisure, properly considered, is a joint product of free time and purchasing power, and only those with sufficient purchasing power can “substitute” leisure for work. Therefore paid work is balanced against leisure and other forms of work. ”

This was certainly a revolutionary idea in economic modeling… 50 years ago when it was introduced by the perfectly neoclassical University of Chicago economist Gary Becker, who talks about how what economists term “leisure” for convenience and historical reasons is actually composed of many activities. You can read his 1965 paper about time allocation here: http://bit.ly/90QspH. You can also turn to page 14 of a standard graduate labor economics textbook and read modeling “household production”, those tasks done at home to either raise additional income or are required for the maintenance of a household. Google Books won’t show you that page, but you can see it in the table of contents: http://bit.ly/9HDMDA.

Because of this mistake, Dr. Prasch makes the mistake of thinking that economists believe that an individual’s labor supply curve is upward sloping everywhere. This is, not true, of course, and you can flip to page 12 to see an example of a labor supply curve with 3 equilibria: http://bit.ly/cG1XGi.

I could go on and on, but you get the picture. The point is that reading this article (and evidently, the book it reviews) will leave you massively misinformed about what economists believe, and what standard economics says. This is unfortunate, because there are many critiques to be made of the current economic orthodoxy. Instead, Dr. Prasch goes tilting away at poorly constructed strawmen.

avatar John Médaille August 4, 2010 at 10:07 pm

Fred, I am sitting here with the popular freshman econ text, “The Economic Way of Thinking.” And yes, they present the labor market as a “normal” commodity curve. And this is typical for introductory texts. Institutionalist texts (like Hugh Stretton’s “Economics: A New Introduction”) will have a much more sophisticated view, but they are still the outliers.

No, I don’t get the picture. I think Bob’s analysis is quite correct.

avatar Fred August 5, 2010 at 3:26 am

Hi Mr. Medaille,

I’ll admit to being a bit dumbfounded. Are you claiming that a freshman survey introductory economics text for non-majors is more representative of what economists think about labor economics than a standard graduate text dedicated to labor economics?

This post is called “Naive Experts: Economists and the Real World”, not “Naive Freshman: The Perils of Simplification in Economics Education”; it begins by talking about why economics is not a useful discipline as it is, and you claim that the author offers useful innovations not incorporated into the mainstream of economics.

I have just demonstrated that nothing he (or you) calls an innovation in labor economics would be surprising or new to anyone who has studied the subject at a graduate level, and your response is to show me a freshman intro text written by someone from the Austrian school? I think you’re going to have to mount a better defense than that.

avatar John Médaille August 5, 2010 at 7:18 am

Fred, let me understand something here about your profession. What you are telling me is that students are told in the introductory texts that labor markets are standard commodity markets, and then when they go to graduate school they are told something completely different? Maybe, but I doubt it. I think economists put that in the freshman texts because that is what they believe. To conclude otherwise would be to say that they are engaged in a conspiracy to deliberately mislead their students and the public. Now, I believe many things about economists, some of them not too flattering. But I do not believe that they are intrinsically evil. But if what you are saying is true, I would have to reach a different conclusion.

And its not labor markets that do not have a standard commodity S&D curve, but credit and land markets as well.

avatar Fred August 5, 2010 at 12:24 pm

Yes, there is a fixed supply of land (so the long run demand curve is vertical), and what you call “a backwards bending supply curve in the credit market” is known in economics as “adverse selection”. Like I said, I didn’t have time go into great detail about each of these characterizations.

I think what you’re calling “evil” is really just called “simplification”, or “approximation”. It’s really not that much different from talking about Newton’s first law without mentioning that it only works in an inertial reference frame, or talking about gravity without talking about general relativity. Would you call teaching F=MA or Newtonian gravity evil?

Even though an individual’s labor supply curve is not everywhere upward sloping, what we actually measure is an aggregate labor supply curve. The aggregate supply curve is roughly upwards sloping, and this is because what constitutes subsistence or satiation varies from individual to individual, somewhat smoothing out the curve. So if we hold constant demand for labor, and increase wages, aggregate hours worked also rise. So drawing an upward sloping demand curve is a good local (near the average level or wages and hours) approximation for what we observe in the economy.

There are countless other ways of making a model of labor supply more complicated. For instance, most people don’t decide the number of hours to work: they are hired at full-time or part-time hours. This doesn’t appear in an aggregate supply/demand story of labor supply. Neither does the fact that sometimes people are fired or laid-off and must seek out new employment, or that some people are self-employed and so face uncertain “wages”, or that some people receive government assistance, changing their incentives. Neither does the fact that labor supply is not a static decision, but all future expected wages and hours, as well as wealth, determine how much a person works, or if they choose to. Notably, these things do not appear in Dr. Prasch’s model either. All models are simplifications.

There’s only so much material that can be covered in a survey of economics class, and there’s only much depth that can be attempted before students become lost. I know this painfully well, since I teach an introductory economics section. I imagine that this is true in most disciplines.

avatar John Médaille August 5, 2010 at 1:16 pm

The problem Fred is that the common presentation is not a “simplification”; it is a complete fabrication. Labor markets are nothing like commodity markets, and to present them like that causes more than confusion, it is outright deception. I would wager that most economists understand it as a commodity market with certain “distortions.” This view, totally false, distorts the public discussion.

I am pretty sure that the labor specialists have a more nuanced view, mainly because the common view is impossible to maintain in the light of the evidence. But this just points to another problem within the profession, namely that some pretty basic things have become “specialties” without actually informing either public policy or even the ordinary economist. These basic things are land, money, and labor, Karl Polanyi’s “fictitious commodities.”

avatar Fred August 7, 2010 at 7:23 pm

I think I’ve presented a persuasive case here. It’s up to you and your readers to decide what to do with it. Reading over your responses, though, I do get the impression that you have not carefully read or considered my arguments or their supporting evidence. This maybe an incorrect impression.

I’d also be interested in seeing the evidence which you believe supports the claim that aggregate labor demand is not upwards sloping in wages. There’s a long literature dedicated to measuring the aggregate labor supply curve, and I can’t think of any study that has found a downward slope.

avatar Wessexman September 17, 2010 at 7:46 am

All Fred is really showing is that neoclassical economists jump all over the place when challenged. Like evolutionists and that sort of “scientist”, and their disciples, it is hard to pin them down because they have all these “get out” clauses. But like evolutionists their main doctrines stay the same. John understands the core of neoclassical economics and there is little persuasive about Fred’s case. He is simply giving the usual smoke screen. I think Piero Sraffa knocked down aggregate supply curve decades ago.

avatar Stephen September 6, 2011 at 9:59 am

Asset prices driven by “highly emotional” “speculation”—Low wages starting a downward wage spiral—The need to boost wages and reverse the cycle by minimum wage laws (and perhaps other interventions?): This is not a bold, humane and innovative new look at economics; this is plain old Keynesianism, the sort that has been orthodox for most of the 20th century. And such also makes use of models to mathematize human behavior.

As an aside, I’m seeing an uptick in articles that blame economics for over-mathematization. People have been complaining about it for years, and they always blame the side they don’t agree with. So again, this presents nothing new to people who have perused recent economic philosophy. Readers of this article would do well to approach Dr. Prasch’s work with some healthy skepticism.

avatar John Médaille September 6, 2011 at 4:41 pm

What does “over-mathematization” mean? And how does one recognize it? Is the solution to “too much” to say “none at all”?

Every labor economist has noted the presence of a “poverty trap.” Do they just have too much math?

Is it really sufficient, intellectually, just to yell some term at an idea in order to dismiss it? The economy has been Keynesian my whole life, and it has been a fairly good life. I’m afraid you’ll have to do better than that. Prasch may be right and he may be wrong; but if he is wrong, you will have to have more to your objections than to merely label him, at least if you expect to persuade reasonable men.

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