università degli studi di torino dottorato in economia della complessita’ e della creativita’

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Università degli Studi di TorinoDOTTORATO IN

ECONOMIA DELLA COMPLESSITA’ E DELLA CREATIVITA’

LECTURES ONTHE HISTORY OF ECONOMIC THOUGHTECONOMIC THEORY IN THE XXth CENTURY

ROBERTO MARCHIONATTI (University of Torino)

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY INTRODUCTION

THE CURRENT STATUS OF H.E.T. AMONG MAINSTREAM ECONOMISTS

• MAINSTREAM = THE IDEAS THAT ARE HELD BY THOSE GROUPS WHO ARE DOMINANT IN THE LEADING ACADEMIC INSTITUTIONS AND JOURNALS AT ANY GIVEN TIME • “NO HISTORY OF IDEAS, PLEASE, WE’RE ECONOMISTS”

•THE RESULT OF THE CONCEPTION OF ECONOMICS PREVAILING AFTER 1945 • A PECULIAR KIND OF HISTORIOGRAPHY:

–G. STIGLER: THE EFFICIENT MARKET OF IDEAS –P. SAMUELSON: A “WHIG” HISTORY OF SCIENCE

• H.E.T. AS A “RATIONAL RECONSTRUCTION”

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SCHUMPETER’S SOPHISTICATED PERSPECTIVE ON THE ROLE OF H.E.T. WHY DO WE STUDY THE HISTORY OF ECONOMICS ?

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SCHUMPETER’S SOPHISTICATED PERSPECTIVE ON THE ROLE OF H.E.T. WHY DO WE STUDY THE HISTORY OF ECONOMICS ?

• “WE STAND TO PROFIT FROM VISITS TO THE LUMBER ROOM …: PEDAGOGICAL ADVANTAGES, NEW IDEAS, AND INSIGHTS INTO THE WAYS OF THE HUMAN MIND”

• FIRST, “THE PROBLEMS AND METHODS THAT ARE IN USE AT ANY GIVEN TIME EMBODY THE ACHIEVEMENTS … THAT HAS BEEN DONE IN THE PAST … THE SIGNIFICANCE AND VALIDITY … CANNOT BE FULLY GRASPED WITHOUT A KNOWLEDGE OF THE PREVIOUS PROBLEMS AND METHODS TO WHICH THEY ARE THE (TENTATIVE) RESPONSE”

• “SCIENTIFIC ANALYSIS IS NOT SIMPLY A LOGICALLY CONSISTENT PROCESS THAT STARTS WITH SOME PRIMITIVE NOTIONS AND THEN ADDS TO THE STOCK IN A STRAIGHT-LINE FASHION”. RATHER IT IS

• “AN INCESSANT STRUGGLE WITH CREATIONS OF OUR OWN AND PREDECESSORS’ MINDS AND IT ‘PROGRESSES’, IF AT ALL, IN A CRISS-CROSS FASHION … AS THE IMPACT OF NEW IDEAS …, AND AS THE … TEMPERAMENTS OF NEW MEN, DICTATE”

• SECONDLY, “OUR MINDS ARE APT TO DERIVE NEW INSPIRATION FROM THE STUDY OF THE HISTORY”

• THIRD, THE STUDY OF THE HISTORY “TEACHES US MUCH ABOUT THE WAYS OF THE HUMAN MIND”

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A NEW CONCEPTION OF ECONOMICS and A NEW CONCEPTION OF THE HISTORY OF ECONOMICS

• THE MAINSTREAM PERSPECTIVE HAS BEEN RECENTLY CHALLENGED BY A CONCEPTION OF ECONOMICS AS A SCIENCE OF SOCIAL COMPLEXITY IN WHICH HISTORY MATTERS

• IN THIS PERSPECTIVE, THE “HISTORICAL RECONSTRUCTION” OF THE ECONOMIC THEORIES RE-ASSUMES AN IMPORTANT ROLE

MY APPROACH. KEY POINTS:• THE SPECIFICITY OF THE THEORIES TO THE HISTORICAL PERIOD • THE CULTURAL MATRIX AND CONVENTION OF DISCOURSE OF THE

COMMUNITY OF SCHOLARS UNDER FOCUS • THE IMPORTANCE OF THE BIOGRAPHICAL DATA • ECONOMICS PROFESSION AS A DYNAMIC ENTITY WHICH GENERATES AN

EVOLVING SYSTEM OF INTERACTING IDEAS• THIS APPROACH PERMITS:

– TO ACCOUNT FOR THE NON-RECTILINEAR EVOLUTION OF THE THEORIES– TO EMPHASIZE CHANGE AND INNOVATION IN THIS EVOLUTION

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THE SUBJECT OF THESE LECTURES: THE EVOLUTION OF THE ECONOMIC THEORY IN THE

TWENTIETH CENTURYPHASES OF THE ECONOMIC THEORY IN THE TWENTIETH

CENTURY:

• 1890-1914: THE CLASSIC AGE OF MARGINALISM

• 1919-1939: THE “YEARS OF HIGH THEORY”

• THE POST-WAR II PERIOD• 1940s - 1970s• 1980s – 1990s

MEN, SCHOOLS &INSTITUTIONS, CENTRES AND PERIPHERIES

(IDEAS HAVE ORIGIN AND GROW BETTER IN SOME ENVIRONMENTS THAN IN OTHERS)

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THE EVOLUTION OF THE ECONOMIC THEORY IN THE TWENTIETH CENTURY PRESENTED IN THE QJE

“WHAT DO ECONOMISTS KNOW NOW THAT MARSHALL AT HIS TIME DID NOT?”

(BAUMOL,2000, STIGLITZ,2000, BOWLES&GINTIS, 2000)

Two types of answers. They focus:• On the relation between theory and empirical research (Baumol)• On the anticipations and intuitions of post-Walrasian economics

(Bowles,Gintis, Stiglitz)

Questions:• What is the relation between the orthodox and the eterodox side of M? • Why did M. adopt a loose attitude towards empirical work?• Why did twentieth-century economics take the Walrasian path ?• Is M. to be considered a precursor of contemporary post-Walrasian

economics ?

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY.

PART I. ECONOMICS IN THE AGE OF CERTAINTY, 1890-1914 INTRODUCTION

THE PERIOD 1890-1914: GENERAL CHARACTERISTICS

• RAPID ECONOMIC GROWTH

• INCREASE OF THE STANDARD OF LIVING

• NEW WAVE OF INDUSTRIALIZATION

• THE LEADERS: GREAT BRITAIN, THEN GERMANY AND UNITED STATES

• HIGH INTEGRATION OF THE WORLD ECONOMY AND THE GOLD STANDARD

• A GOLDEN AGE (J.M. Keynes)

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THE ECONOMIC THEORY OF THE PERIOD: MEN AND SCHOOLS

CENTRES OF ECONOMIC THEORY MEN, SCHOOLS, INSTITUTIONS

• Cambridge & Oxford in UK Marshall, Edgeworth & the Cambridge School

The Royal Economic Society, 1890The Economic Journal, 1891The Cambridge Ec.Tripos, 1903

• Lausanne Walras, Pareto and the Lausanne School

• Vienna (and Berlin) Bohm-Bawerk, Wieser & the Austrian School, Marxism, Historical School, Neoricardism (Bortkievicz)

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PERIPHERIES MEN, SCHOOLS, INSTITUTIONS

IN EUROPE• Sweeden Wicksell, Cassel• Italy: Roma and Torino Pantaleoni & Barone; Einaudi, Jannaccone &

CabiatiIl Giornale degli EconomistiIN UNITED STATES

• Johns Hopkins S. Newcomb, R.T. Ely• Columbia, New York J.B. Clark, W.C. Mitchell• Yale I. Fisher• Harvard F.W. Taussig

The Quarterly Journal of Economics • Chicago J.L. Laughlin

The Journal of Political Economy

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THE ECONOMIC THEORY OF THE PERIOD: THE LEGACY AND SYSTEMATISATION OF MARGINALIST REVOLUTION

THEORY MEN AND SCHOOLS

A. CONSUMER & DEMAND

• THE NATURE OF UTILITY– Psychological Approach Marshall & Edgeworth (Cambridge)– Non-Psychological Approach Pareto, Fisher (Lausanne)

• MEASUREAMENT OF UTILITY– Cardinal Marshall & Edgeworth (Cambridge)– Ordinal Johnson (Ca.), Pareto&Slutsky (Lo.)

• UTILITY & DEMAND– Utility Function Marshall&Edgeworth&Johnson (Ca.)

Pareto, Fisher (Lo.)– Indifference Curves Edgeworth (Ca.), Pareto (Lo.)– Non-Utilitarian Approach Barone, Cassel, Moore

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THE ECONOMIC THEORY OF THE PERIOD …

THEORY MEN AND SCHOOLB. MARKET EQUILIBRIUM

– General Equilibrium Walras&Pareto&Barone (Losanna)

– Partial Equilibrium Marshall (Cambridge)– Market Structure– Competition Marshall (Ca.), Austrian school– Monopoly Marshall (Ca.), Pareto (Lo.)– Oligopoly Marshall&Edgeworth (Ca.)

• C. DISTRIBUTION Wicksteed(UK), Marshall&Edgeworth &Berry&Flux(Ca.) Walras&Pareto&Barone (Lo.), Wicksell

(Stockolm)

• D.CAPITAL Marshall (Ca.), Wieser&Bohm&Schumpeter (Vi.), Wicksell, Cassel (Sv),

Fisher,Clark(US)

• E.MONEY Marshall&Pigou(Ca.), Wicksell, Fisher

• F.TRADE CYCLE Marshall et al.(Ca.), Spiethoff et al.(Berlin),Mitchell (Columbia)

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THE ECONOMIC THEORY OF THE PERIOD: THE EMERGENCE OF A MATHEMATICAL SCHOOL

• A CHANGING ATTITUDE IN ECONOMICS: THE ADOPTION OF THE MATHEMATICAL METHOD OF REASONING, 1871-1915

“The logic of the calculus may be expressed in terms of a small number of concepts such as variables, functions, limits, continuity, derivatives and differentials, maxima and minima. familiarity with these concepts – and with such notions as systems of equations, determinateness, stability, all of which admit of simple explanations – changes one’s whole attitude to the problems that arise from theoretical schemata of quantitative relations between things: problems acquire a new definiteness; the points at which they lose it stand out clearly; new methods of proof and disproof emerge” (SCHUMPETER)

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A PERIODIZATION OF THE CLASSICAL ERA OF MATHEMATICAL ECONOMICS

• THE EMERGENCE OF MATHEMATICAL REVOLUTION IN ECONOMICS, 1871-1881 (JEVONS, MARSHALL, WALRAS)

• SPREAD AND CONSOLIDATON OF THE MATHEMATICAL METHOD IN ECONOMICS, 1880s-1890s (LAUNHARDT, AUSPITZ AND LIEBEN, PANTALEONI, THE MARSHALLIANS, WALRAS&PARETO, FISHER, BARONE, BORTKIEVICZ, MOORE)

• THE ESTABLISHMENT OF THE MATHEMATICAL APPROACH IN ECONOMICS, 1901-1915 (PARETO AND THE PARETIANS)

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AN APPRAISAL OF THE CLASSICAL ERA OF MATHEMATICAL ECONOMICS

• AT THE BEGINNING SOME ISOLATED PIONEERS

• IN 1915 MATHEMATICAL ECONOMICS IS AN ACCEPTED, BUT SMALL, SCHOOL IN ECONOMICS

• THE EARLIER SCEPTICISM ABOUT APPLYING MATHEMATICS TO ECONOMICS WAS LARGELY REDUCED

• SCIENTISTS AND THE USE OF MATHEMATICS IN ECONOMICS: FROM SCEPTICISM TO (MODERATE) FAVOUR

• BUT THE GREAT EXPECTATIONS WERE STRONGLY REDUCED: THE FIELD OF M.E. IS STATIC EQUILIBRIUM; ITS DEFECT: EXTREME ABSTRACTNESS AND UNREALITY OF ASSUMPTIONS

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART I. ECONOMICS IN THE AGE OF CERTAINTY, 1890-1914

ALFRED MARSHALL(1842-1924)

“Marshall’s great work is the classical achievement of the period, that is, the work that embodies, more perfectly than any other, the classical situation that merged around 1900”

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LIFE Educated at St John’s College, Cambridge• 1868 - lecturer in political economy in Cambridge • 1877 - Professor of Political Economy at the Bristol University • 1883 - Professor of Political Economy at the Oxford University • 1885-1908 – Professor of P.E. at the University of Cambridge• 1890 – founding member of the Royal Economic Association • 1891 – founding member of the Economic Journal (first editor F.Y. Edgeworth)

WORKS• 1879 - The Pure Theory of Foreign Trade; The Pure Theory of Domestic Values• 1879 - The Economics of Industry • 1890 - Principles of Economics, first edition (1920, seventh edition)• 1919 - Industry and Trade • 1923 - Money, Credit, and Commerce

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CAMBRIDGE’S CIVILISATION IN THE VICTORIAN AGE AND MARSHALL’S CONCEPTION OF ECONOMICS

• The Victorian demand: an authoritative social doctrine• The two dominant figures in Cambridge: H. Sidgwick and A. Marshall• “We are not at liberty to exercise ourselves on subtleties which lead nowhere”• Economics for Marshall= applied ethics• The mission: to get economics in a position where it could serve as an engine

for moral progress and instrument of social stability

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ALFRED MARSHALL(1842-1924)THE INAUGURAL LECTURE, 1885:

“THE PRESENT POSITION OF ECONOMICS”

• REFUTATION OF THE HISTORICAL SCHOOL'S CRITICISMS: "FACTS BY THEMSELVES ARE SILENT“

• ON CLASSICAL POLITICAL ECONOMY: CONTINUITY WITH THE CLASSICAL ECONOMISTS AS FOUNDERS OF ECONOMICS ON A SCIENTIFIC BASIS, BUT:

• “THEY REGARDED MAN AS … A CONSTANT QUANTITY … [THEY DID NOT ALLOW FOR] HUMAN PASSIONS, INSTINCTS AND HABITS ... THEY THEREFORE ATTRIBUTED TO THE FORCES OF SUPPLY AND DEMAND A MUCH MORE MECHANICAL AND REGULAR ACTION THAN THEY ACTUALLY HAVE”

• “MAN HIMSELF IS IN A GREAT MEASURE A CREATURE OF CIRCUMSTANCES AND CHANGE WITH THEM"

• ECONOMICS IS INDEBTED TO THE SCIENTIFIC MOVEMENT FOR THIS CHANGE, PARTICULARLY TO BIOLOGY

• THE FUNCTION OF ECONOMIC THEORY: SUPPLYING A MACHINERY “TO AID US IN REASONING ABOUT THOSE MOTIVES OF HUMAN ACTION WHICH ARE MEASURABLE”

• THE ECONOMISTS WORKS “IN THE LIGHT OF FACTS”

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THE ECONOMICS OF MARSHALL: THE PRINCIPLES

“THE PRESENT TREATISE IS AN ATTEMPT TO PRESENT A MODERN VERSION OF OLD DOCTRINES WITH THE AID OF THE NEW WORK, AND WITH REFERENCE TO THE NEW PROBLEMS, OF OUR OWN AGE”

THE STRUCTURE OF THE BOOK– Book I Preliminary survey – Book II, Some fundamental notions – Book III, On Wants and their Satisfaction– Book IV, The Agents of Production. Land, Labour, Capital and

Organization – Book V, General Relation of Demand, Supply and Value– Book VI, The Distribution of National Income– Appendices

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ALFRED MARSHALL(1842-1924)ON THE NATURE AND METHOD OF ECONOMICS: THE PRINCIPLES

• The subject of Economics: “a study of men as they live and move and think in the ordinary business of life”

• Economics as a science:"The methods required for this work are not peculiar to economics; they are the common property of all sciences. All the devices for the discovery of the relations between cause and effect, described in treatises on scientific method, have to be used .. by the economist: there is no any one method of investigation which can properly be called the method of economics"

• However, economics differs from the ‘harder’ sciences: “Every cause has a tendency to produce some definite result if nothing occurs to hinder it .. The law of gravitation states how any two things attract one another; .. they will move towards one another if nothing interferes to prevent them. The law of gravitation is therefore a statement of tendencies. It is a very exact statement … Now there are no economic tendencies which act as steadily and can be measured as exactly as gravitation can: and consequently there are no laws of economics which can be compared for precision with the law of gravitation”

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• ECONOMICS IS A SCIENCE OF SOCIAL COMPLEXITY “Progress or evolution, industrial and social, is not mere increase and

decrease. It is organic growth, chastened and confined and occasionally reversed by decay of innumerable factors, each of which influences and is influenced by those around it; and every such mutual influence varies with the stages which the respective factors have already reached in their growth”

• THIS COMPLEXITY HAS SEVERAL FACETS“The forces of which economics has to take into account are more numerous, less definite, less well known, and more diverse in character than those of mechanics; while the material on which they act is more uncertain and less homogeneous”

• LAWS OF ECONOMICS AND LAWS OF BIOLOGY“Economics, like biology, deals with a matter, of which the inner nature and constitution, ... are constantly changing”

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ON THE NATURE AND METHOD OF ECONOMICS: THE PRINCIPLES

HOW DOES THE ECONOMIST HAVE TO DEAL WITH COMPLEXITY ? • "The work to be done is so various that much of it must be left to be

dealt with by trained common sense”• “Economic science is but the working of common sense aided by

appliances of organised analysis and general reasoning, which facilitate the task of collecting, arranging, and drawing inferences from particular facts”

IMPLICATION FOR THE LANGUAGE OF ECONOMICS: EVERYDAY LANGUAGE MAKES IT POSSIBLE TO MAINTAIN THE SHADES OF MEANING THAT IN COMMON USE EVERY WORD HAS, WHICH CAN BE INTERPRETED “BY THE CONTEXT”:

• “The economist … must make the terms in common use serve his purpose in the expression of precise thought, by the aid of qualifying adjectives or other indications in the context. If he arbitrarily assigns a rigid exact use to a word which has several more or less vague uses in the market place, he confuses business men, and he is in some danger of committing himself to untenable positions”

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WHAT IS THE ROLE OF ABSTRACT REASONING IN ECONOMICS?

• “There is a fairly close analogy between the earlier stages of economic reasoning and the devices of physical statics. But is there an equally serviceable analogy between the later stages of economic reasoning and the methods of physical dynamics ? I think not. I think that in the later stages of economics better analogies are to be got from biology than from physics; and consequently, that economic reasoning should start on methods analogous to those of physical statics, and should gradually become more biological in tone”

• “The most helpful applications of mathematics to economics are those which are short and simple, which employ few symbols; and which aim at throwing a bright light on some small part of the great economic movement rather than at representing its endless complexities”

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WHAT IS THE ROLE OF ABSTRACT REASONING IN ECONOMICS?

• “It is obvious that there is no room in economics for long trains of deductive reasoning … It may indeed appear at first sight that the contrary is suggested by the frequent use of mathematical formulae in economic studies. But on investigation it will be found that this suggestion is illusory … [The mathematician] takes no technical responsibility for the material”

• “While a mathematical illustration of the mode of action of a definite set of causes may be complete in itself, and strictly accurate within its clearly definite limits, it is otherwise with any attempt to grasp the whole of a complex problem of real life, or even any considerable part of it, in a series of equations. For many important considerations, especially those connected with the manifold influences of the element of time, do not lend themselves easily to mathematical expression”

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THE ECONOMICS OF MARSHALL: THE PRINCIPLES

THE THEORY OF COMPETITIVE EQUILIBRIUM

• A COMBINED ANALYSIS OF OF BOOKS IV AND V • BOOK IV

– COMPETITION AS A PROCESS: IT RESTS ON THE ‘OPENNESS OF MARKETS’ NOT ON ATOMISTIC PRICE-TAKING BEHAVIOUR

– THE ANALYSIS OF COMPETITION GOES ALONG WITH THE THEORY OF THE FIRM’S GROWTH

• BOOK V: "GENERAL RELATIONS OF DEMAND, SUPPLY AND VALUE"

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ALFRED MARSHALL(1842-1924)THE ECONOMICS OF MARSHALL: THE PRINCIPLES


BOOK V

• IT IS THE ‘THEORETICAL’ BOOK OF THE VOLUME: “The word ‘Theory’ applies to the title of that book alone. It deals with abstractions”

• MECHANICAL EQUILIBRIUM: “a simpler balancing of forces which corresponds rather to the mechanical equilibrium of a stone hanging by an elastic string, or of a number of balls resting against one another in a basin”

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BOOK V• THE THEORY OF VALUE IS STUDIED WITH REGARDS TO THE NORMAL COST

OF PRODUCTION OF A COMMODITY UNDER THE CETERIS PARIBUS HYPOTHESIS

• FIRST STEP: EQUILIBRIUM OF NORMAL DEMAND AND SUPPLY OF A COMMODITY THAT OBEYS THE LAW OF DIMINISHING RETURNS

• SECOND STEP: EQUILIBRIUM WITH REFERENCE TO SHORT AND LONG PERIODS

• THIRD STEP: LONG TERM EQUILIBRIUM & THE REPRESENTATIVE FIRM: IT “MUST BE ONE WHICH HAS A FAIRLY LONG LIFE, AND FAIR SUCCESS, WHICH IS MANAGED WITH NORMAL ABILITY, AND WHICH HAS NORMAL ACCESS TO THE ECONOMIES, EXTERNAL AND INTERNAL, WHICH BELONG TO THAT AGGREGATE VOLUME OF PRODUCTION” EQUILIBRIUM "AS RESEMBLING A BALANCING OF FORCES OF LIFE AND DECAY"

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DIFFICULTIES• The difficulty of assuming the ceteris paribus condition “reach their

highest point in connection with industries which conform to the law of Increasing Returns”

• Long-term supply curves in relation to such industries are irrealistic: “[They] are fascinatingly clear and vivid, but they are made too clear and vivid to be at all near to reality”

• “Abstract reasoning as to the effects of the economies in production, which an individual firm gets from an increase of its output are apt to be misleading, not only in detail, but even in their general effect. This is nearly the same as saying that in such case the conditions governing supply should be represented in their totality. They are … especially troublesome in attempts to express the equilibrium conditions of trade by mathematical formulae”

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ALFRED MARSHALL(1842-1924)THE ECONOMICS OF MARSHALL: THE PRINCIPLESTHE THEORY OF COMPETITIVE EQUILIBRIUM. FROM MECHANICAL

EQUILIBRIUM (BOOK V) TO BIOLOGICAL EQUILIBIRUM (BOOK IV)

• Starting point: the Smithian division of labour concept – the chief advantage of d.l.: machinery supplants purely manual skill – the chief effect of improvement of machinery: “to cheapen and make more

accurate the work which would anyhow have been subdivided”– d.l. generates increasing returns – d.l. tends “to increase the scale of manufactures and to make them more

complex .. therefore to increase the opportunities for d. l. of all kinds”

• The economies of production permitted by the division of labour: – internal economies: “those dependent on the resources of the individual

houses of business engaged in it, on their organisation and the efficiency of their management”

– external economies: “those dependent on the general development of the industry”

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ALFRED MARSHALL(1842-1924)THE ECONOMICS OF MARSHALL: THE PRINCIPLESTHE THEORY OF COMPETITIVE EQUILIBRIUM. EXTERNAL AND

INTERNAL ECONOMIES

EXTERNAL ECONOMIES (discussed in connection with “the concentration of specialised industries in particular localities”)

• internal to the industry • inter-industrialTypology: • dissemination of skill and know-how in the district-areas • diffusion of inventions and improvements in machinery and in the

general organisation of business • growth of subsidiary trades in the neighbourhood • increasing availability of entrepreneurial ability • a local market for special skillMoreover, Marshall stresses that:• The e.e. are by their own nature essentially inter-industrial • They are partial irreversible

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THE ECONOMICS OF MARSHALL: THE PRINCIPLESTHE THEORY OF COMPETITIVE EQUILIBRIUM. EXTERNAL AND

INTERNAL ECONOMIES

INTERNAL ECONOMIES • “economy of skill” • “economy of machinery” • the capability to exploit economies of buying and selling

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THE ECONOMICS OF MARSHALL: THE PRINCIPLESMARSHALL VERSUS COURNOT

• Cournot: Exploiting increasing returns a firm becomes a monopoly • Marshall: I. R. and competition can co-exist

MARSHALL’S REASONING• as much as factors such as skill, inventiveness and

entrepreneurial energy, needed to exploit potential internal economies, exist, a firm can growth rapidly

• Yet, the tendency to monopolisation is not inevitable because the rise of diminishing returns in the life cycle of the firm opposes it

• Monopolisation of the market on behalf of a firm can at the most be partial and temporary limited

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ALFRED MARSHALL(1842-1924)THE ECONOMICS OF MARSHALL: THE PRINCIPLESTHE TYPICAL ‘CYCLE OF LIFE’ OF A FIRMAn able man, assisted perhaps by some strokes of good fortune, gets a firm footing in the trade, he workshard and lives sparely, his own capital grows fast, and the credit that enables him to borrow more capitalgrow still faster; he collects around him subordinates of more than ordinary zeal and ability; ...Corresponding to this steadily increasing economy of skill, the growth of his business brings with it similareconomies of specialised machines and plants of all kinds; every improved process is quickly adopted and made the basis of further improvements; success brings credit and credit brings success; credit and success help to retain old customers and to bring new ones; the increase of his trade gives him great advantages in buying; … and thus diminish his difficulty in finding a vent for them. The increase in the scale of his business increases rapidly the advantages, which he has over his competitors, and lowers the price at which he can afford to sell. This process may go on as long as his energy, his inventive and organising power retain their full strength and freshness; and … he and one or two others like him would divide between them the whole of that branch of industry in which he is engaged … But here we may read a lesson from the

young trees of the forest as they struggle upwards through the benumbing shade of their older rivals. Many succumb on the way, and a few only survive; those few become stronger with every year, they get a larger share of light and air with every increase of their height, and at last in their turn they tower above their neighbours, and seem as though they would grow on for ever ... But they do not. One tree will last longer in full vigour and attain a greater size than another; but sooner or later age tells on them all. Though the taller ones have a better access to light and air than their rivals, they gradually lose vitality; and one after another they give place to others, which … have on their side the vigour of youth. And as with the growth of trees, so was it with the growth of businesses … In every trade there is a constant rise and fall of large businesses, at any moment some firms being in the ascending phase and others in the descending

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ALFRED MARSHALL(1842-1924)THE CONCEPT OF ‘BIOLOGICAL EQUILIBRIUM’

• “A business firm grows and attains great strength, and afterwards perhaps stagnates and decays; and at the turning point there is a balancing of equilibrium of the forces of life and decay”

• this ‘business firm’ is typical, or representative, from a ‘biological point of view’: it represents the typical growth path of a firm

• With the representative firm, M. brings together the equilibrium of the industry and the disequilibrium of the individual firms of the industry, in which some firms are rising and others are declining

• “a fine distinction between ‘theory’ and ‘real life’ in Marshall’s economics is impossible to draw because Marshall himself did not draw it, and never tired of warning others against drawing it” (Chamberlin)

THE LESSON • the abstract reasoning, the chain of theoretical deductions, has to be

limited: absolute rigour means neglecting time and irreversibilities and so come to the wrong conclusions

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THE MARSHALLIANS• Within the English-speaking world, Marshallian economics was the dominant

form of Neoclassicism from the 1890s to the 1920s. • It relied on practical, intuitive arguments rather than mathematical formalism -

taking into account items such as institutional and industrial structure and real world phenomena, such as uncertainty, money and business cycles. Its main focus was on representative conditions, rather than idealized conditions.

• It was a leading force in the professionalization of economics and its establishment as an independent entity in academia. The Marshallian formula was exported to the United States in the hands of Frank Taussig at Harvard and to Italy by Maffeo Pantaleoni.

• Cambridge MarshalliansH.H. Cunynghame (1848-1935)John Neville Keynes (1852-1949)A.W. Flux (1867-1942)Sir John H. Clapham (1873-1946) Arthur Cecil Pigou (1877-1959) Ralph G.Hawtrey (1879-1971) Frederick Lavington (1881-1927) John Maynard Keynes (1883-1946)Walter Layton (1884-1966)Dennis H. Robertson (1890-1963) Gerald F. Shove (1887-1947)

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THE MARSHALLIANS

Cambridge MarshalliansJ.N. Keynes Pigou Hawtrey J.M. Keynes

Robertson

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VILFREDO PARETO (1848-1924) AND THE ECONOMICS IN LAUSANNE

WALRAS’S LEGACYLéon Walras (1934-1910)• Professor of political economy at Lausanne (1870-93)• Works:

– Eléments d’économie politique pure (1874-77, 1889, 1900)– Etudes d’économie sociale, 1896– Etudes d’économie politique appliquée, 1898

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WALRAS’S LEGACY

• The idea of the general economic equilibrium: “Walras’s claim to immortality”

• The origin of W.’s formulation of G.E.T.: Louis Poinsot, Eléments of statistique, 1803

• W.’s analysis of G.E.E.: a step-by-step process:- The case of two-person, two-commodity barter of given stock of

consumer goods- The case of multi-person, multi-commodity exchange of given

stocks of consumer goods- The case of the production of new consumer goods and the

market for factor services- The case of saving, investment, and the use of money and credit

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WALRAS’S LEGACYW.’s procedure: the static picture:- To write down the demand and supply equations on the

assumption of perfect competition - the demand functions of individuals are deduced by their utility

functions)- In the cost-supply equations price are equated to average costs

- To prove the existence of a general equilibrium solution for the set of simultaneous equations by counting the number of equations and unknowns

- If they were equal a general equilibrium solution was possibleW.’s procedure: the “realistic” picture: the tatonnement: the

automatic adjustment of price in response to excess of demand or supply

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Life1870: Degree in Engineering at the Polytechnic Institute of Torino1870-1888: Engineer and manager in industrial firms1889: Retirement from business1893-1907: Professor of Political Economy at the University of Lausanne

succeeding Léon Walras

Works1892-3: “Considerazioni sui principi fondamentali dell’economia politica”,

Giornale degli Economisti1896-7: Cours d’Economie Politique1900: “Sunto di alcuni capitoli di un nuovo trattato di economia pura”,

GdE1906: Manuale di Economia Politica1909: Manuel d’Economie Politique1916: Trattato di Sociologia Generale

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METHODOLOGICAL ISSUES: PARETO VS. WALRAS, OR EXPERIMENTAL METHOD VS. RATIONAL METHOD Walras on method:

“The pure theory of economics … is a physico-mathematical science like mechanics … Economists should not be afraid to use the methods and language of mathematics.The mathematical method is not an experimental method; it is a rational method … The physico-mathematical sciences, like the mathematical sciences, … do go beyond experience as soon as they have drawn their type concepts from it. From real-type concepts, these sciences abstract ideal-type concepts which they define, and then on the basis of these definitions they construct a priori the whole framework of their theorems and proofs. After that they go back to experience not to confirm but to apply their conclusions”

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METHODOLOGICAL ISSUES: PARETO VS. WALRAS, OR EXPERIMENTAL METHOD VS. RATIONAL METHOD

Pareto on method vs. Walras:

“Professor Walras’s great contribution to economic discussion was his discovery of a general system of equations to express the economic equilibrium. I cannot, for my part, sufficiently admire this portion of his work, but I must add that I entirely disagree with him … I am a believer in the efficiency of experimental methods to the exclusion of all others. For me there exist no valuable demonstrations except those that are based on facts”

(Pareto 1897)

45



METHODOLOGICAL ISSUES: PARETO’s LOGICAL-EXPERIMENTAL METHOD

• “Political Economy is a natural science founded exclusively of facts”

• Political Economy’s aim: to find out the regularities of phenomena (i.e. their laws) on the guidance of experience and observation

• The laws are simple hypotheses, abstractions deduced by facts: they are good as far as they agree with the facts (verifiable facts)

46



METHODOLOGICAL ISSUES: PARETO’s LOGICAL-EXPERIMENTAL METHOD

Logical-experimental method. Phases

1. Formulation of hypotheses on the basis of an inductive process of observation of facts (from “concrete cases” to “general propositions”)

2. Deduction of theories from the principles3. Comparison of theoretical deductions with

concrete facts in order to confirm or not the theory 4. Statistics and history are the tools of verification

of a theory

47



METHODOLOGICAL ISSUES: MECHANICS, ECONOMICS AND MATHEMATICS

• The use of mechanical analogy– Fisher (1891): “a systematic representation, in terms of mechanical

interaction, of the economic equilibrium”– Pareto (1896-7): mechanical analogy clarifies concepts in

economics; analogies are worthless “as demonstration of a theory”, they “explain some statements which must be verified by experience”

• Mathematics (according to Pareto)– It is necessary in order to examine the general conditions of

economic equilibrium – It does not make demonstration more rigorous, but it permits us to

treat problems far more complicated than those generally solved by ordinary logic

– To be used with caution

48



METHODOLOGICAL ISSUES: THE SUCCESSIVE APPROXIMATION APPROACH

Logical-experimental method. Levels of abstraction:• Pure economics, or first approximation: the facts

considered are the most fundamental (tastes and obstacles of homo oeconomicus)

• Applied economics, or second approximation: the facts considered go beyond the homo oeconomicus. A mix of theory and applied research

49



CONCEPTUAL ISSUES: FROM THE CARDINAL UTILITY TO THE ORDINAL UTILITY

• The neoclassical theory of value considers the perfect hedonist homo oeconomicus – each force of a system works for the maximum utility of everyone

• Is such an abstraction permissible ?• Pareto 1892-3: the hedonistic hypothesis as a first

approximation • But: is utility a measurable quantity ?• Pareto 1900: The rejection of hedonism: economists

are not interested in the reasons why a good is useful, only in the fact that it is useful

50




“Until now [1900], in order to establish economic doctrines we went back to choice. Choices have been explained as man’s aim to achieve maximum pleasure. Between two things, man choses the one that provides more pleasure. The point of equilibrium is obtained by expressing the conditions mathematically which enable the individual to enjoy the maximum pleasure compatible with the obstacles he meets … The use of this point of view forces us to consider pleasure as a quantity. And this is what the economists who have established pure economic theories have done, and what we ourselves have done in the Cours: but we must admit that this is not a throughly rigorous method”

“In order to examine general economic equilibrium, this measurement is not necessary. It is sufficient to ascertain if one pleasure is larger or smaller than another, This is the only fact we need to build a theory”

51




“In reality and in most general ways, pure economics equations simply express the fact of a choice, and can be obtained independently of the notion of pleasure and pain. This is the most general point of view and also the most rigorous … For us, it is sufficient to note the fact of individual choice, without investigating the psychological or metaphysical implications of such a choice … We do not inquire into the causes of men’s actions: the observation of the fact itself is sufficient … Pure economics equations and their consequences exist unchanged whether we start from the consideration of pleasure as a quantity, or we limit our investigation … exclusively to the fact of choice”

52




Pareto, Edgeworth, Poincaré and the late Walras• To develop his theory of choice Pareto makes use of Edgeworth’s

indifference curves• Edgeworth assumes a measurable utility function from which

indifference curves are derived, Pareto starts from the indifference curves themselves, “provided directly by experience”

• In Pareto’s mathematical formulation, a different index is associated with each indifference curve, with an increasing algebraic value for combination of goods chosen in preference to the initial one

• Pareto’s position is similar to the one affirmed by Poincaré in his letter to Walras, September 30, 1901. In it Poincaré

– asserts the satisfaction is not a measurable quantity though it can be examined mathematically

– introduces the notion of preference– preference is defined by means of an ordinal function

• Walras (1909) accepts Poincaré’s criticism

53



PARETO’S GENERAL ECONOMIC EQUILIBRIUM

The basic structure of the Paretian model of general equilibrium in the Manuale is similar to the static Walras model, although, unlike that system, everything is now cast in the “tastes and obstacles” structure rather than in the “demand and supply functions”:

“The emphasis is entirely on the existence of some set of compatible optimizing choices … The problem is no longer conceived as that of proving that a certain set of equations has a solution. It has been reformulated as one of proving that a number of maximizations of individual goals under interdependent restraints can be simultaneously carried out” (Koopmans)

54


GREAT CONTROVERSIES.THE CONTROVERSY EDGEWORTH-WALRAS ON MATHEMATICS IN ECONOMICS, 1889-1891

1889:• Edgeworth’s review of Walras’s second edition of the Eléments• Edgeworth’s “On the Application of Mathematics to Political

Economy”, Presidential Address to section F of the British Association for the Advancement of Science

• Two criticisms: – Walras’s theory of the entrepreneur – Walras’s theory of tâtonnement

• Edgeworth agrees with Walras “in his plea for the use of mathematical reasoning in economics”, but adds that the French economist prejudices “the case by his advocacy”, because of his excessive use of symbols

• There is an ‘excessive elaboration’ of mathematical reasoning in the Eléments, “in such a manner as to justify the particular prejudice against it” : this is the factor that unifies Edgeworth’s criticism

1890: Walras’s and Bortkievicz’s reaction, Revue d’économie politique 1891: Edgeworth’s “The Mathematical theory of supply and demand and

the cost of production”, Revue d’économie politique

55


GREAT CONTROVERSIES.THE CONTROVERSY EDGEWORTH-WALRAS ON MATHEMATICS IN ECONOMICS, 1889-1891

The ProtagonistsWalras Edgeworth Bortkievicz

56


THE CONTROVERSY EDGEWORTH-WALRAS ON MATHEMATICS IN ECONOMICS, 1889-1891

The issues under discussion A. The concept of the entrepreneur who makes neither a profit

nor a loss – a characteristic of the Walrasian equilibrium in production – in the state of perfect equilibrium, when there is equality in

the quantities supplied and demanded and equality of price and average cost, profit does not exist since total profit is the difference between price and average cost multiplied by the number of units of output sold

– Hence, in equilibrium the Walrasian entrepreneur makes neither a profit nor a loss

B. The process towards equilibrium - the so-called tâtonnement. This is the process through which Walras represents the determination of the equilibrium prices in a competitive market system

57



EDGEWORTH’S CRITICISM: THE NOTION OF IDEAL ENTREPRENEUR VERSUS THE PRINCIPLE OF INDUSTRIAL COMPETITION

• The ‘ideal entrepreneur’ who makes neither a profit nor a loss is an “extreme abstraction”

• Walras confines his attention to final utility. • He does not use, among the factors which determine the

equilibrium, the concept of the cost of production considered as importing sacrifice and effort

• Walras’s representation is useful only to illustrate “the operation of a simple market” of free competition

• Walras’s representation cannot be accepted “when we advance from the simplest type of market to the complexities introduced by division of labour”

Edgeworth’s criticism is a criticism of Walras’s mode of conceiving competition

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WALRAS’S AND BORTKIEVICZ’S REPLY

• Walras left cost of production out of his theory of exchange in which the quantities of the several products were designated as parameters.

• Walras introduced the cost of production into his theory of production where these quantities became variables to be determined by a two-fold condition: that cost of production must equal price and that the quantities demanded of productive services must equal the quantities offered.

• Hence Walras did not make abstraction of the cost of production considered as importing sacrifice and effort.

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EDGEWORTH’s REPLY • The concepts of commercial and industrial competition • Commercial competition = “the system of markets .. is that which

would arise if all the articles of exchange were periodically rained down like manna upon several proprietors”: economic equilibrium does not include the cost of production explicitly

• Industrial competition = the equilibrium is conceived as the result of the combined effect of utility and cost of production in order to deal with the industrial competition. It takes account of efforts and sacrifices

• In industrial competition two equations – that of the final utility for different kinds of expenditure and that of the ‘net advantages’ in different occupations – may be considered the conditions of normal economic equilibrium

• Consequently industrial competition, which characterizes the modern economic world, may be represented only by considering the disutility of labour in an ‘more explicit’ way than Walras’s.

• Moreover: the complexity of the mathematical problem of dealing with industrial competition

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EDGEWORTH’s 1925 RI-EXAMINATION OF THE CONTROVERSY

“Economic theory ... does require the recognition of the ... industrial competition. ... Walras’s peculiar doctrine ... cut him [the entrepreneur] from this [industrial competition] essential principle ... It is difficult to see how the equality .. of profits in different occupations can be reconciled with this favourite tenet of the Lausanne School. Of course it may be tolerated as an extreme abstraction, a simplification permissible to a path-breaker. But it seems to deserve pardon rather than praise”

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WALRAS’S TÂTONNEMENT VERSUS EDGEWORTH’S RECONTRACTING

WALRAS’S TÂTONNEMENT• Walras poses the problem of the relation between the theoretical

solution of the exchange and the market solution - “which is solved in practice in the market by the mechanism of free competition”

• “the upward and downward movement of market prices in conjunction with the effective flow of entrepreneurs from enterprises showing a loss to enterprises showing a profit is purely and simply a method of tâtonnement towards a solution of the equations involved in these problems”

• Walras conceives the general market as an auction market and introduces an auctioneer who continues to change prices until supply and demand imbalances with respect to all commodities disappear

• Walras considers the tâtonnement as the way the mechanism of free competition solves his system of equations

• Walras’s tâtonnement is an ideal simulation of the mechanism working in the actual markets if free competition were to prevail

62



EDGEWORTH’S CRITICISM• “Walras’s lessons indicate a way, but not the way of descent to equilibrium” • Walras’s account of tâtonnement lacks sufficient generality (its validity is

restricted to competitive markets) “[Walras] describes a way rather than the way by which economic equilibrium is reached. For we have no dynamical theory determining the path of the economic system from any point assigned at random to a position of equilibrium. We only know the statical properties of the position ... Walras’s laboured description of prices set up or cried in the market is calculated to divert attention from a sort of higgling which may be regarded as more fundamental than his conception, the process of recontract ... The proposition that there is only one price in a perfect market may be regarded as deducible from the more axiomatic principle of recontract”

• The problem is to present “a conception appropriate for a certain kind of facts” • Edgeworth re-contracting hypothesis is not only an alternative mechanism but

one more general than Walras’s tâtonnement

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E.’ RE-CONTRACTING HYPOTHESIS IN MATHEMATICAL PSYCHICS

• Man as a pleasure machine • The calculus of pleasure is divided into Economical and Utilitarian Calculus• Economical Calculus investigates the equilibrium of a system of hedonic forces

each tending to maximum individual utility • Contract = a type of action according to which a self-interested agent acts with

‘the consent of others affected by his action’ • E. inquires the degree to which a contract is indeterminate• E. begins with a case of barter• E. inquires into when the two individuals will reach equilibrium • The contract does not supply conditions sufficient enough to determine the

equilibrium solution• Then E. introduces additional competitors into the field until the limit case of

the perfect market is reached: here the contract is determined • Competition needs to be supplemented by arbitration • Arbitration between self-interested contractors is based upon the greatest

possible sum-total utility

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The controversy. Its meaning

• two different conceptions of the core of the theory of exchange: Walras’s competitive markets and Edgeworth’s fields of competition

• the controversy may be traced back to the issue of the role of abstract reasoning and the use of mathematics in economics, and ultimately to the two authors’s difference about what economics is

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART II. ECONOMICS IN THE AGE OF UNCERTAINTY, 1919-1939

INTRODUCTION

THE PERIOD BETWEEN THE TWO WORLD WARS

• World War I: the end of the “yesterday’s world” and its main institutions: gold standard and free markets

• Chief problems of European Governments:– Public Debt – Inflation– Unemployment

• Phases of economic growth– 1920s: crisis in Europe and rapid growth in the US– 1929: the Wall Street great crash– 1930-1937: world depression

66


INTRODUCTION


CENTRES OF ECONOMIC THEORY MEN, SCHOOLS, INSTITUTIONSEuropeCambridge, UK Pigou, Hawtrey, Keynes, Robertson, Kahn,

J. Robinson, Economic Journal

LSE, UK Robbins, Hayek, Hicks Economica (1921), Rev. of Ec. Studies (1933)

Vienna, Austria Mises, Hayek and the Neo-Austrians, Morgenstern, Zeitschrift fur Nationalokonomie (1921) Wiener Kries, Menger, Wald, vonNeumann

Kiel Institute, Germany Lowe, Marschak, Leontief, Neisser, Weltwirtschaftliches Archiv (1913)

North Europe Countries:Stockolm Cassel, Myrdal, Ohlin, Lindhal (The

Stockolm School) Oslo Frisch Rotterdam Tinbergen

Econometrica (1933)Torino, Italy, an important periphery Einaudi, Cabiati and Jannaccone

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INTRODUCTION


CENTRES OF ECONOMIC THEORY MEN, SCHOOLS, INSTITUTIONSUSAHarvard Young, Schumpeter, Leontief,

Hansen, Chamberlin, Samuelson, Quarterly Journal of Economics Rev. Economics & Statistics (1919)

Chicago The Walrasians (Lange, Schultz), Cowles Commission (1939) The Knight- Viner ‘Chicago School’ Journal of Political Economy

Columbia Mitchell and the Institutionalism, NBER

New School for Social Research, NY Lederer, the ex-Kiel Institute Yale FisherPrinceton von Neumann, Morgenstern

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INTRODUCTION

THE ECONOMIC THEORY OF THE PERIOD: DESTRUCTION AND RECONSTRUCTION

THEORY MEN AND SCHOOLA. MICROECONOMIC THEORY

Systematisation of Paretian consumer theory HicKs&Allen, LSE; Samuelson, MIT

General equilibrium- neo-walrasian model Schlesinger&Wald&von Neumann, Vienna- input-output analysis Leontief, Kiel- dynamic stability Samuelson, MITImperfect competition P. Sraffa, J. Robinson, CambridgeMonopolistic competition Chamberlin, HarvardIndustrial Organisation Mason, HarvardUncertainty and knowledge Hayek, LSEGame theory von Neumann and Morgenstern

69


INTRODUCTION


THEORY MEN AND SCHOOLB. MACROECONOMICS

Cycle Theories - Multiplier-accelerator model Harrod, Oxford; Samuelson, MIT - impulse-propagation business cycle Frisch, Oslo; Slutsky, URSS - quantitative studies on business cycle Mitchell, Columbia, NBER - structural theories of growth Lowe and the Kiel Institute - monetary overinvestment theories Hayek (Vienna,LSE), Hawtrey, Ca. - Keynesian theories Kalecki, Kaldor, LSE Money and Employment- Keynesian ‘revolution’ Keynes, Cambridge- Wicksellian macrodynamics Myrdal&Lindhal&Ohlin, Stockolm;

Robertson,Ca - Neo-classical synthesis Harrod, Ox.; Meade, Ca.; Lange, Ch.; Hicks, LSE

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INTRODUCTION


THEORY MEN AND SCHOOL

C. EMPIRICAL RESEARCH - empirical studies Mitchell, Kutznets and NBER - econometrics Frisch, Tinbergen and the Cowles CommissionD. METHODOLOGY

- Mill restated Mises, Vienna; Robbins, LSE- Logical positivism Vienna Circle- Axiomatisation program Menger Circle, Vienna- Marshallian tradition Keynes, Cambridge- Institutionalism Mitchell, Columbia

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART II. ECONOMICS IN THE AGE OF UNCERTAINTY, 1919-1939 THE COST CONTROVERSY IN THE 1920s

The protagonists Edgeworth Pigou Young Knight Robertson

Sraffa Robbins

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART II. ECONOMICS IN THE AGE OF UNCERTAINTY, 1919-1939 THE COST CONTROVERSY IN THE 1920s

PHASES OF THE CONTROVERSY

• The starting point: he “bewildering vagueness” of the term competition in Marshall (H. L. Moore, 1906)

• A discussion in three stages:1. external economies: a device to resolve the dilemma increasing-returns competition ? (Edgeworth, Pigou, Young)2. The criticism of Marshall in the Twenties in USA and UK. The pre-Sraffian phase: - Knight 1921-1925- The controversy on the ‘empty economic boxes’, 1922-‘24 3. The criticism of Marshall. Sraffa 1925-26

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART I. ECONOMICS IN THE AGE OF UNCERTAINTY, 1919-1939 THE COST CONTROVERSY IN THE 1920s

FIRST STAGE EXTERNAL ECONOMIES AS A SOLUTION OF COURNOT’S DILEMMA

• Edgeworth,1905: two key-points and an ingenious solution– The marginal cost is a function of a particular firm’s output and of the

aggregate industrial output: rising marginal cost curves for the individual firms would shift downwards with a rise in industrial output, leading to a falling long-term supply curve of the industry;

– the output of each producer is small in comparison with the collective output of all his competitors: the individual firm must be so small that the entrepreneur does not take into account the influence of his output on industrial output. He therefore acts as if his costs were rising (as a function of his output) when actually they may be falling

• Pigou (1912, 1920) adopted E’s treatment of external economies • Marshall (1914): Pigou overrated the possibilities of the statical

method • Allyn Young (1913): lack of practical relevance of Pigou’s theory

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KNIGTH’S CONTRIBUTION (1921-1925)The complete formulation of the concept of perfect competition

and the separation between statics and dynamicsWORKS

- Risk, Uncertainty and profit (1921)-‘Cost of production and price over long and short period’,JPE 1921

- Fallacies in the interpretation of social cost’, JPE 1924CRITICISM OF MARSHALL

– Marshall’s theory: old-fashioned, eclectic – Marshall adopted a cautious, almost anti-theoretical attitude

towards fundamentals – K. argues for a sharp separation between the static and the

dynamic problems – The Marshallian concept of external economies and I.R. fall within

the dynamic area – The assumptions of perfect competition: complete ‘rationality’;

‘perfect mobility in all economic adjustments’, no costs involved in movements or changes; ‘perfect, continuous, costless intercommunication between all individual members of the society’, free and independent individuals

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KNIGTH’S CONTRIBUTION (1921-1925)The formulation of the concept of perfect competition and the separation

between statics and dynamics

• The criticism of the idea of external economies– Under conditions of perfect competition the long-term supply

curve must have an increasing shape. In fact – decreasing cost as a long-run tendency is incompatible with long-

run competitive conditions – the Pigouvian idea of external economies is dismissed:

“I have never succeeded in picturing them in my mind, or finding any convincing reason to believe they exist” “the category of decreasing cost under stable competition remains an empty economic box”

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The controversy on the ‘empty economic boxes’, E. J. 1922-‘24

• J.C. Clapham, ‘Of empty economic boxes’ (1922) ‘[In]The Economic of Welfare … there is not even one illustration of what industries are in which boxes, though argument begins - ”when conditions of diminishing returns prevail” or “when conditions of increasing returns prevail”, as if everyone knew when that was.’

• Pigou (1922) :‘These boxes .. are not merely boxes; they are also elements in the intellectual machinery by which the main part of modern economic thought functions... These elements … cannot be singled out from the rest and condemned as useless; they are an organic and inseparable part of that machinery’

• Dennis H. Robertson (1924):‘So determined is the Professor to banish these old friends that, disturbed by the apparent theoretical incompatibility of pure competition with the prevalence of decreasing cost at all, he seems to hold that each firm is … working under conditions of i. c. while the industry as a whole is working under conditions of decreasing costs. I would prefer to offend the mathematical theory of competition than to follow him through this logical hole in his own logical net’

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Sraffa’s contribution, 1925-’26

1925: “Sulle relazioni tra costo e quantità prodotta”, Annali di economia1926: ”The law of returns under competitive conditions”, Economic Journal

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Sraffa’s contribution, 1925-’26First Step. The difficulties in classifying the various industries • They depend on the heterogeneousness of the laws of increasing and decreasing returns • Such heterogeneousness depends on the fact that those laws a) originate from different

parts of classic theoretical apparatus and b) are connected one, the law of decreasing returns, to changes in factor proportions, the other, the law of increasing returns, to changes in the scale of production

• The co-ordination of the two laws in a single law of variable costs in order to explain the value of competition – which emphasises the functional connection between cost and quantity produced - was a neo-classical operation. But in order to reach this result:‘It was found necessary to introduce certain modifications into the form of the two laws. Very little was necessary as regards the law of diminishing returns, which merely required to be generalised from the particular case of land to every case in which there existed a factor of production of which only a constant quantity was available. The law of increasing returns, however, has to be subjected to a much more radical transformation: the part played in it by the division of labour – now limited to the case of independent subsidiary factories coming into existence as the production of an industry increases – was greatly restricted; while consideration of that greater internal division of labour, which is rendered possible by an increase in the dimensions of an individual firm, was entirely abandoned, as it was seen to be incompatible with competitive conditions. On the other hand, the importance of ‘external economies’ was more and more emphasised – that is, of the advantage derived by individual producers from the growth, not of their own individual undertakings, but of the industry in its aggregate.’

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Sraffa’s contribution, 1925-’26Second step. The analytical difficulties of Marshallian theory

‘The really serious difficulties make their appearance when it is considered to what extent the supply curves based on the laws of returns satisfy the conditions necessary to enable them to be employed in the study of equilibrium value of single commodities produced under competitive conditions’

• the punctum dolens: the decreasing supply curve. He assumes Knight’s criticism of Pigouvian external economies

• To explain increasing returns by external economies, external to the individual firm but internal to the industry is a way of escaping from this difficulty and constructing an industry decreasing supply curve ‘perfectly correct, at least from the formal point of view’, but:‘Those economies which are external from the point of view of the individual firm, but internal as regards the industry in its aggregate, constitute precisely the class which is most seldom to be met with … In any case, in so far as external economies of the kind in question exist, they are not likely to be called forth by small increases in production.’

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Sraffa’s contribution, 1925-’26

In general:• “the supply schedule with variable costs cannot claim to be a

general conception applicable to normal industries; it can prove a useful instrument only in regard to such exceptional industries as can reasonably satisfy its conditions”

• “There are strong reasons .. for saying that, in a static system of perfect competition, in the determination of the particular equilibria of commodities, not proportional cost curves cannot be traced, if not in exceptional cases, without introducing hypotheses which are contrary to the nature of the system”

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Sraffa’s contribution, 1925-’26Viable research directions • As a first approximation, the Ricardian constant cost hypothesis,

according to which the cost of production of commodities produced competitively ‘must be regarded as constant in respect of small variations in the quantity produced’

• ‘Of course in reality the connection between cost and quantity produced is obvious’ but ‘simply cannot be considered by means of the system of particular equilibria for single commodities in a regime of competition devised by Marshall’. The routes available were a) the simultaneous equilibrium of all industries (Pareto’s point of view), b) the abandon of assumption of perfect competition. According to Sraffa the Paretian conception was not fruitful because of its complexity (a judgement shared with many Italian economists, Pantaleoni for example), therefore Cournot’s route seemed to be the only viable research direction: it is a further approximation, which permits consideration of the increasing returns case

82


Robbins’ attack of the representative firm, 1928

• The Representative Firm is essentially a long-period conception without statistical significance neither practical usefulness

• The representative firm is not a necessary tool: ‘There is no more need for us to assume a representative firm or representative producer, than there is for us to assume a representative piece of land, a representative machine, a representative worker. All that is necessary for equilibrium to prevail is that each factor shall get at least as much in one line of production as it could get in any other’

• The representative firm is unessential to the hypothesis of static equilibrium, which Marshall rejected because of ‘his curious predilection for biological analogies’ or ‘for fear of becoming unintelligible to business men and economic historians’

• The representative firm is a very poor tool in order to examine the problems of change and development. In a note, he refers to the contemporary research program of Allyn Young

• He questions the existence of external economies referring to the criticisms of Young and Knight to the external economies

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The Marshallian defence: Pigou, Robertson and Shove, 1927-1930

• Pigou’s definite statement of the theory of competitive supply, 1927-’28• Robertson defence, 1930 “We seem to agree that the [Marshall’s] theory cannot be interpreted in a way

which makes it logically self-consistent and, at the same time, reconciles it with the facts it sets out to explain. Mr. Robertson’s remedy is to discard mathematics, and he suggests that my remedy is to discard the facts; perhaps I ought to have explained that, in the circumstances, I think it is Marshall’s theory that should be discarded’”

• Shove’s contribution, 1930 The firm’s costs are not a function of only two variables (firm’s and industry’s output), but three (… and time). The Marshallian life cycle of the firm explains the coexistence of a large number of firms. He proposes an analysis of dynamic equilibrium[Newman & Wolfe 1961, the distribution of firm size as the result of a process of chance, employing the technique of non-homogeneous Markov chains]

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Young , 1928, and Schumpeter, 1928: the return to the classics’ dynamics

• the partial equilibrium apparatus which economists have built up for dealing with the range of questions raised by the phenomena of increasing returns permits examination only of some aspects of it

• ‘No analysis of the forces making for economic equilibrium … will serve to illuminate this field, for movements away from equilibrium, departures from previous trends’

• Smith’s theorem ‘the division of labour depends upon the extent of the market’

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART I. ECONOMICS IN THE AGE OF UNCERTAINTY, 1919-1939

ECONOMICS, MATHEMATICS AND PHILOSOPHY IN VIENNA

The protagonists Mises Hayek Schlick Neurath

Carnap

Menger Wald v.Neumann

86


ECONOMICS, MATHEMATICS AND PHILOSOPHY IN VIENNA(Based on: G. Becchio and R. Marchionatti, “Economic Theory, Philosophy and Mathematics. A

reconstruction of the viennese debate in the Wiener Kreis and in the MathematischeKolloquium, 1922-38”)

Between the Wars a great debate on the economic theory took place in Vienna:

• in Hans Mayer’s and Ludwig von Mises’s seminars where the Austrian school tradition was being continued

• in two other circles: – the Wiener Kreis, created at the beginning of the 1920s

by the physicist and philosopher of science Moritz Schlick, where neo-positivism was founded

– the Mathematische Kolloquium run by the mathematician Karl Menger

87



WIENER KREIS AND MATHEMATISCHE KOLLOQUIUM. A HISTORICAL OUTLINE

1922. The Kreis comes into existence. It is a philosophical circle gathered weekly around Moritz Schlick. Members of the circle: the mathematicians Hans Hahn and Kurt Reidemeister, the social scientist Otto Neurath, the philosopher Rudolph Carnap, the mathematician and philosopher Friedrich Waismann

1929. Wissenschaftliche Weltauffassung: Der Wiener Kreis (A scientific world-view. The Vienna Circle)

From 1934 on. Emigration. The project of The International Encyclopaedia of Unified Science

88



WIENER KREIS AND MATHEMATISCHE KOLLOQUIUM. A HISTORICAL OUTLINE

1928. The mathematician Karl Menger -- the son of the economist Carl Menger - founds the Mathematische Kolloquium “Studies on the recent development of geometry and logics as well as studies concerning the new applications of exact sciences to problems of sociological character were carried out … for example on the existence and uniqueness of solutions for the production equations in mathematical economics”

• Some economists and mathematicians dealt with economics: Karl Menger, Karl Schlesinger, Abraham Wald and John von Neumann

• The axiomatization of the Walrasian general economic equilibrium• Mid 1930s the great Viennese culture began to fade: “it resembled a bed

of delicate flowers to which its owner refused soil and light while a fiendish neighbour was waiting for a chance to ruin the entire garden”

• 1938: Nazi occupation

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The logical positivism of the Wiener Kries

• The true task of philosophy is to analyze statements with the aim of making such propositions clear and unambiguous

• Use of logical analysis for the clarification of problems:“we have characterized the scientific world-conception essentially by two features. first it is empiricist and positivist: there is knowledge only from experience, which rest on what is immediately given. this sets the limits for the context of legitimate science. second, the scientific world-conception is marked by the application of a certain method, namely logical analysis. the aim of scientific effort is to reach the goal, unified science, by applying logical analysis to the empirical material” (H. Hahn, O.Neurath and R.Carnap, Der Wiener Kries)

90



The logical positivism of the Wiener Kries• Only meaningful statements have scientific status• Meaningfulness is defined as being attributable to two types of

statement:– analytical statements - that can be evaluated using the rules of logic – synthetic statements, i.e. factual statements, verifiable by empirical

evidence “the consistent empiricist does not deny the transcendent world, but shows that both its denial and affirmation are meaningless … the empiricist does not say to the metaphysician ‘what you say is false’, but ‘what you say asserts nothing at all!’. he does not contradict him, but says ‘i don’t understand you’” (M. Schlick)

• Verifiability implies testability: a proposition is meaningful only to the extent that it may be subjected to empirical test

91



ECONOMICS IN THE WIENER KRIES• Manifesto

Economics is placed among the five branches of science that “must conduct an epistemological examination of its foundations, a logical analysis of its concepts”. A program of “purification” of metaphysical residuals, an anti-metaphysical attitude

• Encyclopaedia Economics is defined a social science. According to Neurath it is a part of the sociology founded on relatively constant quantitative relations expressed in the universal language of empiricism, i.e. physicalism

• Wiener Kries and Econometric SocietyThe aim of unifying theoretical rigour and empirical analysis found its achievement in the program of the Econometric Society, whose founders were strongly influenced by the logical empiricismRobert Gibrat (1936) at the Paris Conference in 1935:

– the use of mathematical language has become unavoidable in the making of economic theory because the ordinary language is inadequate

– He proposes to employ econometrics. Econometrics “has to be defined as a way of treating economic problems, not an a priori demarcation of its field”.

– He associates Kries’s program with the recently born econometric movement.

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Ragnar Frisch, founder of Econometrica

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The Econometric Society, 1930 and Econometrica 1933

• Econometrics = the unification of statistics, economic theory and mathematics

• Econometrica, the official journal of the Econometric Society• First editorial: The object of the journal presented by R. Frisch:

– “[The main object] shall be to promote studies that aim at a unification of the theoretical-quantitative and the empirical-quantitative approach to economic problems and that are penetrated by constructive and rigorous thinking similar to that which has come to dominate in the natural sciences”

– “Thus mutual penetration of quantitative economic theory and statistical observation is the essence of econometrics. And therein lies the need for mathematics, both in formulation of the principles of economic theory, and in technique of handling the statistical data. Mathematics is certainly not a magic procedure which in itself can solve the riddles of modern economic life, as is believed by some enthusiasts. But, when combined with a thorough understanding of the economic significance of the phenomena, it is an extremely helpful tool”

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ECONOMICS AS A MATHEMATICAL SCIENCE IN THE MATHEMATISCHE KOLLOQUIUM

• In in Walrasian and Paretian schools the key problem was the correspondence between the theoretical model and the empirical reality, whereas the mathematical side of the model was considered in a large extent completed and the analytical problems essentially solved.

• The mathematical dimension becomes central in the Mathematische Kolloquium • 1935. Karl Schlesinger first took on the issue of the existence of economically

meaningful (positive) solutions in the Walrasian model. The model considered by Schlesinger was the so-called Walras-Cassel system, based on Gustav Cassel’s simplified reformulation of the Walrasian general economic equilibrium (1918).Schlesinger reformulated Cassel’s system in terms of inequalities, but without going on in its mathematical solution

• 1935-36. Abraham Wald demonstrates the existence of an equilibrium for the Walras-Cassel system

• John Von Neumann publishes his 1932 paper on general economic equilibrium dynamics read to the Princeton Mathematical Society in the Ergebnisse. It was published in the 1935-36 volume edited by Menger and Wald

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Towards the mathematization of economics: Karl Menger on mathematical economics

Menger (1936) shared Hilbert’s formalism. He builds a meta-mathematical model applicable to economics. The meaning of meta-mathematical model is the following:

• “Following a suggestion of Hilbert, modern logicians refer to the study of the logical relations between the statements of a theory as the corresponding meta-theory”

• “from the point of view of methodology”, Menger’s writing represents “the first instance in economics of a clear separation between the question of logical interrelations among various propositions and the question of empirical validity”. This was the key point needed in order to transform economics into a science

• This “clear separation” between the question of logic and the question of empirical validity, is at the basis of Wald’s work and of the programme of new mathematization of Walrasian general economic equilibrium theory

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Wald’s and von Neumann’s mathematical economics: the formalist perspective Abraham Wald’s contribution: between tradition and innovation

• “mathematical economics” is “a new method” • “mathematics has already became an indispensable tool for many subtle

investigations of various areas of economic phenomena” • Unfortunately “sins have been committed in mathematical economics”:

unawareness of the assumptions and their implications, of their realism and their condition of validity: “They have their origin in inappropriate, even erroneous, applications of mathematics”

• For a “fruitful application of mathematics in economics” it was essential that all the assumptions “be enumerated completely and precisely”

• “if these directions are strictly adhered to”, then “the only objection which can be raised against a theory is that it includes assumptions which are foreign to the real world and that, as a result, the theory lacks applicability”

• The analytical questions: existence and uniqueness of equilibrium: “the equality of the number of equations and unknowns does not prove that a solution exists, much less the uniqueness of a solution”

• Wald shows the existence of solutions under a set of hypotheses

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Wald’s and von Neumann’s mathematical economics: the formalist perspective Beyond tradition: John von Neumann’s 1937 contribution

The intellectual origins of the model:a) the Viennese discussion on the Walras-Cassel model b) the Berlin debate in Bortkievicz’s circle. Von Neumann adopted a

representation of the economy as a circular process of production of classical (neo-ricardian) type (Remak)

Von Neumann’s method of analysis • It did not use differential techniques but used topological techniques for the

first time in economics • The demonstrative technique transformed the problem of determining an

equilibrium into a minimax problem: “The solution of the system of equations is possible only by means of a generalization of Brouwer’s Fixed-Point Theorem”

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Wald’s and von Neumann’s mathematical economics: the formalist perspective Beyond tradition: John von Neumann’s 1937 contribution

The axiomatic approach in economics• It is applied in a totally coherent way, in the sense that the concern for the

economic interpretation of the model disappears:“In order to be able to discuss [the properties of the economic system] quite freely we shall idealize other elements of the situation …”

• This theoretical attitude derived: – firstly, from the fact that von Neumann dealt with the economic question

“as a mathematician” . In this way he obtained a mathematical solution of a “highly generalised problem in theoretical economics”, that it characterized by elegance, logical completeness, concision and rigor, but adopts “extremely artificial assumptions” or “idealisations”

– secondly, von Neumann’s attitude derives from the fact that he dealt with theoretical economic problems like a formalist mathematician -- i.e. he conceived the model as a formal structure whose legitimacy and cogency depend on its internal consistency

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ON THE RELATIONSHIP BETWEEN WIENER KRIES AND MATHEMATISCHE KOLLOQUIUM Continuity and discontinuity between the Wiener Kries and the Mathematische Kolloquium

• the Kolloquium was influenced by the Kreis reaction against metaphysics• However, a fundamental epistemological break took place between the two

circles: – Kries’s members adopted Russell’s logicism and the inductive-experimental

approach to reality taken by physics – Kolloquium’s members adhered to Hilbert’s mathematical formalism and

adopted a deductive, highly formalized, and axiomatic method– Moreover, the mathematicians of the Kolloquium refuted Kreis’s physicalism and

tended to reduce the importance of the verificationist paradigm• The disagreement between the Wiener Kries and the Mathematische

Kolloquium may be trace back to the old classical disagreement between Léon Walras and Vilfredo Pareto on the nature and method of political economy

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THE METHODOLOGICAL DEBATE IN THE 1930S

L.ROBBINS, ESSAY ON THE NATURE AND SIGNIFICANCE OF ECONOMIC SCIENCE (1935)

• A restatement of the Mill-Cairnes position, influenced by Mises • It generalizes the apparatus of economics in order to deal with non-material

welfare, as well as material:‘Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”

• “The generalizations of economics”: neither historical experience nor controlled experiment provides us with grounds for asserting the general propositions of economics. They are deductions from a series of postulates, or universally acknowledged facts of experience.

• Economics “can never be completely assimilated to the procedure of the physical science”

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JOHN M. KEYNES (1883-1946)

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JOHN M. KEYNES (1883-1946)LIFEEducated at Eton and King’s College, Cambridge1906 –8 - Civil Servant, UK India Office1908 -42 – Teacher in economics, University of Cambridge1911 – Editor of the Economic Journal1915-1918 – UK Treasury 1918 - member of the British delegation to the Versailles Peace ConferenceSecond World War II – UK Treasury1944 – Head of the British delegation to the international conference in Bretton Woods

WORKS1913 - Indian Currency1919 – The Economic Consequences of the Peace 1921 – The Treatise on Probability1923 – Tract on Monetary Reform1930 – The Treatise on Money 1931 - Essays in Persuasion1936 - The General Theory of Employment, Interest and Money 1940 - How to Pay for the War

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JOHN M. KEYNES (1883-1946)Keynes on Marshall, 1924

“The study of economics does not seems require any specialised gifts of an usually high order. It is not, intellectually regarded, a very easy subject compared with the higher branches of philosophy and pure science ? Yet good, or even competent, economists are the rarest of birds. An easy subject, at which very few excel ! The paradox finds its explanation, perhaps, in that the master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher – in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in the light of the past for the purposes of the future. No part of man’s nature or his institutions must lie entirely outside his regards. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician. Much … of this ideal many-sidedness Marshall possessed. But chiefly his mixed training and divided nature furnished him with the most essential and fundamental of the economist’s necessary gifts – he was conspicuously historian and mathematician, a dealer in particular and the general, the temporal and the eternal, at the same time”

Marshall understood that the economic interpretation of the “complex and incompletely known facts of experience” requires to go beyond the “bare bones of economic theory”. Marshall was able to amalgamate “logic and intuition and wide knowledge of facts, most of which are not precise”. This “is required for economic interpretation in its highest form”

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JOHN M. KEYNES (1883-1946) ON THE NATURE AND METHOD OF ECONOMICS

• “Economics is essentially a moral science (i.e. human science) and not a natural science”

• “Economics is a science of thinking in terms of models joined to the art of choosing models which are relevant to the contemporary world. It is compelled to be this, because, unlike the typical natural science, the material to which it is applied is, in too many respects, not homogeneous through time”

• “Economics … employs introspection and judgements of value” • “[Economics] deals with motives, expectations, psychological

uncertainties. One has to be constantly on guard against treating the material as constant and homogeneous”

• Due to the nature of economic material, “a generalisation to cover everything is impossible and impracticable"

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JOHN M. KEYNES (1883-1946)ON THE NATURE AND METHOD OF ECONOMICS

• “Generalising in economics is thinking by sample, not by generalisation” • As a consequence economics’s way of exposition is quasi-formal:

“When we write economic theory we write in a quasi-formal style; and there can be no doubt, in spite of these disadvantages, that this is our best available means of conveying our thoughts to one another. But when an economist writes in a quasi-formal style, he is composing neither a document verbally complete and exact .. nor a logically complete proof. Whilst it is his duty to make his premises and his use of terms as clear as he can, he never states all his premises and his definitions are not perfectly clear-cut. He never mentions all the qualifications necessary to his conclusions. He has no means of stating, once and for all, the precise level of abstraction on which he is moving, and he does not move on the same level all the time. It is, I think, of the essential nature of economic exposition that it gives, not a complete statement, which, even if it were possible, would be prolix and complicated, to the point of obscurity, but a sample statement, so to speak, out of all the things which could be said, intended to suggest to the reader the whole bundle of associated ideas”

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• If “we cannot hope to make completely accurate generalisations”, the right language for the construction of the model is ordinary language:

• in ordinary discourse, … we are not blindly manipulating but know all the time what we are doing and what the words mean …”

• Ordinary language seems to be more efficient in handling the complexity of the economy. The essential consequence of this argument is that economic thinking cannot be reduced simply to “blind manipulation”:

• “The object of our analysis is, not to provide a machine, or method of blind manipulation, which will furnish an infallible answer, but to provide ourselves with an organised and orderly method of thinking out particular problems; and, after we have reached a provisional conclusion by isolating the complicating factors one by one, we then have to go back on ourselves and allow, as well as we can, for the probable interactions of the factors among themselves. This is the nature of economic thinking”

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• The construction of the relevant model is the key problem • The adequacy of the model depends on the ability to select the relevant

factors, “the factors whose changes mainly determine our quaesitum” • The decision which part of concrete reality to incorporate into a

model is termed by Keynes ‘judgement of value’. This also makes economics an art because the construction of the relevant model needs the art of ‘introspection’ in order to study psychic processes, and judgements of value

• The model is the result of a continuous correction of judgement. The selection of the relevant factors which constitute the model begins with the analysis of facts and facts are what economists must continuously refer to

• “The specialist in the manufacture of models will not be successful unless he is constantly correcting his judgement by intimate and messy acquaintance with the facts to which his model has to be applied”

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Conclusions• K. emphasises the characteristics of economic material, which makes

economics a moral science and a science of thinking in terms of models• This forces the economist to use introspection and judgement of value

constantly corrected by “intimate and messy acquaintance with the facts”

• The economist is often force to write in a quasi-formal style• This methodological strategy of research has its core in the logical

question: is it correct to apply a certain method to a certain specific problem ? This is the opposite of the method of blind manipulation

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The economics of Keynes:The General Theory

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General Theory

“This book is chiefly addressed to my fellow economists. I hope that it will be intelligible to others. But its main purpose is to deal with difficult questions of theory, and only in the second place with the application of this theory to practice … An attempt by an economist to bring to an issue the deep divergences of opinion between fellow economists which have for the time being almost destroyed the practical influence of economic theory … A more general theory, which includes the classical theory with which we are familiar, as a special case … The composition of this book has been for the author a long struggle to escape from habitual models of thought and expression … The difficulty lies, not in the new ideas, but in escaping from the old ones, which ramify … into every corner of our minds”

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JOHN M. KEYNES (1883-1946)The economics of Keynes:The General TheoryThe“habitual models of thought and expression”. The classical

economic analysisThe classical economic analysis: • is concerned “with long-period equilibrium”• assumes that “the amount of the factors employed was given

and the other relevant facts were known more or less for certain”

• assumes that “at any given time facts and expectations were … given in a definite and calculable form … The calculus of probability … was supposed to be capable of reducing uncertainty to the same calculable status as that of certainty itself”

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The economics of Keynes:The General Theory

The contents• Book I.Introduction• Book III.The Propensity to Consume• Book IV.The Inducement to Invest• Book V. Money-Wages and Prices• Book VI. Short Notes Suggested by the General

Theory

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General Theory

Book I. Introduction“I have called this book the General Theory of Employment, Interest and Money, placing the emphasis on the prefix general. The object of this title is to contrast the character of my arguments with those of the classical theory of the subject … which dominates the economic thought, both practical and theoretical, of the governing and academic classes of this generation… The postulates of the classical theory are applicable to a special case only and not to the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium”

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook I.IntroductionThe criticism of the classical postulates• The postulates of the classical economics determine the amount of employment

at the point of full employment. They are compatible with frictional and voluntary employment. But:– “Ordinary experience tells us … that a situation where labour stipulates for a

money wage … is the normal case”– “The contention that the unemployment which characterises a depression is

due to a refusal by labour to accept a reduction of money-wages is not clearly supported by the facts”

• If the wage bargain does not determine the real wage, then “there is no longer any reason to expect a tendency towards equality between the real wage and the marginal disutility of labour”

• Keynes introduces a third category of unemployment, namely involuntary unemployment“If the classical theory is only applicable to the case of full employment, it is fallacious to apply it to the problems of involuntary unemployment - if there be such a thing (and who will deny it ?)”

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The economics of Keynes: The General TheoryBook I.IntroductionThe criticism of Say’s Law

“From the time of Say and Ricardo the classical economists have taught that supply creates its own demand … As a corollary of the same doctrine, it has been supposed that any individual act of abstaining from consumption necessarily leads to … causing the labour and commodities … to be invested in the production of capital wealth … Those who think in this way are deceived, nevertheless, by an optical illusion, which makes two essentially different activities appear to be the same. They are fallaciously supposing that there is a nexus which unites decision to abstain from present consumption with decision to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former”

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The economics of Keynes: The General TheoryBook I.IntroductionThe principle of effective demand

• The aggregate supply function Z = (N) where Z = the aggregate supply price of the output from employing N men

• The aggregate demand functionD = f (N) where D = the proceeds which entrepreneurs expect to receive from the employment of N men “If for a given value of N the expected proceeds are greater that the aggregate supply price, i.e. if D is greater than Z, there will be an incentive to entrepreneur to increase employment beyond N … up to the value of N for which Z has become equal to D ... Thus the volume of employment is given by the point of intersection between the aggregate demand function and the aggregate supply function; for it is at this point that the entrepreneurs’ expectation of profit will be maximised. The value of D at the point of the aggregate demand function, where it is intersected by the aggregate supply function, will be called the effective demand”

• Note that, according to the classical doctrine, the “Supply creates its own Demand”, that is (N) and f (N) are equal for all values of N, i.e. for all levels of output and employment. Instead, effective demand “is an infinite range of values all equally admissible”

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The economics of Keynes: The General TheoryBook I. IntroductionThe essence of the General Theory

• The amount of labour N which the entrepreneurs decide to employ depends on the sum (D) of two quantities, namely the amount which the community is expected to spend on consumption, and the amount which is expected to devote to new investment. D is the effective demand

• Hence the volume of employment in equilibrium depends on 1) the aggregate supply function, 2) the propensity to consume, and 3) the volume of investment. This is the essence of the General Theory of Employment. “The volume of employment is not determined by the marginal disutility of labour … The propensity to consume and the rate of new investment determine between them the volume of employment, and the volume of employment is uniquely related to a given level of real wages – not the other way round. If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available at the existing real wage ”

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The economics of Keynes: The General TheoryBook IV. The inducement to investCharter 11. The marginal efficiency of capital • “I define the marginal efficiency of capital as being equal to that rate of discount

which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price”

• The marginal efficiency of capital is defined in terms of prospective yield, i.e. income expectation. It depends on the prospective yield of capital, and not merely on its current yield”

• “The schedule of the marginal efficiency of capital is of fundamental importance because it is mainly through this factor (much more than through the rate of interest) that the expectation of the future influences the present. The mistake of regarding the marginal efficiency of capital primarily in terms of the current yield of capital equipment, which would be correct only in the static state where there is no changing future to influence the present, has had the result of breaking the theoretical link between to-day and to-morrow … The fact that the assumptions of the static state often underlie present-day economic theory, imports into it a large element of unreality”

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The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 12. The state of long-term expectations, 1The state of long-term expectation depends on: • The most probable forecast we can make • The confidence with which we make this forecast – on “how highly we

rate the likelihood of our best forecast turning out quite wrong” • “The state of confidence, as they term it, is a matter to which practical

men always pay the closet and most anxious attention … The state of confidence is relevant because it is one of the major factors determining [the schedule of the marginal efficiency of capital]”

• “There is … not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology”

• The state of confidence depends on knowledge • “The outstanding fact is the extreme precariousness of the basis of

knowledge on which our estimates of perspective yields have to be made”

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 12. The state of long-term expectations, 3• How to get around the informative and cognitive shortage, so permit

investment activity?• In his answer K. considers two phases of capitalism:• Under old-fashioned capitalism. “In former times, when enterprises

were mainly owned by those who undertook them or by their friends and associates, investment depended on a sufficient supply of individuals of sanguine temperament and constructive impulses who embarked on business as a way of life, non really relying on a precise calculation of prospective profit”

• Under mature capitalism. With the development of organised investment markets “certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange at an immediate profit … rather than by the genuine expectations of the professional entrepreneur”

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The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 12. The state of long-term expectations, 4• “How then are these highly significant daily, even hourly, revaluations of existing

investments carried out in practice ?”• “In practice we have tacitly agreed, as a rule, to fall back on what is… a convention. The

essence of this convention … lies in assuming that the existing state of affaire will continue indefinitely, except in so far we have specific reasons to expect a change”

• This convention gives stability in affairs, but it is arbitrary and consequently precarious• Factors which accentuate this precariousness:

– Owners’ ignorance of the business in question– Excessive influence on the market of the day-to-day fluctuations in the profits of

existing investments– Dependance on sudden fluctuation of opinion, in abnormal times in particular: the

market will be subject to waves of optimistic and pessimistic sentiment – Behaviour of professionals: ‘To beat the gun’. “Most of these persons are … largely

concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public”

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 12. The state of long-term expectations, 5

Keynes’s conception of business activity• Business activity is a mix of enterprise, stock market evaluations and

speculation• Enterprise is based, as far as possible, on reasonable calculation,

supplemented by spontaneous optimism and “animal spirits”“Animal spirits .. A spontaneous urge to action rather than inaction”

• Investor activity is fundamentally guided by conventional judgement• Thus, comprehensively, business behaviour is a mix of reasonable

calculation, conventional judgement and animal spirits

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to invest

Chapter 13. The general theory of the rate of interestWhat determines the rate of interest ?• “The psychological time-preferences of an individual require two distinct sets of decisions

to carry them out completely” • “The first is concerned with … the propensity to consume, which, … determines for each

individual how much of his income he will consume and how much he will reserve in some form of command over future consumption”

• “But this decision having being made, there is a further decision which awaits him, namely, in what form he will hold the command over future consumption which he has reserved … Does he want to hold it in the form of immediate, liquid command ? Or is he prepared to part with immediate command for a specified or indefinite period ? … In other words, what is the degree of his liquidity-preference ?”

• “The mistake in the accepted theories of the rate of interest lies in their attempting too derive the rate of interest from the first of these two constituents of psychological time-preference to the neglect of the second”

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 13. The general theory of the rate of interest

What is the rate of interest ?“The rate of interest cannot be a return to saving or waiting as such. For if a man hoards his savings in cash, he earns no interest, though he saves just as much as before … The rate of interest is the reward for parting this liquidity for a specified period … Thus the rate of interest at any time, being the reward for parting with liquidity, is a measure of the unwillingness of those who possess money to part with their liquidity control over it . The rate of interest is not the price which brings into equilibrium the demand for resources to invest with the readiness to abstain from present consumption. It is the price which equilibrates the desire to hold wealth in the form of cash with the available quantity of cash… Liquidity-preference is a potentiality … which fixes the quantity of money which the public will hold when the rate of interest is given … L = L(r)”

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The economics of Keynes: The General TheoryBook IV. The inducement to investChapter 13. The general theory of the rate of interest

“Why such a thing as liquidity-preference exists”• “Given that the rate of interest is never negative, why should anyone

prefer to hold his wealth in a form which yields little or no interest to holding it in a form which yields interest ?"

• The “necessary condition is the existence of uncertainty as to the future of the rate of interest” (“risk of a loss being incurred in purchasing a long-term debt and subsequently turning it into cash, as compared with holding cash”)

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The economics of Keynes: The General Theory“The General Theory of Employment”, QJE 1937 “we have … only the vaguest idea of any but the most direct consequences of

our acts … Our knowledge of the future is fluctuating, vague and uncertain … [This] renders [the accumulation of Wealth] a peculiarly unsuitable subject for the methods of the classical economic theory”

“I accuse the classical economic theory of being itself one of these pretty, polite techniques which tries to deal with the present by abstracting from the fact that we know very little about the future … This is particularly the case in his treatment of money”

“Our desire to hold money as a store of wealth is a barometer of our distrust of our own calculations and conventions concerning the future”

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to investCHAPTER 18. THE GENERAL THEORY OF EMPLOYMENT RE-

STATEDGiven elements: • The existing skill and quantity of available labour, the existing

quality and quantity of available equipment, the existing technique, the degree of competition, the tastes and habits of the consumer, the social structure

Independent variables:• The propensity to consume, the schedule of the marginal efficiency

of capital, the rate of interestDependent variables:• THE VOLUME OF EMPLOYMENT and THE NATIONAL

INCOME

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CHAPTER 18. THE GENERAL THEORY OF EMPLOYMENT RE-STATED, 2

“The division of the determinants of the economic system into the two groups of given factors and independent variables is … quite arbitrary … The division must be made entirely on the basis of experience, so as to correspond on the one hand to the factors in which the changes seem to be slow or so little relevant as to have only a small and comparatively negligible short-term influence on our quaesitum; and on the other hand, to those factors in which the changes are found in practice to exercise a dominant influence on our quaesitum"

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JOHN M. KEYNES (1883-1946)The economics of Keynes: The General TheoryBook IV. The inducement to investCHAPTER 18. THE GENERAL THEORY OF EMPLOYMENT RE-

STATED, 3

• The rate of new investment is pushed to the point where the marginal efficiency of capital approximates the rate of interest

• “That is to say, the physical conditions of supply in the capital-goods industries, the state of confidence concerning the perspective yield, the psychological attitude to liquidity and the quantity of money .. Determine … the rate of new investment"

• “An increase in the rate of investment will have to carry with it an increase in the rate of consumption … The ratio … between an increment of investment and the corresponding increment of aggregate income … id given by the investment multiplier … We infer the increment of the employment …”

• “repercussions …”

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CHAPTER 18. THE GENERAL THEORY OF EMPLOYMENT RE-STATED, 4

“Thus the position of equilibrium will be influenced by these repercussions; and there are other repercussions also … Hence the extreme complexity of the actual course of events. Nevertheless these seem to be the factors which it is useful and convenient to isolate. If we examine any actual problem along the lines of the above schematism, we shall find it more manageable; and our practical intuition … will be offered a less intractable material upon which to work”

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THE KEYNES-TINBERGEN CONTROVERSY ON ECONOMETRIC METHOD

(in collaboration with Giovanna Garrone)

The protagonists

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Jan Tinbergen (1903-1994)1936-38: League of Nations Secretariat

Statistical Testing of Business-Cycle Theories (1939)Vol.1: A Method and its Application to Investment Activity

The method of econometric study as a synthesis of statistical business cycle research and quantitative economic theory

• multiple correlation analysis applied to business cycle theory translated into a a parametrised mathematical-economic model (dynamic form)

• application to 3 case studies

- innovative testing procedures- aimed at providing forecasts and guide policies

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Keynes’s harsh critique: • triggers a lively debate (1939-1943)• compounds methodological questions, technical remarks and a few

misunderstandings• assessment still controversial

- 1940s-1970s: “a priori antieconometrician”- since 1970s: increasing recognition of relevance

Stages of the debate:• August-September 1938: exchange of letters (with T., Tyler, Harrod,

Kahn, Loveday)• September 1939: Keynes’s review • March 1940: Tinbergen’s reply

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Keynes’s Criticism“Professor Tinbergen’s Method”, EJ, 1939

“This brand of statistical alchemy is [not] ripe to become a branch of science”

1. The question of methodology:“The logic of applying the method of multiple correlation to unanalysed economic material, which we know to be non-homogeneous through time” “…I would urge that the next instalment should be primarily devoted to the logical problem, explaining fully and carefully the conditions which the economic material must satisfy if the application of method to it is to be fruitful”

2. Specific issues: the conditions of validity 2.1. Completeness of significant factors:otherwise “the method is not able to discover the relative quantitative importance [of the included ones]”

2.2. Measurability of all significant factors“It withdraws from the operation of the method all those economic problems where political, social and psychological factors, including such things as government policy, the progress of invention and the state of expectation, may be significant.”

2.3. Independence of factors, simultaneity, and ‘spurious correlations’

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Keynes’s Criticism“Professor Tinbergen’s Method”, EJ, 1939

2.4. Choice of the functional formKeynes criticizes the assumption of linear relations, and points out that the uniqueness of the result depends on the choice of the forrn.

2.5. Time-lags and trends Problems of data manipulation: “with a free hand to chose coefficients and time lags, one can always [cook] a formula to fit moderately well a limited range of past facts. But what does it prove?”

3. The question of structural instability and inductive generalisation“How far are these curves and equations meant to be no more than a piece of historical curve-fitting and description, and how har do they make inductive claims with reference to the future as well as to the past?”

“[For inductive geenralisation] the most important condition is that the environment in all relevant respects, other than the fluctuations in those factors of which e take particular account, should be uniform and homogeneous over a period of time”

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Tinbergen’s Reply, EJ, 1940“The proof of the pudding is in the eating”

1. “It is difficult to meet Keynes’ remarks on methodology in general”

2. Technical questions2.1. A correct specification is subject to statistical testing. 2.2. Expectations are product of human mind: are based on past experience; are hidden in some systematic variables; may be influenced by external events: part of unexplained residuals.2.3. Independence of the explanatory variables: for statistical purposes they only need to be uncorrelated2.4. Stability of the coefficients: assumed as a first approximation2.5. Lags and trends: “they are sometimes assumed by common sense guessing”

3. Inductive generalisation and structural changeInductive generalisation is possible in the absence of structural changes, but “even if structural changes take place, it will, in many cases, be possible to localise their influence”

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An Appendix to the Debate: Review of Tinbergen’s Vol. II (Business Cycles in The USA, 1919-32)by Erwin Rothbarth

(German economist working closely with Keynes in Cambridge)

• Previous review of Tinbergen (1937), on Dutch economy: the case for econometrics is “unassailable”, but caution as to how far it can go

• “Brilliant pioneering effort”, in spite of failure to explain trade cycle in the USA:– findings do not allow to decide between alternative interpretations – results not conclusive: poor statistics and behaviours not constant in time– potential importance of immeasurable factors– neglect of collinearity and degrees of freedom

• Exhortation to use smaller models• Greater weight to be placed on the investigation of the economic material prior

to manipulation • Non-homogeneity

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The Econometricians and Keynes, 1939-1943. From Reconciliation to Rejection.Exchange with Szeliski, 1939.

• Szeliski and Roos’s study on the determinants of the demand for automobiles, reviewed by Willford I. King:

– suitability of data and neglect of the movement of the supply curve, problem of identification– general distrust in inductive methods; limited role for mathematics

• Roos and Szeliski’s reply:– Econometrics as a step towards defining concepts “in terms of the series of operations by which

they are measured”, as in physical sciences.– But too much attention devoted to purely formal mathematical exercises: “… little has been done

regarding examination of underlying premises of economic theory, the basic material for the deductions.” Keynes among the exceptions.

“Actual demand schedules can only be found by analysis of statistics. The issue here is how they shall be analysed, and above all how the method of analysis can be related to the theoretical background…”

• Keynes (replying to Szeliski, who asked whether his criticism applied to their work):“…you have chosen just the sort of problem where multiple correlation methods may be useful. You are dealing with details of a specific problem where the main causes are pretty well known a priori, and where the statistics are definite and precise. The method is always full of danger, but …[here it] is properly in place.”

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The Econometricians and Keynes, 1939-1943. From Reconciliation to RejectionAttempts at reconciliation: Marshack-Lange, 1940

• Article submitted to EJ in February 1940 and rejected (Tinbergen’ reply had already been accepted)

• Overall conciliatory tone: “profound agreement” with Keynes’ theories “capable of empirical and statistical verification” (but weakly argued)

• Technical remarks, some to the point:– Cycles determined by linear relationships– Treatment of qualitative variables

• …others less convincing:– Defence of trends– Discussion of the correct shape of investment equation to estimate

• Issue of homogeneity tests

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The Econometricians and Keynes, 1939-1943. From Reconciliation to RejectionKoopmans, 1941. Attempt at a rigorous defence while taking in Keynes’s points.

• “Elements of the logical situation”: Availability of time series data; “General working hypothesis” (causal connections dominate on mere chance fluctuations); additional information.

• Statistician seeks set of coefficients and lags compatible with all 3 sets of premises:– Mathematical function representing the influence on dependent variable by determining vars.– Other influences either sum up to random component, or to a function of time, or affect only a

few observations– Assumptions on value of coefficients and lags. But economic premises are crucial:

“Knowing how easily a statistically undetectable omission of one relevant determining variable , or an incorrect specification of an a priori known lag, may …distort the values and even the signs of the other coefficients, the investigator will devote a full share of his suspicion to the less technical part of the procedure: the choice of the premises”

• Alternative premises to dubitable ones must be expressed so as to be liable to statistical testing.

The validity of method is reaffirmed. When basis of premises is solid and sufficient (not Tinbergen’s case), results can be used for policy purposes and for prediction - a “more hazardous undertaking”.

Keynes replies with appreciation but stresses the unaddressed point of the stability of the environment.

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The Econometricians and Keynes, 1939-1943. From Reconciliation to Rejection Haavelmo (1943-44): The Probabilistic Approach Takes Over

• Change of paradigm necessary for “an objective and intelligent discussion of such questions as those of Lord Keynes”, a supposed believer in the supremacy of “the noble art of theoretical deductions based on ‘general economic considerations’”

• Model as formal logical construction: non-logical jump between model and reality always needed.

• Actual data arbitrarily chosen as counterparts of theoretical variables (Both redefined as stochastic objects)

• Theories as hypothesis on joint probability law allowing probability statements about facts (room for type I and II errors)

• Ineliminable problem of different theories indistinguishable from point of view of observations:“Theories with different economic meaning might lead to exactly the same probability law… just as different pairs of supply and demand curves might have the same intersection point”

• Provides basis for Cowles Commission methodology

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Concluding Remarks

• Keynes not a critic of econometric work per se…• Core question of methodology / Conditions for induction

“The successful application of this method to so enormously complex a problem as the business cycle does strike me as singularly unpromising project in the present state of our knowledge”

• Why was Keynes’s criticism so harsh?– Mistrust for a new anti-Marshallian conception on the nature, method and

style of economics– Concern for the appropriation of his work by the emerging approach:

“I am frightfully afraid of the tendency of which I see signs in you [Harrod], to appear to accept my constructive part and to find some accommodation between this and deeply cherished views which would in fact be only possible if my constructive part had been partially misunderstood”

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Roberto Marchionatti , ECONOMIC THEORY IN THE XXth CENTURY. PART III. ECONOMICS IN THE AGE OF GLOBALIZATION, 1947 TO NOW

INTRODUCTION

The period. General characteristics• Phases of economic growth:

- 1950-1973: rapid growth - 1970s: stagflation and international monetary disorder- 1980s-today: growth interrupted by short recessionary period

• Leader: USA• Globalization is identified with a number of trends developed since

World War II. These include: – greater international movement of commodities, money, information, and

people – development of technology, organizations, legal systems, and

infrastructures – Culturally, the major trend is the great international cultural exchange

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INTRODUCTION


CENTRES OF ECONOMIC THEORY USAHarvard, MIT Hansen, Leontiev, Haberler, Samuelson, Solow, Modigliani,

Kuznets, Duesenberry, Arrow, GalbraithChicago Friedman, Stigler, Becker, Coase, Lucas, HayekYale& Cowles Foundation Tobin, Marschak, Koopmans, DebreuPrinceton Morgenstern, Machlup, Koopmans, BaumolNew York Universitties and institutions Machlup, Baumol, …Carnegie-Mellon Modigliani, Lucas, SimonPennsylvania KleinCalifornian universities(Stanford, Berkeley, LosAngeles) Bain, Stiglitz, Williamson, Leijonhufvud, Clower,

Debreu, ArrowSanta Fe Institute ArthurPERIPHERIES OF ECONOMIC THEORY The other American UniversitiesEurope (the most important universities)Cambridge Sraffa, J.Robinson, Meade, Hahn, Kaldor Oxford Harrod, HicksLSE Robbins, Hayek

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INTRODUCTION

THE ECONOMIC THEORY 1947-early 1980sTHEORY MEN AND SCHOOL

A. Microeconomics Method Samuelson

General equilibrium Debreu, Arrow, HahnTheory of games Nash

B. MacroeconomicsNeoclassical Synthesis Hansen, Modigliani, Samuelson,

Solow, Tobin, PatinkinChicago School, IMonetarism FriedmanChicago School, IINew Classical School Lucas

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INTRODUCTION

THE ECONOMIC THEORY 1947-early 1980sTHEORY MEN AND SCHOOL

C. Empirical ResearchEconometrics Cowles Commission

D. MethodologyOperationalism SamuelsonInstrumentalism FriedmanPopperian approaches

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INTRODUCTION

THE ECONOMIC THEORY mid1980s- todayTHEORY

Economics of Information Stiglitz, AkerlofBounded Rationality SimonTransaction costs WilliamsonBehavioral Approach Akerlof, Kahnemann, TwerskiEvolutionary game theory M.SmithEconomics of complexity Arthur Empirical research- Computer Simulation- Experimental economicsMethodology- Rethorical Approach McCloskey- Critical realism Lawson

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INTRODUCTION

The rise in the number of economics journals. Some new entries

The Journal of Economic Theory (1969)Journal of Economic Literature (1969)Bell Journal of Economics (1970) The Journal of Economic Issues (1967)The Journal of Post-Keynesian Economics (1978)Journal of Economic Behaviour and Organisation (1980)Journal of Evolutionary Economics (1990)

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PART III. ECONOMICS IN THE AGE OF GLOBALIZATION, 1947 TO NOW POST-WAR ECONOMICS I:

HARVARD-CHICAGO ECONOMICS, 50s - 70s

THE PROTAGONISTSSamuelson Modigliani, Samuelson and Solow Arrow

Tobin Klein

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THE PROTAGONISTSFriedman Stigler Coase

Lucas

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PAUL A. SAMUELSON (1915-)“Samuelson’s contribution has been that, more than any other

contemporary economist, he has contributed to raising the general analytical and methodological level in economic science” (From the reasons for awarding Samuelson the Nobel Prize)

Life1941 PhD Harvard University 1944 Professor of Economics, MIT1970 Nobel Prize in EconomicsWorks1939 “A Synthesis of the Principle of Acceleration and the Multiplier”, JPE1947 Foundations of Economic Analysis1948 “Consumption theory in terms of revealed preferences”, Economica1948 Economics. An Introductory Analysis1949 “International trade and the equalisation of factor prices”, EJ1958 Linear Programming and Economic Analysis (with R. Dorfman and R. Solw)1960 "Analytical Aspects of Anti-Inflation Policy", with R.M. Solow, AER1969 "Lifetime Portfolio Selection by Dynamic Stochastic Programming", REStat.

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PAUL A. SAMUELSON (1915-)

EducationSamuelson’s teachers at Harvard: • E.B. Wilson: “revered teacher of mathematical economics and statistics”

and “the last of the universal mathematicians”• Hansen, Schumpeter, Haberler and LeontiefThe atmosphere in Harvard in that period:“My transfer from Chicago to Harvard put me right in the forefront of the

three great waves of modern economics: the Keynesian revolution …, the monopolistic or imperfect competition revolution, and … the fruitful clarification of the analysis of economic reality resulting from the mathematical and econometric handling of the subject”

“Harvard made us. Yes, but we made Harvard”

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Samuelson’s Foundations of Economic Analysis (1947), 1

• Aim: to provide a unified treatment of the most disparate fields of economic theory in accordance with general criteria– the methods to apply are a particular application of “the more general

practice of scientific deduction”, identified with the study of the behavior of a system through a system of equation

– Physics is the ideal point of reference for the construction of economic theory

– Analogies with the biological sciences are rejected• Any problem of economic theory may be reduced to the specification of a

system of equations– The structure of the mathematical model marks the borderline between

rigorous theory and hazy knowledge– Economic thery is a family of models dealing at differing levels of

abstraction with different fields• Walrasian general equilibrium is an example of the maximum analytical

generality

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Samuelson’s Foundations of Economic Analysis (1947), 2

• Purpose of the Foundations is to identify within the various fields of the theory “formally identical meaningful theorems … each derived by an essentially analogous method”

• A meaningful theorem is “simply an hypothesis about empirical data which could conceivably be refuted, if only under ideal conditions”

• This sounds like a statement of Percy Bridgam’s operationalism applied to economics. Bridgam (1927) insisted that concepts which are to be permitted into the domain of scientific discourse must be definable by a specifiable set of operations: “we mean by any concept nothing more than a set of operations”

• Samuelson’s work as contained in his Foundations was a development informed by a positivistic philosophy of science (in the Vienna Circle sense)

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SAMUELSON’S ECONOMICS. ECONOMIC THEORY AND MATHEMATICS (1952)

• Mathematics is language• Economics = a very imperfect science, based on induction and deduction• The importance of deduction• On Marshall’s objections. What Marshall must have had in mind when

speaking of the dangers involved in long chain of logical reasoning: “Obviously … Marshall was describing a property of that biological biped or computing machine called homo sapiens”

• “The convenience of mathematical symbolism for handling certain deductive inferences is, I think, indisputable … Logic is no protection agaist false hypotheses; or against misinterpretation of reality; or against the formulation of irrelevant hypotheses. I think it is one of the advantages of the mathematical medium … that we are forced to lay our cards on the table so that all can see our premises”

• Samuelson's method of economic theory, as illustrated in his Foundations (1947), follows two rules : with every economic problem (1) reduce the number of variables and keep only a minumum set of simple economic relations; (2) if possible, rewrite it as a constrained optimization problem

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The Macroeconomics of the Neo-classical SynthesisMacroeconomics reconceived in terms of equilibrium

Hicks (1937), “Mr. Keynes and the Classics. A suggested interpretation”: he reduces the two theories to three equations:

- One for the demand of money- One for investment- The third taking investment as equal to savingReformulated in this manner the two theories hardly

conflict any more

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The Macroeconomics of the Neo-classical Synthesis

Hicks (1937),2• Classical model: (1) M = kY, (2) I = I (i), (3) I = S(i, Y)• K.’ special theory: (1) M=L(i), (2) I = I (i), (3) I = S (Y)• K.’general theory: (1) M = L(i,Y), (2) I = I (i), (3) = I =S(i,Y)• Hicks turns the “generalized General Theory” into a graphic

presentation in a diagram on which he draws the IS-LL diagram, the ancestor of the IS-LM model.

• “The most important thing in Mr.Keynes’s book” is “the shape of the curve LL”, “nearly horizontal on the left, and nearly vertical on the right”. Thus, if the IS curve lies to the left of the LL curve, then “we cannot … increase employment by increasing the quantity of money”. “So the GT is the Economics of depression”

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The Macroeconomics of the Neo-classical SynthesisMacroeconomics reconceived in terms of equilibriumThe search for a simplified version of Keynes’s theory• 1944, F. Modigliani, “Liquidity preference and the theory of

interest and money”:• The hypothesis of wage stickiness essential to explain

underemployment equilibrium• 1947, L. Klein, The Keynesian Revolution and Samuelson,

Foundations: two mathematical repesentations of the GT, along the same line as Hicks and other

• 1960, Samuelson & Solow, “Analytical aspects of Anti-Inflation Policy”: The Phillips curve entered the arsenal of Keynesian Macroeconomics

Theoretical refinements:• 1963, Modigliani, “The life-cycle hypothesis of saving”• 1958, J. Tobin, “Liquidity Preference as Behavior towards Risk”

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Chicago economics: Milton Friedman

Friedman on methodEssay on the Methodology of Positive Economics (1953)

He proposed a sort of methodological instrumentalism, or the idea that theories are instruments for generating predictions

• “positive economics deals with ‘what is’, not with ‘what ought to be’”• “Its task is to provide a system of generalizations that can be used to make

correct predictions about the consequences of any change in circumstances. Its performance is to be judged by the precision, scope, and conformity with experience of the predictions it yields. In short, positive economics is, or can be, an ‘objective science, in precisely the same sense as any of the physical sciences”

• “The ultimate goal of a positive science is the development of theory or hypothesis that yields valid and meaningful (i.e., not truistic) predictions about phenomena not yet observed. Such a theory is, in general, a complex intermixture of two elements. In part, it is a language designed to promote systematic and organized methods of reasoning. In part, it is a body of substantive hypotheses designed to abstract essential features of complex reality”

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Chicago economics: Milton FriedmanEssay on the Methodology of Positive Economics (1953), 2

• Viewed as a body of substantive hypotheses “theory is to be judged by its predictive power”:

• “The only relevant test of the validity of a hypothesis is comparison of its predictions with experience. The hypothesis is rejected if its predictions are contradicted …; it is accepted if its predictions are not contradicted; great confidence is attached to it if it has survived many opportunities for contradiction. Factual evidence can never prove a hypothesis; it can only fail to disprove it, which is what we generally mean when we say, somewhat inexactly, that the hypothesis has been confirmed by experience”

• “the choice among alternative hypotheses equally consistent with the available evidence” must be arbitrary to some extent because “relevant considerations are suggested by the criteria ‘simplicity’ and ‘fruitfulness’”

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Chicago economics: Milton FriedmanEssay on the Methodology of Positive Economics (1953, 3

• “In so far as a theory can be said to have "assumptions" at all, and in so far as their "realism" can be judged independently of the validity of predictions, the relation between the significance of a theory and the "realism" of its "assumptions" is almost the opposite of that suggested by the view under criticism. Truly important and significant hypotheses will be found to have "assumptions" that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions (in this sense)”.With reference to the last proposition, he says:

• “The reason is simple. A hypothesis is important if it "explains" much by little, that is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of them alone. To be important, therefore, a hypothesis must be descriptively false in its assumptions; it takes account of, and accounts for, none of the many other attendant circumstances, since its very success shows them to be irrelevant for the phenomena to be explained. To put this point less paradoxically, the relevant question to ask about the "assumptions" of a theory is not whether they are descriptively "realistic," for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions. The two supposedly independent tests thus reduce to one test”

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Chicago economics: Milton FriedmanEssay on the Methodology of Positive Economics

(1953), 4

According to Friedman, a good theory is one that predicts successfully on the basis of a few important elements. Friedman thus argued that the relevant issue was not the realism of the assumptions but whether the assumptions were good enough approximations for the purpose in hand. This statement implies that theories are not ways of description of

the reality, but that are instruments to formulate predictions

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Chicago economics: Milton FriedmanEssay on the Methodology of Positive Economics (1953) Samuelson vs Friedman on the irrelevance of the realism of assumptions

“When a writer on positive economics says that hypotheses or theories should be judged on their consequences – or their ability to describe well and organize well empirical observations – he is saying something valuable … But what I and other readers believe is his new twist – which from now on I shall call the F-Twist … - is the following: a theory is vindicable if (some of) its consequences are empirically valid to a useful degree of approximation; the empirical unrealism of the theory itself, or of its assumptions, is quite irrelevant to its validity and worth. At points, the F-Twist seems to go even farther and claim: It is a positive merit of a theory that (some of) its content and assumptions be unrealistic since only if it is not tailored closely to one small bit of reality can it give a useful fit to a wide spread of empirical situations. Unless we explain complex reality by something simpler than itself we have accomplished little …The basic F-Twist … is fundamentally wrong in thinking that unrealism in the sense of factual inaccuracy even to a tolerable degree of approximation is anything but a demerit for a theory or hypothesis”

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Chicago economics, Milton FriedmanFriedman’s monetarism1956, “The quantity theory of money: a restatement”1963, “The relative stability of monetary velocity and the investment

multiplier in the USA, 1897-1958”1968, “The role of monetary policy”The main points:• The demand for money is a relatively stable function (the velocity of

circulation of money is stable)• The income multiplier is low and unstable• Keynesian policies (public spending) are ineffective• Monetary policies are unpredictable• Classical liberalism re-stated

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A Modigliani-Friedman model ?According to Modigliani (1977): • Neoclassical synthesis and Friedman’s criticism

could be joined into the Keynesian Macroeconomics

• Convergence at the analytical level, divergence at the political level

• Theoretical differences could be reduced to a controversy about the empirically relevant values of the parameters

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The new Chicago economics, from Friedman to Lucas

Lucas’s New Classical Macroeconomics• Walrasian microfoundations for macroeconomics• A reconstruction of macroeconomics on the basis of the

extension of the rationality postulate to include information and expectations

• 1972, LucasTwo sources:Stigler 1961Muth 1961

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PART III. ECONOMICS IN THE AGE OF GLOBALIZATION, 1947 TO NOW POST-WAR ECONOMICS, II:

POST-WALRASIAN ECONOMICS, mid ’80s to now(in collaboration with Stefano Fiori and Magda Fontana)

The ProtagonistsStiglitz Akerlof Simon Kahneman

Arthur David V.Smith

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POST-WALRASIAN ECONOMICS

Two key contributions

• H. Simon and the concept of bounded rationality

• Santa Fe Institute and the conception of economics as a science of complexity

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H. SIMON (1916-2001) AND THE CONCEPT OF BOUNDED RATIONALITY

• 1942, Ph.D. in Political Science from the University of Chicago • From 1949 until his death: Professor of Computer Science and

Psychology at Carnegie Mellon University

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Hayek’s notions of information and knowledge, 1• “Fragmentation of knowledge” or “dispersed knowledge”. Individuals

possess only a bit of information, that is, information is dispersed among a number of agents (we “have only a small fraction of the knowledge possessed by all”

• Individuals do not possess perfect information, therefore they only seek “relevant information” to achieve their plans

• Information is a flux and not a state, which changes over time. In general terms, knowledge is a continuous process of discovery (search)

• Cognitive processes are implicitly evoked to explain how knowledge and information are subjectively used, and how and why a certain element of information is perceived as “relevant”, where others are not

• Cognitive processes determine relevance criteria• Yet these concepts (knowledge and information) are not theoretically

distinguished in Hayek’s work, and are prevalently treated as synonyms

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Hayek’s notions of information and knowledge, 2• Inarticulate (tacit) knowledge:

a) Individuals act “not by conscious choice” or “deliberate control”: “we can make use of so much experience, not because we possess that experience, but because, without our knowing it, it has become incorporated in the schemata of thought which guide us” b) These latter are abstract “rules of conduct”, which prevailed by means of cultural selection, “because they made a group of men successful”, although they “were not adopted because it was known that they would bring about desired effects”c) Abstract rules of conduct “are observed in action without being known to the acting person in articulated (‘verbalized’ or explicit) form.”, and manifest themselves “in a regularity of action”; therefore they help coordination among individuals. Finally, they have an essential role in characterizing institutions, market and society as “spontaneous orders”

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Hayek’s notions of information and knowledge, 3

• “Fragmentation of knowledge” and “inarticulate knowledge” refer to two different notions of information:

• On the one hand, explicit information is “dispersed” among individuals. On the other hand, each individual possesses a certain amount of unconscious information

• Dispersed, explicit, information implies a quantitative notion: a fragment of information is measurable

• On the contrary, inarticulate knowledge and information imply a more complex cognitive process (an unconscious mechanism which permits their tacit use). In short, inarticulate knowledge and information are not measurable

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Hayek and Simon• There are many differences between Hayek and

Simon’s approaches. Yet they share at least three points:

• Individuals are characterized by bounded rationality (informational, computational, cognitive limits)

• Cognitive limitations induce search processes;• Individuals adopt strategies for reducing the

complexity of the world

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SIMON’S CONTRIBUTION, 1• Theories of bounded rationality, Simon maintains,

dealt with the limits of “information processing capacities”. More precisely, the definition of information processing stresses two constraints on individuals:

• a) the limits of information, which is gathered and processed;

• b) the limits of computational capacities, which emerge when agents face complex situations

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SIMON’S CONTRIBUTION, 2• Actors, upon receiving an external input or stimulus, react by either

replicating past behaviours (routines), if they do not encounter unforeseen situations, or by following new courses of action, in order to solve new and unexpected situations. In the latter case, problem-solving procedures are activated, and agents treat complex problems sequentially

• In particular, they reach a node (a choice point) using information collected in the previous steps, and this latter, in turn, allows them to gather new information. Since uncertainty prevails in the real world, neither all the alternatives nor the consequences that would follow from them are evaluated, and heuristics are adopted for simplifying search processes

• Therefore, decision-makers look for a “satisficing”, rather than an optimal, alternative, and the criteria, which perform this role in decision-making processes, are called “aspiration levels”

• Finally, problem-solving (sequential) procedures are attained by breaking down the problem into smaller components. In fact, problems are often too complex for the agents’ computational capacities, and this requires their decomposition into sub-problems that are less computationally complex

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THREE DIFFERENCES BETWEEN SIMON AND HAYEK

• Simon emphasizes the analogy between human thinking and computer intelligent behaviour. Human thought and problem-solving process are considered in terms of an information processing system (IPS), that is, a system consisting of a set of memories, a processor, effectors, and receptors. On the contrary Hayek refers to a neurobiological approach (The Sensory Order)

• Simon denies any form of tacit knowledge. Rationality can be represented in symbolic form, and as a sequence of unambiguous operations

• The “architecture of complexity” is different. According to Hayek, “planning” impedes the emergence of evolutionary “spontaneous orders”. On the contrary, Simon considers “planning” to be a coherent part of evolutionary processes: unintentional outcomes derive from endless interaction among plans of different actors (social institutions and individuals)

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ECOLOGICAL RATIONALITY: A NEW VERSION OF BOUNDED RATIONALITY, 1 This perspective is summarized as follows:

“The concept of an adaptive toolbox, as we see it, has the following characteristics: First, it refers to a collection of rules or heuristics rather than to a general-purpose decision-making algorithm […]. Second, these heuristics are fast, frugal, and computationally cheap rather than consistent, coherent, and general. Third, these heuristics are adapted to particular environments, past or present, physical or social. This “ecological rationality” - the match between the structure of a heuristic and the structures of an environment – allows for the possibility that heuristics can be fast, frugal and accurate all at the same time by exploiting the structure of information in natural environments. Fourth, the bundle of heuristics in the adaptive toolbox is orchestrated by some mechanism reflecting the importance of conflicting motivation and goals.” (Gigerenzer and Selten, 2002)

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ECOLOGICAL RATIONALITY: A NEW VERSION OF BOUNDED RATIONALITY, 2 • This vision suggests that (limited) rationality is less characterized by precise

(sequential) choices, and is more unintentional and adaptive, where adaptive rationality implies a decision-making activity largely connoted by unconscious (adaptive) mechanisms.

• In the former case, individuals are considered intentional problem solvers, whose explicit rationality is limited; in the latter one, individuals are adaptive problem solvers, connoted by scarce degrees of awareness, as regards their responses to the environment.

• Heuristics are fast and frugal, because they use little information and computation to make a variety of kinds of decision, and “only search for some of the available information”. In fact, “There is a point where to much information and too much information processing can hurt” (Gigerenzer, Todd, 1999)

• Fast and frugal heuristics exploit environmental structure to make adaptive decisions, and lead to accurate and useful inferences. In short, simple heuristics use “minimal time and information”, and this happens both in basic ecological situations (as in the prey-predator case), in which fast decisions provide an advantage, and in complex social circumstances

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ECOLOGICAL RATIONALITY: A NEW VERSION OF BOUNDED RATIONALITY, 3

• Ecological rationality is a theory (among others) which introduces a notion of rationality weaker than Simon’s one, although Simon’s heritage is widely recognized.

• Computation has a limited role, since the most important bounds of rationality are not computational or mental (internal) factors, but depend on the environment (external) pressures, and on how environmental forces have selected simple heuristics for making decisions.

• In particular, “computationally simple strategies” are better than “computationally complex” ones. On the contrary, in Simon’s view, given the computational limits of processing information, the more such limits are reduced, the more subjects are rational, and the more they carry out good strategies for solving problems

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Arthur, the Santa Fe Institute and the Economics as a science of complexity

• Ph.D., industrial engineering operations research, Un. of California at Berkeley • Professor of Economics, the Santa Fe Institute, New Mexico Works• The Economy as an Evolving Complex System II (1997)• Increasing Returns and Path Dependence in the Economy (1994)

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Arthur, the Santa Fe Institute and the Economics as a science of complexity The present state of economics according to B. Arthur“The history of science in the twentieth is one of a steady loss of certainty. Much of

what was real and machine like and objective and determinate at the start of the century, by mid-century was a phantom, unpredictable, subjective and indeterminate. What had defined the science at the start of the century –its power to predict, its clear subject/object distinction – no longer defined it at the end.

What is then of economics? Is economics a science? I believe it is. It is a body of well reasoned science. Yet until the last few years it has maintained its certainty. And so we must ask: Is its object of study, the economy, inherently free of uncertainties and indeterminacies? Or is economics in the process of losing its innocence and thereby joining the other sciences?

I believe the latter. In fact, there are indications everywhere these days in economics that the discipline is losing its rigid sense of determinism, that the long dominance of positivist thinking is weakening and that economics is opening itself to a less mechanistic, more organic approach”.

Brian Arthur 1998, The End of Certainty in Economics

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Arthur, the Santa Fe Institute and the Economics as a science of complexity Arthur’s Analytical Contributions

Premise• “economy relies on human beings and not on

orderly machine components. Human beings with all their caprices, emotions, and foibles.”

• “technology destroys neatness because it keeps the economy changing”

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POST-WAR ECONOMICS, II: POST-WALRASIAN ECONOMICS, mid ’80s to now

(in collaboration with Stefano Fiori and Magda Fontana)

Arthur, the Santa Fe Institute and the Economics as a science of complexity Arthur’s Analytical Contributions

• the case for indeterminacy when perfectly rational actor has to form expectations on the behaviour of others whose expectations, in turn, depend of what the former actor decides So there results a self referential loop that prevents the deductive method from working. He proposes to substitute inductive reasoning and bounded rationality to the previous decision-making models (AER 1994)

• treatment of increasing returns and path dependence (1988-1989)

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Arthur, the Santa Fe Institute and the Economics as a science of complexity

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Arthur, the Santa Fe Institute and the Economics as a science of complexity Santa Fe InstituteThe SFI is a private institution which was founded in 1984 by

physicists, biologists, and economists (Kenneth Arrow)Its primary concern is to focus the tools of traditional scientific

disciplines and emerging new computer resources on the problems and opportunities that are involved in the multidisciplinary studies of complex system

The SFI is the culmination and the fusion of two phenomena that have began to ripe years before its foundation

i) The growing dissatisfaction with the Harvard-Chicago approachii) Cheapening of computational power and development of versatile

programming languages

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Arthur, the Santa Fe Institute and the Economics as a science of complexity WHAT COMPLEXITY THEORY IS ?

• Complexity theory represents an effort to analyse the functioning of highly organised but decentralised systems composed of very large numbers of individual components.

• Complexity theory starts from the bold and controversial conjecture that these diverse systems have important features in common that transcend their apparent differences in scale, material components and laws of motion.

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Arthur, the Santa Fe Institute and the Economics as a science of complexity WHAT COMPLEXITY THEORY IS ?THE PREDECESSORS OF THE COMPLEXITY THEORY: Norbert Wiener(1894-1964) and the CYBERNETICS 1910 he began graduate studies in zoology at Harvard than he changed to

mathematics and philosophy at Cornell 1911 Cambridge (UK) to study under Russel who told him that in order to

study the philosophy of mathematics he needed to know more mathematics so he attended courses by Hardy

1914 Göttingen to study differential equations under Hilbert1915 receives an invitation from O. Veblen to undertake war work on

ballistics at the Aberdeen Proving Ground in Maryland appointed as an instructor in mathematics at the MIT

1931-32 mainly in UK visiting Hardy in Cambridge which provided a base from where he was able to visit colleagues on the Continent. Among these were K. Menger, Frank and Godel

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THE PREDECESSORS OF THE COMPLEXITY THEORY: Norbert Wiener(1894-1964) and the CYBERNETICS

Wiener’s idea (1956) was that, in order to obtain a complete mathematical treatment of a system, it was necessary to assimilate its different parts to a single basis either human or mechanical. Since the understanding of mechanical elements appeared far ahead of psychological understanding, he chose to construct a mechanical analogue of the relation between human and mechanical: the feedback which, roughly, implies circular causation

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Arthur, the Santa Fe Institute and the Economics as a science of complexity WHAT COMPLEXITY THEORY IS ?THE PREDECESSORS OF THE COMPLEXITY THEORY: John von NEUMANN

From 1943 to 1955 von Neumann worked at Los Alamos National Laboratories as a consultant to the armed forces

In a close relation with his applied work with simulation, in the late ’40 he started developing a theory of automata that, due to his premature death, was left incomplete. Being convinced of the existence of important similarities between computer and natural organisms and of the usefulness of comparing such related systems, he sought a theory that would cover them both. He called it the “Theory of cellular automata”. It was concerned with the structure and organisation of both natural and artificial systems and the role of language and information, programming and control in such systems

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• What these systems share is a potential to configure their components in an astronomically large number of ways (they are complex), constant change in response to environmental stimulus and their own development (they are adaptive), a strong tendency to achieve recognisable stable patterns in their configuration (they are self organising), and an avoidance of stable, self-reproducing states (they are non-equilibrium systems).

• The task complexity science sets itself is the exploration of the properties of complex, adaptive, self-organising, non equilibrium systems and the attempt to grow them:“fundamental social structures and group behaviours as emerging from the interaction of individuals operating in artificial environments under rules that place only bounded demands on each agent’s information and computational capacity. We view artificial societies as laboratories where we attempt to grow certain social structures in the computer […] the aim being to discover fundamental local or micro mechanisms that are sufficient to generate the macroscopic social structures and collective behaviour” (Epstein and Axtell)

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COMPLEX SYSTEMS: DEFINITION• dispersed interaction among heterogeneous acting locally on each

other in some space• no global controller that can exploit all opportunities or interactions in

the economy even though there might be some weak global interactions

• cross-cutting hierarchical organization with many tangled interactions • Continual adaptation by learning and evolving agents• Perpetual novelty as new markets, technologies, behaviours, and

institutions create new niches in the ecology of the system• Out of equilibrium dynamics with either zero or many equilibria

existing and the system unlikely to be near a global optimum (Arthur, Durlauf and Lane 1997)

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Arthur, the Santa Fe Institute and the Economics as a science of complexityWHAT COMPLEXITY THEORY IS ?

A complexity theorician at work“no one would fault a “theoremless” laboratory biologist for claiming to understand population dynamics in beetles when he reports a regularity observed over a large number of experiments. But when agent based modellers show such results […] there is a demand for equations and proofs. […] one can do perfectly legitimate science with computer, sweeping the parameter space of one’s model, and conducting extensive sensitivity analysis, and claiming substantial understanding of the relationship between model inputs and model outputs, just as in any empirical science for which general laws are not yet in hand” (Epstein, 1999)

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Arthur, the Santa Fe Institute and the Economics as a science of complexity WHAT COMPLEXITY THEORY IS ?IMPLICATIONS

• The appropriate model for economics is evolutionary biology

• Methods are highly empirical and inductive. The complex system scientist tends to study the properties of particular simplified and abstract models of complex systems

• Experimental science: models are laboratories in which one can make different hypotheses on the phenomenon under study and observe the output (i.e. regularities emerging from micro rules)

• These models involve the study of the interaction of large numbers of elements represented in computer simulations with the aim of identifying properties of adaptability and self organisation common to a wide range of complex systems

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(in collaboration with Stefano Fiori and Magda Fontana)Arthur, the Santa Fe Institute and the Economics as a science of complexityImplications for economics or the debate on the role of

mathematics re-opened

• “previously, a premium was placed on a deductive formal proofs of theorems that sought to derive general solutions broadly applicable […] Now we see a greater emphasis on computer simulations and experimental methods to determine possible outcomes and ranges of solutions. Emergent phenomena from complex systems are not usually discovered by theorems, but more frequently by the use of increasingly powerful computers to explore the limits and possibility that can arise.” Barkley Rosser (2003)

• “not only will our successors have to be far less concerned with general laws than we have been, they will have to bring to the particular problems they will study particular histories and methods capable of dealing with the complexity of particular, such as computer simulation. Not for them […] the pleasure of theorems and proofs. Instead, the uncertain embrace of history, sociology and biology”. Frank Hahn (1991):

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Arthur, the Santa Fe Institute and the Economics as a science of complexityImplications for economics or the debate on the role of

mathematics re-opened

Mathematics is inappropriate because:- is descriptive and not explanatory: an oscillatory time series can

be described by a function of the kind P(t) = A+B Sin(Ct). The behaviour of P is accurately described in mathematical terms, but what happens inside the system, which “rule of behaviour” generates, on aggregate, the observed oscillation, remains unknown. To this purpose, the function is devoid of explanatory power in spite of its descriptive accuracy (Epstein 1999)

- is not manageable: for complex systems in not obvious how to write down (choose the functional form) and then solve the equations (probably high dimensional difference or differential equation) (Epstein 1999)

- cannot deal with non-linearity complex systems are non-linear. They exhibit qualitative differences in their behaviour in stimulus to different intensity and scales (Foley 2003)

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Arthur, the Santa Fe Institute and the Economics as a science of complexityThe Santa Fe solution: Agent-based models

Agent-based models are computer simulations that describe agent, rules and environment and let them interact locally with no intervention of the researcher side

Agent-based models allow for:• Explanation: what kind of micro rule generates a given macro

pattern• Decentralisation: “natural” non-linearity• Heterogeneity• Bounded demand on cognitive computational skills of the involved

entities

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Arthur, the Santa Fe Institute and the Economics as a science of complexityINCREASING RETURNS as ANOMALIES

• Smith virtuous cycle linking the division of labour as resulting and, at the same time, fostering the widening of the market is an early example of increasing returns (But pervasive increasing returns is incompatible with the establishment of a neoclassical competitive equilibrium)

• Marshall and Young: – i) with increasing returns one firm tends to dominate each industry – ii) from a dynamic perspective, they destroy the local stability and the

uniqueness of the neoclassical equilibrium but firms cannot grow indefinitely large, and countervailing forces come into play to regulate the evolution even if competition cannot enforce the neoclassical marginal equalities

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Arthur, the Santa Fe Institute and the Economics as a science of complexityINCREASING RETURNS as PERVASIVEArthur (1988-89), the technology case, 1• economy is inherently open-ended and path dependent like the

evolution of species • if rival technologies independently of their relative efficiency are

cumulative, an initial advantage that could depend on entirely on casual circumstances can neutralise the competitive selection.

• If a technological solution gains some advantages on its rivals there arise strong incentives to subtract resources from investment in the latter. This is a self-reinforcing mechanism: once the resources are concentrated on the dominant technology its further improvements encourage the abandonment of the rival technologies.

• Concentration occurs due to: i) large fix set up costs that imply decreasing costs as the production

increases (Arthur 1989)ii) learning effects thank to which products are improved or produced at a

lower cost as their prevalence increases (David 1985)

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Arthur, the Santa Fe Institute and the Economics as a science of complexityINCREASING RETURNS as PERVASIVEArthur (1988-89), the technology case, 2

iii) network externalities that generate advantages from cooperation among agents that adopt similar actions (Katz-Shapiro 1985)

iv) adaptive expectations according to which the current prevalence of a solution increases the likelihood of a future prevalence (Arthur 1988).

• The crucial hint is that there is no reason to believe that the selected technology will be somehow the optimal one and that the selection of a technology cannot be predicted in advance. In fact, quite the opposite is the case: the emergence of the suboptimal QWERTY typewriter board (Arthur 1989, David 1985) to the ubiquity of the MS-Dos software, and the victory of the inferior VHS video system over the BETAMAX standard (Arthur 1988).

• This kind of selection is called hyperselection. It occurs when the growth rate of technologies are coupled in non-linear ways. The result is that very different evolutionary outcomes can emerge from small variations in initial conditions (the butterfly effect) and the dynamic is irreversible: once a path is taken even small amendments are made very difficult.

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