The Crisis of Vision in Neoclassical Economics

I think of the notion that prices act as scarcity indices and of the principle of substitution as central to the pre-analytic vision of neoclassical economics. (These principles should only be thought of acting reliably in the absence of imperfections in competition, complete knowledge, etc.) My view is not unique:

"The [Demand-and-Supply-based Equilibrium] theory visualizes the economy as an aggregate of atomistic individuals (producers and consumers) making their decisions autonomously, with no interference from the influence of 'externalities'. Relative prices and quantities are determined simultaneously in equilibrium as an outcome of the interplay of 'forces of demand and supply', generated by the optimizing behavior of individuals subject to their resource constraints. A certain symmetry characterizes the behaviour of producers and consumers. Each producer, given the technological possibilities, chooses the profit-maximizing activities and outputs, at the going prices; each consumer, given his budget constraints and scales of preferences, maximizes satisfaction at the going prices. It is through the operation of the 'fundamental' and 'universal' principle of substitution that individuals adjust their chosen quantities in response to the parametrically given prices...

Further, the notion of 'change' in the DSE theory gets restrictively predetermined by the theory in the following ways. First, all changes in quantities within the system are seen as the outcome of the ever-active principle of substitution. Thus the changes are primarily in relative quantities involving allocational variations. The role of prices as a scarce-resource allocator, given the resources, dominates the theory as contrasted with the resource-creational role of prices in classical theory... Secondly, all changes are explained as induced by changes in relative prices and operate through the decisions of individuals who are only 'quantity adjusters'; that is, all influences affecting quantities have to be necessarily mediated through relative prices or changes on the market and are outcomes of the atomistic responses of individuals. The relative prices acquire the all-powerful role of resource-allocation and the 'market' becomes the 'arena' of action." -- Krishna Bharadwaj (1989, p. 7-8)

Naturally, one can find many statements from advocates of neoclassical economics promulgating this vision. Here’s an example:

"It is indeed the great contribution of the Pure Logic of Choice that it has demonstrated conclusively that even such a single mind could solve this kind of problem only by constructing and constantly using rates of equivalence (or 'values' or 'marginal rates of substitution'), that is, by attaching to each kind of scarce resource a numerical index which cannot be derived from any property possessed by that particular thing, but which reflects, or in which is condensed, its significance in view of the whole means-end structure...

Fundamentally, in a system in which the knowledge of the relevant facts is dispersed among many people, prices can act to co-ordinate the separate actions of different people in the same way as subjective values help the individual to co-ordinate the parts of a plan. It is worth contemplating for a moment a very simple and commonplace instance of the action of the price system to see what precisely it accomplishes. Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin has arisen, or that one of the sources of tin has been eliminated. It does not matter for our purpose - and it is significant that it does not matter - which of these two causes has made tin more scarce. All that the users of tin now need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply... The whole acts as one market, not because any of its members survey the whole field, but because their limited individual fields of vision sufficiently overlap so that through many intermediaries the relevant information is communicated to all. The mere fact that there is one price for any commodity - or rather the local prices are connected in a manner determined by the cost of transport, etc. - brings about the solution which (it is just conceptually possible) might have been arrived at by one single mind possessing all the information which is in fact dispersed among all the people involved in the process." -- F. A. Hayek (1945)

Here is an old textbook:

"Let us then suppose that...there is a strike on the part of one group of workers, say the plasterers, or that there is some other disturbance to the supply of plasterers' labour...The rise in plasterers' wages would be checked if it were possible either to avoid the use of plaster, or to get the work done tolerably well and at a moderate price by people outside the plasterers' trade: the tyranny, which one factor of production of a commodity might in some cases exercise over the other factors through the action of derived demand, is tempered by the principle of substitution." -- Alfred Marshall (1920, Book V, Chapter VI)

And here is exposed nonsense perhaps still being taught to some put-upon students:

"Suppose the number of carpenters suddenly increases, due to the immigration of thousands of new carpenters from Mexico. Both before and after the change, carpenters receive their marginal revenue product... But the wage after the migration is lower than the wage before. Since the supply of carpenters is higher than before, the equilibrium wage is lower.

...an increase in the supply of an input I own drives down its price (and marginal revenue product) and so decreases my income. The same is true for an increase in the supply of an input that is a close substitute for an input I own. If I happen to own an oil well, I will regard someone else's discovery of a new field of natural gas--or a process for producing power by thermonuclear fusion--as bad news." -- David Friedman (1990)

As leaders of mainstream economics know, this neoclassical vision has collapsed:

"Even people who have made no study of economic theory are familiar with the idea that when something is more plentiful its price will be lower, and introductory courses on economic theory reinforce this common presumption with various examples. However, there is no support from the theory of general equilibrium for the proposition that an input to production will be cheaper in an economy where more of it is available. All that the theory declares is that the price of the use of an input which is more plentiful cannot be higher if all other inputs, all other outputs and all other input prices are in constant proportions to each other." -- Christopher Bliss (1975).

I think the collapse of the underlying vision of neoclassical economics (Cohen 1993) leaves some questions open:

• Can the Arrow-Debreu model of intertemporal equilibrium, in its current state, serve as a foundation for price theory, including in applications (Rizvi 1994)?
• Can Sraffa effects be used, (and if so, how) to critique the Arrow-Debreu model?
• If the Arrow-Debreu model fails, how can mainstream economists understand prices? (Game theory is an obvious answer to explore (Rizvi 1999). Sraffians and Post Keynesians have other answers.)

References

• Bharadwaj, K. (1989). Themes in Value and Distribution: Classical Theory Reappraised, London: Unwin Hyman.
• Bliss, C. J. (1975). Capital Theory and the Distribution of Income, Amsterdam: North Holland Press.
• Cohen, Avi J. (1993). "What was Abandoned Following the Cambridge Capital Controversies? Samuelson, Substance, Scarcity, and Value", History of Political Economy, Annual Supplement, V. 25, N. 5: 202-219
• Friedman, D. D. (1990). Price Theory: An Intermediate Text, Second Edition, Cincinnati: South-Western Publishing.
• Hayek, F. A. (1945). "The Use of Knowledge in Society", American Economic Review, V. 35, N. 4 (Sept.): 519-530.
• Marshall, A. (1920). Principles of Economics: An Introductory Volume, Eighth edition. Macmillan.
• Rizvi, S. Abu Turab (1994). "The Microfoundations Project in General Equilibrium Theory", Cambridge Journal of Economics, V. 18: 357-377
• Rizvi, S. Abu Turab (1999). "Rationality, Evolution and Games", Strategic Rationality in Economics, Sant'Arcangelo di Romagna, Italy (26-27 August)