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Before going on, it is necessary to take note of the rise and fall of the German
Historical school and the American Institutionalist school, which levelled a steady
barrage of critical attacks on the orthodox mainstream. The German historical
economists, who had many different views, basically rejected the idea of an abstract
economics with its supposedly universal laws; they urged the necessity of studying
concrete facts in national contexts. While they gave impetus to the study of
economic history, they failed to persuade their colleagues that their method was
invariably superior. The institutionalists are more difficult to categorize.
"Institutional economics," as the term is narrowly understood, refers to a movement
in American economic thought associated with such names as Thorstein Veblen,
Wesley Clair Mitchell, and John R. Commons. These writers had little in common
aside from their dissatisfaction with the abstract theorizing of orthodox economics,
its tendency to cut itself off from the other social sciences, and its preoccupation
with the automatic market mechanism. They failed to develop a theoretical
apparatus that would replace or supplement the orthodox theory. This may explain
why the phrase "institutional economics" has become little more than a synonym
for "descriptive economics." The hope that institutional economics would furnish
a new interdisciplinary social science proved stillborn. (This is perhaps not
surprising, because it was by abstracting purely economic forces from the totality
of social interactions that economics got so far ahead of the other social sciences
in theoretical rigour.) Although there is no longer an institutionalist movement in
economics, the spirit of institutionalism is alive in such works as the Harvard
economist John Kenneth Galbraith's The Affluent Society (2nd ed., 1969) and
The New Industrial State (1967).
Returning to the innovations of the 1930s, the theory of monopolistic or
imperfect competition remains somewhat controversial to this day. The older
economists had devoted all their attention to two extreme types of market structure,
that of "pure monopoly," in which a single seller controlled the entire market for
one product, and that of "pure competition," characterized by many sellers, highly
informed buyers, and a single, standard product. The theory of monopolistic
competition gave recognition to the range of market structures that lie between
these extremes, including (1) markets having many sellers with "differentiated
products," employing brand names, guarantees, and special packaging that cause
consumers to regard the product of each seller as unique; (2) "oligopoly," markets
dominated by a few large firms; and (3) "monopsony," markets with a single
monopolistic buyer and many sellers. The theory produced the powerful conclusion
that competitive industries in which each seller has a partial monopoly because of
product differentiation will tend to have an excessive number of firms, all charging
a higher price than they would if the industry were perfectly competitive. Since
product differentiation—and the associated phenomenon of advertising—seems
to be characteristic of most industries in developed capitalist economies, the new
theory was immediately hailed as injecting a healthy dose of realism into orthodox
price theoiy. Unfortunately, its scope was not great enough. It failed to provide a
satisfactory theory of price determination under conditions of oligopoly. In
advanced economies many of the manufacturing industries are oligopolistic. The
result has been to leave a somewhat undigested lump at the centre of modern price
theory, a constant reminder of the fact that economists still lack an adequate
explanation of the conditions under which the giant firms of rich countries conduct
The second major breakthrough of the 1930s, the theory of income
determination, was primarily the work of one man — John Maynard Keynes.
Keynes asked questions that in some sense had never been asked before; he was
interested in the level of national income and the volume of employment rather
than in the equilibrium of the firm or the allocation of resources. It was still a
problem of demand and supply, but "demand" here means the total level of effective
demand in the economy, and "supply" means the nation's capacity to produce.
When effective demand falls short of productive capacity, the result is
unemployment and depression; when it exceeds the capacity to produce, the result
is inflation. The heart of Keynesian economics consists of an analysis of the
determinants of effective demand. If one ignores foreign trade, effective demand
consists essentially of three spending streams: consumption expenditures,
investment expenditures, and government expenditures, each of which is
independently determined. Keynes attempted to show that the level of effective
demand so determined may well exceed or fall short of the physical capacity to
produce goods and services: that there is no automatic tendency to produce at a
level that results in the full employment of all available men and machines. This
fundamental implication ofthe theory came as something of a shock to exponents
of the traditional economics who had been inclined to take refuge in the assumption
that economic systems tend automatically to full employment. By keeping his
attention focussed on macroeconomic aggregates, like total consumption and total
investment, and by a deliberate simplification of the relations between these
economic variables, Keynes achieved a powerful model that could be applied to a
wide range of practical problems. His system subsequently underwent considerable
refinement — some have said that Keynes himself would hardly have recognized
it — and became thoroughly assimilated into the body of received doctrine (see
economic stabilizer). Still, it is not too much to say that Keynes is perhaps the only
economist to have added something really new to economics since Walras and
perhaps since Ricardo.
Keynesian economics as conceived by Keynes was entirely "static"; that is,
it did not involve time as an important variable. But a disciple of Keynes, Roy
Harrod, soon developed a simple macroeconomic model of a growing economy;
in 1948 he published Towards a Dynamic Economics, launching an entirely new
speciality, "growth theory," which absorbed the attention of an increasing number
Methodological considerations in contemporary economics
Economists are sometimes confronted with the charge that their discipline is
not a science. Human behaviour, it is said, cannot be analyzed with the same
objectivity as the behaviour of atoms and molecules. Value judgments, philosophical
preconceptions, and ideological biases must interfere with the attempt to derive
conclusions that are independent of the particular economist espousing them.
Moreover, there is no laboratory in which economists can test their hypotheses.
This argument raises issues for all of the social sciences. Only a veiy general
reply can be given here. Economists are wont to distinguish between "positive
economics" and "normative economics." Positive economics seeks to establish
facts: Will a subsidy to butter producers lower the price of butter? Will a rise in
wages in the automobile industry reduce the employment of automobile workers?
Will devaluation improve the balance of payments? Does monopoly foster technical
progress? Normative economics, on the other hand, is not concerned with matters
of fact but with questions of policy, of "good" or "bad": Should the goal of price
stability be sacrificed to that of lull employment? Should income be taxed at a
progressive rate? Should there be legislation in favour of competition?
Positive economics in principle involves no judgments of value; its findings
may be as impersonal as those of astronomy and meteorology, two natural sciences
that are also denied the advantage of conducting laboratory experiments. As the
British philosopher David Hume argued 200 years ago, there is no logical way to
deduce "ought" from "is" or prescriptions from descriptions; all statements of fact
are ethically neutral. In that sense a value-free economics is possible (at least in
principle): if economics is about the application of means to achieve given ends,
there would seem to be no reason why one cannot analyze the allocation of means
to achieve any end. This is not to deny that most of the interesting economic
propositions involve the addition of definite value judgments to a body of
established facts, that ideological bias creeps into the veiy selection of the questions
that economists investigate, that what is a means from one point of view may be an
end from another, nor even that much practical economic advice is loaded with
concealed value judgments, the better to persuade rather than merely to advise.
This is only to say that economists are human. The commitment of economists the
world over to the ideal of value-free positive economics (or to the candid declaration
of personal values in normative economics) serves as a defense against the attempts
of special interests to bend the science to their own purposes. The best assurance
against bias on the part of any particular economist is the criticism of other
economists. The best protection against special pleading in the name of science is
the professional standards of scientists.
Methods of inference
But how, one may ask, are facts established in a science that cannot conduct
experiments? In essence, the answer is: by means of statistical inference. Economists
typically begin by describing the area under study according to what they feel to
be important. Then they construct a "model" of the real world, deliberately
repressing some of its features and emphasizing others; they abstract, isolate, and
simplify, thus imposing order on a world that at first glance appeared disorderly.
Having evolved an admittedly unrealistic representation of the real world, they
then manipulate the model by a process of logical deduction, arriving eventually
at some prediction or implication that is of general significance. At this point, they
return to the real world to see whether or not the prediction is borne out by observed
But the observable events that are available to test a theory never exhaust
the population of all such events: they are merely a sample of it. This raises the
problem of statistical inference; namely, what can be inferred about a population
from a sample of the population? The theory of statistical inference is simply an
agreed-upon procedure for making such inferences, but in the nature of the case it
never succeeds in removing all elements of judgment from an inference. Thus the
empirical truths of economics are invariably surrounded by a band of doubt, and
economists speak of them as "probable" or "likely"; they are propositions in which
economists have "a certain degree of confidence" because it is unlikely that they
could have come about by chance.
It follows that judgments are at the heart of both positive and normative
economics. It is easy to see, however, that judgments about "degrees of confidence"
and "statistical levels of significance" are of a totally different order from those
that crop up in normative economics. When men say that every individual should
be allowed to spend his income as he likes, that people should not be free to
control material resources and to employ others, or that governments must offer
relief for the victims of inexorable economic forces, they are making the kind of
value judgments that laymen have in mind when they accuse economists of
producing personal preferences in the guise of scientific conclusions. There is no
room for such value judgments in positive economics.
Since Keynes, economic theory has been of two kinds: macroeconomics —
or the study of the determinants of national income — and the traditional
microeconomics. The latter approaches the economy as if it were made up only of
business firms and households (ignoring governments, banks, charities, trade
unions, and all other economic institutions) interacting in two kinds of markets —
product markets and markets for productive services, or factor markets. Households
appear as buyers in product markets and as sellers in factor markets, where they
offer men, machines, and land for sale or hire. Firms appear as sellers in product
markets and as buyers in factor markets. In each type of market, price is determined
by the interaction of demand and supply, and the problem of microeconomic theory
is to say something meaningful about the forces that make up demand and supply.
Theory of choice
At first it appears that all one can say is that everything depends on everything
else. But firms and households do not behave in a vacuum. Firms face certain
technical constraints in producing goods and services, and households have definite
preferences for some products over others. It is possible to express the technical
constraints facing business firms by writing down a series of "production functions,"
one for each firm. A production function is simply a kind of equation that expresses
the fact that the output of a firm depends on the quantity of inputs it employs and,
in particular, that inputs can be technically combined in different proportions to
produce a given level of output. A production engineer could calculate, on the
basis of existing technical knowledge, the largest possible output that could be
produced with every possible combination of inputs and in this way could define
a boundary to the range of production possibilities open to a firm. By itself this
does not tell how much the firm will produce or what mixture of products it will
make or what combination of inputs it will adopt: these depend on the prices of
products and the prices of inputs (or "factors of production"), which have yet to be
determined. One may assume that the firm is motivated in a particular way: it
wants to maximize profits, which are defined as the difference between the sales
value of its output and the money outlays required to obtain its inputs. It will,
therefore, select that combination of inputs that minimizes the costs of producing
any given quantity of output and will select from the range of possible combinations
of products that combination that maximizes its revenues. This is to say that it
always tries to move along its production function, along the edge of the boundary
of technical possibilities. But where it ends depends, in part, on the demand for its
products. This leads to the part played by households in the system.
Households are endowed with definite "tastes" that can be expressed in a
series of "utility functions," one for each household. A utility function is an equation
like a production function, expressing the fact that the pleasure or satisfaction that
households derive from consumption depends on the products that they purchase
and on the various ways in which they combine these products in consumption to
yield a given level of satisfaction. The utility function need not be specified in the
same detail as a production function. One may think of it as a general description
of the household's preferences between all the paired alternatives with which it
will be confronted. Here, too, it is necessary to assume something about motivation
to make any progress: the assumption is that households seek to maximize
satisfaction, distributing their given incomes among available consumer goods in
such a way as to derive the largest possible "utility" from consumption. Their
incomes, however, remain to be determined.
The purpose of production functions in economic theory is to provide an
anchor in the bedrock of technology from which to derive the "supply curves" of
firms in product markets and the "demand curves" of firms in factor markets.
Similarly, the purpose of utility functions is to provide an anchor in subjective
"tastes" from which to derive the "demand curves" of households in product markets
and the "supply curves" of households in factor markets. All of these demand and
supply curves express the quantities demanded and supplied as a function of prices,
not because price is the only determinant of economic behaviour but because the
purpose is to have a theory of price determination. Much of economic theory is
devoted to showing how various production and utility functions, coupled with
certain assumptions about behaviour, lead to demand and supply curves in which
the quantity demanded is inversely related and the quantity supplied positively
related to price. The figure depicts these relationships (curves would be just as
suitable as straight lines).
Not all demand and supply curves look alike. The essential point is that most
demand curves are negatively inclined, while most supply curves are positively
inclined. This may seem a modest result for a great deal of effort, but the argument
has powerful implications. The participants in a market will be driven automatically
to the price at which the two curves intersect; this price p is called the "equilibrium"
price or "market-clearing" price because it is the only price at which supply and
demand are equal. If it is a market for butter, any change in the production function
of dairy farmers or in the utility function of butter consumers or in the prices of
cows, grassland, and milking equipment or in the incomes of butter consumers or
in the prices of nondairy products that consumers buy can be shown to lead to
definite changes in the equilibrium prices of butter and in the equilibrium quantity
of butter produced. Better still, the effects of a government ceiling on the price of
butter or of a tax on butter producers or of a price-support program for dairy
farmers can be predicted with almost perfect certainty. As a rule, the prediction
will refer only to the direction of change (the price will go up or down); but if the
demand and supply curves of butter can be defined in quantitative terms on the
basis of past data, one may be able to predict the actual magnitude of the change.
Theory of allocation
This analysis of the behaviour of firms and households is to some extent
symmetrical: all economic agents are conceived of as ordering a series of attainable
positions in terms of an entity they are trying to maximize. For a firm these attainable
positions are essentially input combinations; for a household they are product
combinations. From the maximizing point of view, some combinations are better
than others; the best combination is called the "optimal" or "efficient" combination.
The rule for efficient, optimum allocation may now be stated baldly: an optimum
allocation is one that equalizes the returns of the marginal or last unit to be
transferred between all the possible uses. In the theory of the firm, an optimum
allocation of outlays among the factors of production implies that the "marginal
physical product" of an additional dollar devoted to hiring the services of any one
of the factors is the same for all factors; the so-called law of eventually diminishing
marginal productivity, a property of a wide range of production functions, ensures
that such an optimum exists. In the theory of consumer behaviour an optimum
situation obtains when the consumer has distributed his given income in such a
way that the "marginal utility" of each additional dollar spent on any of the products
purchased is equal for all products; the "law of eventually diminishing marginal
utility," a property of a wide range of utility functions, ensures that such an optimum
exists. These are merely particular examples of the "equimarginal principle," which
is not only at the core of the theory of the firm and the theoiy of consumer behaviour
but also underlies the theory of money, of capital, and of international trade. In
fact, the whole of microeconomics is nothing more than the spelling out of this
principle in ever wider contexts.
The equimarginal principle is, of course, applicable to any decision that
involves alternative courses of action. Economics furnishes a technique for thinking
about decisions, whatever their character and whosoever makes them. Military
planners may, for example, consider a variety of weapons in the light of a single
objective, that of damaging an enemy; some of the weapons are effective against
the enemy's army, some against the enemy's navy, and some against his air force;
the problem is to find an optimal allocation of the defense budget, one that equalizes
the marginal contribution of each type of weapon. But defense departments rarely
have single objectives; along with maximizing damage to an enemy there may be
another objective, such as minimizing losses from attacks. In that case, more than
the equimarginal principle is needed for a decision; it is necessary to know how
the department ranks the two objectives in order of importance, since different
rankings will imply different optima. But a ranking of objectives is simply a utility
function or a preference function.
In other words, when an institution pursues multiple ends, decisions about
how to achieve them require a weighting of the ends. Every decision involves a
"production function"—a' statement of what is technically feasible — and a "utility
function"; the equimarginal principle is then invoked to provide an efficient,
optimal strategy. This applies just as well to the running of hospitals, churches,
and schools as to the conduct of a business enterprise, to the location of an
international airport as well as to the design of a development plan for an
underdeveloped country. This is why economists crop up in what seem to be the
most unlikely places, advising on activities that are obviously not being conducted
for economic reasons.
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