Classical Economics: Lost and Found.

• Author: Inoua, Sabiou M.
• Position: Adam Smith's "The Wealth of Nations" and "Theory of Moral Sentiments" - Critical essay

The Indeterminacy of Neoclassical Value Theory

At mid-twentieth century, the neoclassical mathematical theory of value culminated in Kenneth Arrow and Gerard Debreu's (1954) model, which characterizes the static general equilibrium state of an economy. However, this description is unsatisfactory unless markets converge to such an equilibrium. That the Arrow-Debreu model could not accomplish this is an implication of the important results obtained by Hugo Sonnenschein (1972, 1973a, 1973b), Rolf Mantel (1974), and Gerard Debreu (1974), also known as the SMD Theory. (1) The heart of the problem is that the principle of individual utility maximization has no interesting implication for aggregate market demand, not even the law of demand; in fact, demand is essentially arbitrary in this theory. But this aggregation problem is often if unintentionally evaded through the artifice of the representative agent (Arrow 1986; Kirman 1992). Yet the problem is endemic, leading Frank Hahn to suggest that "we shall have to conclude that we still lack a satisfactory descriptive theory of the invisible hand" (1982, 746). Going further, Franklin M. Fisher concludes that "we do not have an adequate theory of value, and there is an important lacuna in the center of microeconomic theory. Yet economists generally behave as though this problem did not exist" (2013, 35).

We want to record the observation that acting as if a "problem does not exist" is not unique to economics or any science, for in general "[s]cientists ... do not abandon a theory merely because facts contradict it[;] ... they direct their attention to other problems" (Lakatos 1978, 4).

We argue that neoclassical value theory suffers from a more basic and serious logical indeterminacy that is inherent in the axiom of price-taking behavior and that renders price dynamics indeterminate before any inquiry is made as to its stability. if everyone in the economy takes prices as given, where do these prices come from? Who is determining these prices? In the late nineteenth century, Stanley Jevons ([1871] 1988) avoided the indeterminacy by assuming that people must have complete information on supply and demand and on the consequent equilibrium prices-"perfect competition." Leon Walras (1954) in effect imported an external agent who found the prices by trial-and-error correction (the Walrasian auctioneer). Paradoxically, both approaches had the potential to serve central planning more than a market economy. A theory based on price-taking agents required some agency for giving prices. Indeed, the fit with socialism was rigorously established by influential neoclassical authors, starting with Friedrich von Wieser (1893, chap. 6) and Vilfredo Pareto (1897, 364-71; 1909, 362-64) and, more formally during the Socialist Calculation Debate by Barone ([1908/1935] 2009), Abba Lerner (1934), and Oskar Lange (1936, 1937). The paradox is hidden in the idea of "perfect competition," a passive treatment of individuals who are not even interacting, let alone interacting in a rivalrous manner. "Perfect competition" is the negation of any real competition, as Friedrich A. Hayek (1948) emphasized.

Experimental Market Economics

Although theoretical economics failed to provide a satisfactory account of the market mechanism, experimental economics, beginning in the mid-twentieth century, established the remarkable stability, efficiency, and robustness of the market process under ordinary trading rules (notably the double-auction institution, which existed apart from the economics literature) and under realistic market conditions (V. Smith 1962, 1982; Plott 1982; Davis and Holt 1993). (2) These findings could not have been further from the expectations of the early neoclassic-trained experimentalists; their first struggle was with the failure to confirm widely shared expectations based on the Jevons-Walras utility theory. Laboratory markets typically involve only a few buyers and a few sellers, who know only their personal values and costs, or reservation prices, and who are obviously making the prices through their bids and asks. According to the neoclassical theory, we should expect only "market failures" in this context. Yet the experimental markets generally converge to maximum efficiency. We argue that these experimental findings are in reality a corroboration of the classical view of the market mechanism (Inoua and Smith 2019; Smith and Inoua 2019). In fact, wherever we examine an account of market price formation in the neoclassical literature, the authors invoke the old view (for example, Marshall [1890] 1920, bk. 5, chap. 2), and the Austrian marginalists articulated explicitly a price-discovery process through collective "higgling and bargaining" in essentially the same way that the classical economists explained it. The modern introductory textbook, in describing equilibrium tendencies, also appeals to the outbidding and underselling of buyers and sellers in disequilibrium.

Rediscovering Classical Economics

The neoclassical school replaced the classical one, yet its root deficiencies are direct consequences of its departure from the older paradigm. First, concerning method, the classical economists, notably Adam Smith ([1776] 1904), observed carefully the market economy and derived a theory of markets from these acute observations. Thus, smith and his followers observed the experience of market participants and discovered the sophisticated, unintended, collective regularities that emerge from myopic, self-interested, individual behaviors and interactions, finding that this process is the cause of specialization--the famous "invisible hand" metaphor, referring to agents' lack of awareness of what they have wrought. In place of this process, the neoclassical school in effect substituted thought experiments about an imaginary economy whose regularities rest entirely on artificially sophisticated individual rationality, epitomized by one idealized person (Robinson crusoe, the Walrasian auctioneer, the representative agent, the social planner) and evoking a command economy.

The Classical View on Demand and Supply

Before the marginal revolution, the primitive concept in the theory of value was an individual's valuation of a good--that is, value in use, which means the value that a person attaches to a good in view of the good's personal usefulness, as measured by the amount that this person is willing to pay (give up) in exchange for the good. From Adam Smith to Jules Dupuit, demand is willingness to pay. Thomas Malthus, for example, stated in Principles of Political Economy that "demand will be represented and measured by the sacrifice in money which the demanders are willing and able to make in order to satisfy their wants" ([1820] 1836, 62). In his memoirs on utility, Dupuit (1844,1849), while refining an intuition described by Jean-Baptiste Say, emphasized that use-value is given by maximum willingness to pay--namely, by what we call today the reservation price. John Stuart Mill reached the same conclusion but put it in a more technical way: "Value in use ... is the extreme limit of value in exchange"--that is, price. Or, "the utility of a thing in the estimation of the purchaser, is the extreme limit of its exchange value" ([1848] 1909, bk. 3, chap. 1, sec. 2; chap. 2, sec. 1). Given the reservation price as a primitive concept, an individual's demand is very simple: by definition, one is willing to buy a good if one attaches to it a...