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A Complement to The Economist Anti-Textbook (Hill & Myatt)

Students in search of critical approaches in economics can find in Rod Hill and Tony Myatt’s The Economics Anti-Textbook) plenty of information, references and insights about the weaknesses and failures of mainstream economics. However, we believe that if Hill and Myatt had focused more on some of the crucial assumptions of mainstream theory, their Anti-Textbook could have been more incisive and considerably shorter. It is indeed a waste of time and energy to develop theories whose foundations are nonsensical. The purpose of this “complement” is to set out these crucial points : if they are well understood, then almost all microeconomics textbooks’ developments (specially, those with maths and curves) appear immediately useless and even harmful since they divert students’ attention from the real problems in economics.

  1. The crucial points missed by the Anti-Textbook are the following : 1. In a competitive market, if ALL agents are “price takers” it is (logically) necessary that somebody – or something – sets prices and centralises agents’ demands and supplies. 2. Marginal productivity is in general equal to zero (increasing the amount of only one input does not suffice to increase the output) 3. Marginal costs are, in general, constant (goods are made of inputs in fixed proportions). 4. If there are fixed costs, “long run” equilibrium doesn’t exist. 5. Marginal productivity theory of distribution is inconsistent.

1. COMPETITIVE MARKETS : don’t forget the price setter !

The Anti-Textbook starts by giving the following “standard presentation” :

"1.1 What is a competitive market ?
There is no ‘competing’ behaviour in a competitive market – no advertising, no price-setting strategies, no rivalry. This is because all buyers and sellers are price-takers. This requires large numbers of buyers and sellers, with no one buyer or seller having a significant market share, and all firms producing an identical (or homogeneous) good or service".(p 44)

Now, if all buyers are price-takers, common sense suggests to ask : who set prices ? Asserting that there are “large numbers of buyers and sellers” does not provide an answer to this question. Unhappily, the Anti-Textbook is not aware of this problem and unconditionally accepts the “large number” explanation.
The criticisms Hill and Myatt address the perfect competition model essentially deal with its “applications” – or its “predictive power”. They write for example :

"The material summarized in the previous section is often called ‘How markets work’, the terminology of Parkin and Bade (2006) and Mankiw et al. (2006). It follows a discussion of models and methodology that emphasizes the overriding importance of predictive power, and it contains applications to a broad range of labour and product markets. The range of these applications, the position of these chapters near the front of the text, and the immediately preceding methodological discussion that plays down realism of assumptions, all suggest that the supply and demand framework is a generic tool that can be applied to all markets. Colander et al. (2006 : 72) are explicit here, saying supply and demand provides ‘a good off-the-cuff answer for any economic question’. But the supply and demand framework is actually a simplified representation of a perfectly competitive market structure, one which (according to some textbooks) is so rare as to be hardly ever found in practice".(p 53,our underlining)

According to the authors, standard textbooks “contain applications to a broad range of labour and product markets” ; “perfectly competitive market structure (sic)” can “be found in practice”, even if it is “hardly” and through a “simplified representation”. We totally disagree : in a market economy, it is impossible that all agents – whether numerous or not - are price takers, because that means that they all accept that somebody outside the economy sets prices. As this fictitious agent doesn’t exist, at least in market economies, the model cannot be “applied” to them. It is also why the “applications” given in (microeconomics) textbooks are invented by their authors. Indeed, the Anti-Textbook is aware of the “who set prices ?” problem. Ten pages later, when the authors deal with stability, they explain that the model needs somebody – the famous auctioneer – to “move” prices :

“The lack of an explanation for price movements in the demand and supply model is known as Arrow’s Paradox, after the issue raised by Kenneth Arrow (1959) : all individuals and firms are assumed to be ‘price-takers’ and to have no influence over the market price, yet somehow the market price adjusts and reaches the equilibrium value. One ‘solution’ to this conundrum is to invent an auctioneer, who is the visible, if imaginary, embodiment of the invisible hand. He has no economic involvement in the market : no mention is made of his objectives or constraints” (p 64, our underlining).

Indeed, you don’t need to be a Nobel Prize winner to understand that if all agent’s are price takers, there must be somebody (or “something”) who sets prices, even before “moving” them. Furthermore, this “person” is supposed to collect, add and compare agents’ demands and supplies to determine whether the “settled” prices are equilibrium prices or not. The Anti-Textbook invokes the legendary auctioneer as a possible “solution” to this “conundrum”. Why don’t Hill and Myatt observe from the start, when they present “competitive markets”, that there is a “conundrum” about the “person” who sets prices, collects individuals’ supplies and demands, etc. ? We don’t know. But had they done it, it would have been pointless to dedicate dozens of pages to supply and demand curves that implicitly assume that there is an auctioneer – or some kind of centralised organisation.

Questions for your professor. Please, tell me who sets prices – as you assume that all agents are price takers ? And who collects and aggregates individuals’ supplies and demands to determine if the settled prices are equilibrium prices ? and demands to determine if the settled prices are equilibrium prices ?
If a professor cannot answer these questions – and we think that he or she can’t (i.e. “the market” is not an answer) –, then students must refuse to waste their time and energy with all the demand and supply paraphernalia.

2. MARGINAL PRODUCTIVITY : don’t forget the flour !

Marginal productivity is an empty concept for an obvious reason : it is generally equal to zero [1]. If you increase the quantity of only one input, in general, you cannot produce more, unless you increase the quantity of at least one other input. The example given in the Anti-Textbook is typical [2] :

"Following the textbook tradition, let’s consider fictitious data about a firm that produces loaves of bread using ‘labour’ (workers, all identical in skills and effort) and ‘capital’ (all the things such as ovens, buildings and so on that workers use to make loaves of bread)"...."In our simple two-factor setting, this amounts to saying that capital is effectively fixed for a time, so managers have only choices about varying labour if they want to change production" (Anti-textbook p 93-94, our underlining).

We are sorry, but bread is not made of thin air. Its production needs, at least, flour. If you choose to vary labour, you have to vary the quantity of flour. If flour is included in “capital”, then you cannot produce more bread with more workers if you don’t increase “capital” (at least, it’s flour part). If you consider flour as (another) “factor of production”, then more bread requires more of this “factor”.
Unfortunately, the Anti-Textbook seems unaware of this obvious fact – so corrosive for mainstream theory. As all textbooks, it pesters its readers with a nonsensical “example” of decreasing marginal productivity. However, unlike usual textbooks, it eludes the question of “factors’ substitutability” – another piece of nonsense. But, by doing so, the Anti-Textbook misses the opportunity to strike the theory with another severe blow : substitutability is (ideologically and “mathematically”) very important for neoclassical economists (e.g. point 4 about distribution theory).

Question for your professor : How is it possible to produce more output by increasing the quantity of only one input ? More bread with more work but without more flour ? Or more bread with more flour but without more work ?If a professor can’t answer – and he or she can’t – then refuse all the partial derivatives and marginal rates of substitution paraphernalia.

3. MARGINAL COST : don’t forget product composition !

As usual textbooks, the Anti-Textbook gives a particular importance to the cost function – that is, a partial equilibrium approach. The reader is, again, pestered with a lot of U-curves : average and marginal costs, on the “short run” and the “long run”. And, again, he is wasting his time : in reality, goods are compounded by well defined proportions of inputs, and are produced by well defined proportions of labour and machines. Thus, their marginal cost is constant.
Unhappily, the anti-textbook starts by accepting the mainstream assumption of increasing marginal costs. It is only after a long and boring discussion with all kind of U shaped curves that the Anti-textbook invokes “evidences” coming from “empirical studies” (e.g. Mansfield or Blinder) to raise doubts about the adequacy of these curves’ form :

“an interesting conclusion of the empirical studies is that marginal cost in the short run tends to be constant in the relevant output range … The short-run and the long-run U shaped average costs curves that inhabit the pages of the textbooks and which pose as typical cost curves are bogus constructions that owe their place to the desire to construct and justify a theory of perfect competition. They are not based on empirical evidence about actual costs” (p 105).

Yet, common sense sufficed to understand that U-shaped costs curves are “bogus constructions”. Here again, the Anti-Textbook could have spared students’ time and energy by telling them from the start that the only “realistic” possibility is a “flat” (horizontal) marginal cost curve and a decreasing “hyperbolic” average cost curve (as there are fixed costs). Thus, the mainstream “result” according to which “marginal cost = price”, is not valid. Otherwise, firms could not amortize fixed costs where as the most casual observation of economic activity confirms how fixed costs are important and cannot be abstracted from goods’ prices. Indeed, discussing U shaped curves is more than loosing time : it gives a wrong idea of price formation in market economies.

Questions for your professor. How can the production cost of an extra unit of a good can be different from the cost of the goods already produced, as they are all compounded by exactly the same inputs ? If marginal costs are constant, how does a price taking firm with fixed costs choose its plan of production ?

Textbooks don’t like constant marginal costs because they are not compatible with perfect competition. In effect, at a given price p, the profit of a firm with a marginal cost a and a fixed cost c_F is given by

pq – (aq + c_F) = (p – a)q – c_F.

If p > a, the competitive supply is (in theory) infinite. If p < a, it is nil (profit is negative). If p = a and c_F = 0, it is indeterminate (profit is nil, for all q).
Neoclassical economists try, in vain, to “solve” this problem by introducing a distinction between the “short run” and the “long run”.

4. SHORT RUN AND LONG RUN : don’t forget that fixed costs are indivisible !

In our view, an « anti-textbook » must start by recalling that a general equilibrium approach – the only “rigorous” one for a neoclassical economist – there is no distinction between “short” and “long” runs. With the assumption of a complete set of markets, agent’s make intertemporal choices. Fixed costs are thus excluded, as they imply discontinuous supply functions – which endanger the existence of an equilibrium.
If we return to the bread production example, abstracting from the flour problem, the Anti-Textbook explains that “in the short run”, capital is fixed and only work varies. Lets suppose that “capital” is reduced to the oven. We now have two possibilities : either we can produce more in the same oven or adding a “marginal” worker requires a new oven, or a bigger one. In other words, we are facing either an inefficient combination of inputs (the oven was previously “too big” for the quantity produced) or a discontinuity (since employing the “marginal worker” leads to a leap in the costs to buy the new oven). And, both cases are incompatible with the tale of the production function which combines inputs “efficiently”.
“Long run” is supposed to resolve this incompatibility problem – thanks to “free entry”. The Anti-Textbook states :

“Figure 5.6 shows the profit-maximizing output in the long run in the case of the perfectly competitive firm, which takes the market price as given. Using the usual profit-maximizing logic, the firm produces output up to the point where its long-run marginal cost equals its marginal revenue, in this case the market price. In the situation illustrated, the firm is just covering all of its costs. (Chapter 6 explains how the assumption of easy entry of firms into the industry ensures this outcome occurs in perfectly competitive industries.)” (p 99).

So does this imply that “long run” means that “the firm is just covering all of its costs” ? If so, profit is null. Any normal person should ask why firms would do this. Isn’t their purpose to earn a (strictly) positive profit. Why would they engage in a production activity if their profit is null ? Is it by masochism ? Furthermore, if we return to our bakery, is this “long run” solution even possible ? Well, it is, only if the bakery has some kind of “elastic oven” whose capacity is exactly equal to the demand at the given prices. Only then is the cost minimum.
Unhappily, the anti-textbook accepts the mainstream textbooks’ explanation of zero profit in the long run by “easy entry” – without giving details. The authors therefore miss another occasion to criticize neoclassical economics on a neuralgic point.
Suppose that there is a firm with a fixed cost c_F and an increasing variable cost function c_v(⋅). Suppose that for a (given) price p and a demand d(p), the profit of the firm is strictly positive (pd(p) > c_F + c_v(q)). The textbooks argue that there will then be “free entry” until profit disappears. That is, until the price reaches a value p^* such that

p^*d(p^*) = c_F + c_v(q^*) (zero profit),

with

n^*q^* = d(p^*) (supply = demand),

where n^* is the number of firms that “enter” (for simplicity we suppose that all firms are identical). So we deduce that :

n^*p^*q^* = cF + c_v(q^*)

and

n^* = (c_F + c_v(q^*))/ p^*q^*.

Remember that as n^* is a number of firms, it must be an integer. But the probability that the ratio (c_f + c_v(q*))/ p^*q^* is an integer is nil. It is the “integer problem”, according to Mas-Colell, Whinston and Green’s Microeconomic Theory. As a consequence, there is no (“long run”) equilibrium but, on the contrary, a totally instable system : Let n° be the integer part of (c_F + c_v(q^*))/ p^*q^* - so that

align=center>n°&nbsp;< n^* < n°&nbsp;+ 1

If n° firms “enter”, profit is still positive, and (at least) another firm will enter. But, then, the price will fall below p^* and profit will become (strictly) negative. Some firms, at least, will exit, and the price will again exceed p^*. New firms will then enter, until the price falls below p^*, etc. This entry-exit process will never “stop” at an equilibrium. We do not understand why the anti-textbook authors accept unconditionally the “long run equilibrium” inconsistent tale.
For neoclassical economists, the existence of a profit – as a “residual”, a “rent” or a “quasi rent” – has always been problematic, mainly for ideological reasons, in relation with the marginal theory of distribution.

Question for the professor. The “short run/long run” distinction is justified by the existence of fixed costs. Fixed costs imply that (competitive) supply curves are discontinuous. How can you be sure that the number of firms that “enter” can produce exactly the quantity demanded of the good so that their profit is nil ?

CONCLUDING REMARKS

The purpose of our contribution to the Anti-Textbook is to remember that the competitive model is not relevant as a representation of a market economy. Thus, we do not agree with textbooks, nor with the Anti-Textbook, when they assert that the competitive model is used “as an approximation”. A not so bad approximation for mainstream textbooks, a very bad for the Anti-Textbook. But, for both, the competitive model is a benchmark, a reference – the other models (with “imperfections”) are, sooner or later, compared to it.
Our purpose here was to underline the fact that the “competitive model” is not an approximation – not even a very bad one – of any existing present or past economy. Thus, it is totally useless and should be taught course on the history of economic thought. One could consequently insist on the oddness resulting from the association of a highly centralized model (at least in its’ maths) with the ideal of a “decentralised economy”. Does that mean that, ideally, economies should not be decentralized ?


[1We say “in general” because it is always possible to imagine some “immaterial” produced goods, as education, where you can produce more varying only one input (work) – even if somebody can remark that more teaching needs more chalk, more electricity, more heating…

[2Curiously it is the same used by Gregory Mankiwin in his Macroeconomics (see Fred Moseley, p116)

 
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