Postscript to Neo-Classical Economics

The intellectual achievement of the neo-classical economists was formidable. Without doubt, the models formulated by its contributors register high on the scales of aesthetic appeal and logical symmetry. Their work fitted the pieces of a complex system into a coherent package and stated the relationships between them in a fashion amenable to mathematical analysis. Their approach brought new standards of rigour to economic discourse and largely silenced the overtones of inevitability which, in varying degree, had been associated with classical and Marxian argumentation. Human volition was brought to the centre of the stage. Economic analysis, as construed by writers of a neo-classical persuasion, centred on the functioning of the market system and its major objective was to clarify the choices open to producers and consumers in market situations. From this perspective fears that cleavages in the economic structure might be unbridgeable were suppressed. Instead, the economic order was viewed as an organic unit, the components of which were mutually interdependent. On this basis, judgements about the welfare of the whole society (as opposed to statements about gains and losses to individual groups) were legitimate. Though the early neo-classicists did not speak with one voice on this matter, most maintained that - apart from cases in which economies of scale prevailed - the free functioning of the market would normally advance the general welfare.

These conclusions - as well as the elegant formal system from which they were derived - rested on two important assumptions. In the first place, it was necessary to hold that highly competitive conditions characterized the bulk of economic activity. It was, of course, recognized that certain lines of production (i.e. those subject to increasing returns) were inconsistent with these assumptions and that some form of government intervention to deal with them was justified. Nevertheless, it was held that, in most markets, consumers ultimately guided the allocation of resources and that producers could not exercise unilateral influence over prices. But if this outcome was to be judged as beneficent, it was also necessary to maintain that no resources would be involuntarily idle. From neo-classical premisses, confidence that 'full employment' would be the normal operating level of the economy flowed naturally. This did not mean that fluctuations in the aggregate level of economic activity could never occur. Despite occasional disturbances arising from miscalculations and malfunctionings in the monetary system, the normal operation of the market system would be sufficient to assure speedy correction of these abnormalities.

The appropriateness of the second of these assumptions was challenged by events in the 1930s and, at the analytical level, by the path-breaking work of John Maynard Keynes. The foundations of the first assumption began to erode even earlier. In manufacturing, particularly, markets dominated by a small number of large producers (rather than by the large number of sellers required by tight models of a competitive regime) became increasingly prominent. In face of these institutional changes, Marshall's assurances about the constraints to the exercise of market power imposed by the life cycle of the firms and by 'special' markets lost much of their plausibility. Economic theory, however, did not satisfactorily embrace the grey area between pure competition and pure monopoly until the late 1920s when Mrs Joan Robinson in Cambridge and Professor E. H. Chamberlin of Harvard worked out theories of 'imperfect' and 'monopolistic' competition respectively. These contributions, while modifying earlier neo-classical propositions, were still cast in the mould of neo-classical marginalist reasoning.

The apparatus of neo-classical reasoning has also been perpetuated by theorists who have abandoned any claims to realism for its premisses concerning competition. They have instead asserted that the outcome described in the perfectly competitive model - in which market power is diffused and the economy's resources optimally allocated - is socially desirable. The model no longer purports to be descriptive, but is accorded a normative status. Supporters of this general position divide into two camps. One school advocates legislation to enforce competition by splintering large-scale producers into small competing firms. The other has opposed such attempts to reproduce atomistic competition and has instead used neo-classical reasoning to support a programme of socialism. In the latter view industries which fail to meet the standards of perfect competition should be nationalized. Under public ownership, managers would be directed to price their outputs at marginal cost. Such procedures, it has been maintained, would permit the optimum allocative solution of the perfectly competitive regime to be approximated.

Both of these adaptations of neo-classical theory have been challenged by writers whose roots in the neo-classical tradition are no less deep. In tones reminiscent of the later J. B. Clark, another school has contended that the essential characteristics of competition can be preserved (even in markets with a small number of sellers) so long as a high rate of technical innovation is sustained. Moreover, it has been argued that the abnormally high profits available to firms enjoying considerable market power permit heavier ploughbacks into research than would otherwise have been possible. With the introduction of these dynamic considerations, industrial concentrations have been defended.

Similar adaptations of neo-classical argument have been made for application to the problems of the underdeveloped world. In this setting-where the market is often far from ubiquitous - neoclassical ideas have emerged in two prominent forms. One version, for which there are a number of eminent spokesmen, maintains that the mobility of resources and their efficient allocation is thwarted by restrictions based on race, tribal affiliation, or caste. The inference drawn for policy from this reading of the situation is that such 'imperfections' should be eliminated; the extension of the market system should be encouraged as a spur to efficiency, to a faster rate of growth, and as a social levelling device. A variant of this point of view, though one with the same intellectual parentage, holds that government intervention bears a heavy responsibility for waste, inefficiency, and misallocation of economic resources. Greater freedom for the market through massive reductions in government controls is regarded as the appropriate course for policy.

A more sophisticated extension of neo-classical doctrines to the underdeveloped world is less confident about the capacity of untampered markets to produce desirable results. This version of neo-classical reasoning proceeds from the assumption that fundamental structural obstacles prevent an optimum allocation in underdeveloped economies and that government should be assigned the task of adjusting the prices of productive factors in order to come closer to the optimum solution. It is contended that wage rates are higher than is warranted by the productivity of the labour force (primarily because of minimum wage legislation and social pressures on employers) and that the price of capital is too low to reflect the real scarcity of capital (primarily because interest rates in organized capital markets are linked more closely to international lending rates than to local conditions). It is then argued that governments should redress this imbalance in a manner calculated to approximate the factor prices that would prevail in an equilibrium situation. Under the recommended system of `accounting prices' the buyer of labour would be subsidized while the buyer of capital would be taxed. If this scheme could be effectively administered (a point about which there can be considerable legitimate doubt), it is expected that output, employment, and the rate of economic growth would be considerably enlarged.

The reformulation and extension of neo-classical ideas along these lines by no means exhaust its legacy. The counter-revolution in economic literature touched off by early neo-classicism also deserves mention. Perhaps its most colourful critic was Thorstein Veblen (1857-1929), an irrepressible pupil of J. B. Clark who challenged the presuppositions of his master's teaching. The neo-classical modus operandi, he maintained, was too formal, too deductive, and too static to provide leverage on the problems that mattered. Not only did it accord low priority to dynamic factors in economic life, but it was almost totally oblivious to the analysis of change. What passed for a discussion of the causal mechanics of the economic system was, in his view, only teleology. Change was not explained. Instead, neo-classical procedure worked with single assumed changes (when all other conditions were held constant) and attempted to trace the path to a new equilibrium. Even the neo-classical concept of equilibrium was alleged to be spurious. Inasmuch as it rested on the assumption of rational calculating behaviour, it clashed with Veblen's insistence that human action was more instinctive than reflective. In his interpretation two drives were particularly forceful in social conduct: the instinct of workmanship and the instinct of emulation.

From this position Veblen offered both a critique of orthodox neo-classical postulates and a competing explanation of the economic process. As he saw the matter, man's natural impulse to produce, to create, and to innovate - if allowed to express itself without restraint - would embarrass society with abundance. That this fate had been averted could be explained, in part, by the emergence of a leisure class, the social function of which was to waste the abundance that human energy had produced. At the same time, a highly organized market system had mechanisms for suppressing output built into it. In Veblen's account, the engineers (who epitomized the instinct of workmanship in societies with high technologies) sought to expand output without limit. Their creative energies, however, were frustrated by businessmen who, prompted by fears of spoiling established markets and of destroying capital values, became the agents of institutionalized waste. In search of maximum profits, big business kept outputs well below technologically feasible levels.

This account was clearly at odds with the mainstream of neo-classical thought. Veblen rejected all of the basic propositions of neo-classical economics. If advised that consumers would normally buy more of a commodity at lower than at a higher price, Veblen would object that considerations of emulation and conspicuous consumption might, in certain circumstances, yield the opposite result; luxury goods valued as status symbols, for example, might actually be purchased in reduced quantities as their prices fell. If told that labour had a disutility attached to it (an assumption underlying neo-classical distributional theory), Veblen would counter with the argument that man's workmanlike instincts meant that he obtained positive satisfactions from productive effort. If informed that the proper area of investigation for the economic theorist was the formal analysis of the market's allocative properties under static equilibrium conditions, Veblen's response would be most vehement. The real issue, he maintained, was the reverse: the investigation of the destabilizing impact of changes in tastes and technology.

Veblen did much to rekindle interest in an 'institutional' approach to economic problems - i.e. one which largely eschews notions derived from pure theory in favour of empirical inquiries into the workings of an economy's basic institutions. Some readers of recent best sellers on contemporary economics and social problems may also detect echoes of Veblenian themes. J. K. Galbraith's The Affluent Society, for example, is built on the thesis that the maintenance of a high level of economic activity in rich societies has required producers to become taste makers in order to dispose of their abundant product.

Perhaps the most sophisticated of the later criticisms of the structure of neo-classical reasoning has challenged the claim that economics can achieve the status of an exact science. Much of the attack has been directed at the value judgements latent in such standard neo-classical terms as 'equilibrium' and `optimum' and the risk that their use will prescribe what ought to be. The transition from descriptive to normative statements proceeds so smoothly that it often escapes notice. Yet it is an operation of this sort which many of the latter-day practitioners of neo-classicism have performed. Even if it were logically legitimate - which it is not - to derive ethical conclusions from scientific data, difficulties would not be entirely avoided. It might still be questioned whether or not the neo-classical image of an economic system in which the interests of various groups were harmonized constituted an accurate characterization of reality. Some critics have maintained that unfortunate effects have stemmed from the neo-classical preoccupation with efficiency in production and exchange. Emphasis on these matters has diverted attention from distributional considerations and from divergences in the interests of various groups within society.

Despite these dissents there can be no doubt that the neo-classical economists attained a high standard of formal elegance. Their choice of central focus precluded a sharp inspection of two major economic issues - e.g. those of long-period growth and aggregative instability - and even the limited attention they gave to these matters was deficient. But the apparatus of reasoning cementing their ideas together has a utility which transcends the usual domain of economic problems. Indeed, the neo-classical mode of thought has been construed as providing the basis for a generalized logic of choice with much to offer to those charged with planning national defence strategies as well as to businessmen.