Supply & Demand: Fundamentally Flawed Model of Labor Market

This is an outline of the lecture 3 in Advanced Microeconomics — expands somewhat on the slides available from the link. This should be useful to heterodox economists looking for ways to teach an alternative course, radically different from conventional approaches. First two lectures consisted of some preliminary math, and can be skipped without lack of continuity.  Video of the lecture (90m) is available at the bottom of the post.

Supply & Demand is Central to Economics: This is the modern Theory of Value. The market price determines the value – this is in conflict with classical conceptions of value.

BUT, this theory is WRONG!  The central question in theory of Value is: HOW are prices determined? Why are water and tomatoes cheap, and why are diamonds expensive?

Current answer is the Supply and Demand theory of economics. Classical economists’ answers were  Labor Theory of Value.

Modern Answers are seriously deficient. Classical Schools had substantially more insight into these questions. We will be discussing classical thinking (Adam Smith, Ricardo, Marx, Sraffa) later in the course. This lecture deals with: Failure of Supply & Demand in Labor Market. This failure was the Raison-d’etre of Keynesian Economics

Chapter 2: General Theory of Employment, Interest, and Money: Starts by saying that NeoClassical Economics does not have a theory of employment. Why? Because neo-classical theory of the labor market assumes a supply and demand equilibrium, which ensures full employment.

BUT, Keynes argues that: – genuine unemployment was OBSERVED during/after Great Depression. So S&D, at least in labor market, is wrong.

According to neoclassical S&D: Firms maximize profits, Laborers maximize utility, Stable Equilibrium outcomes result.

If this is so, then Why are there Business Cycles? Why does employment fluctuate?

Not possible according to Classical Theory – Keeps getting empirically refuted, and keeps getting revived. NAIRU, Real Business Cycles are re-incarnations. Romer ridicules these theories by saying they invoke gremlins and phlogistons as explanations for these fluctuations.

After examining empirical evidence, Keynes rejected the classical axiom that: Labor decision is based on real wage. Note that modern labor economics continue to make this same assumption Keynes rejected.

ONE REASON for Keynes’ rejection of classical theory: Asymmetric reaction by labor to price increase and wage cuts. This proves that real wage is not driver of labor decision. Neoclassical sanitized this damaging observation by saying that Keynes assumes money illusion. This is slander – Keynes argued that it is structurally impossible for laborers and firms to set the real wage, and hence negotiations cannot be about real wages.

Keynes set out to build a New Theory in which levels of employment would naturally vary – would not be fixed at full employment in equilibrium. Two key elements of his theory are:

  • Labor Negotiations are around Nominal Wages, not real wages. Note that this immediately implies that money enters the economy in an essential way, and cannot be neutral in short or long run – an implication stated explicitly by Keynes.
  • Real Wages are an Emergent Phenomenon. (Complexity Theory)

To explain this further,  agents within the system determine nominal wages, System as a whole determines real wage, which are out of control of individual actors within the system.

In Stanford grad school, my macroeconomics teacher, Duncan Foley, told us that:

  • Keynes drove a Truck through the Classical Theory Brick Wall
  • Everyone admired his accomplishment.
  • Set out to repair damage bit-by-bit
  • Eventually put the entire structure back – without any change.

Today, labor economics teach Neo-Classical Theory of Supply & Demand – without any mention of Keynes – this is swept under the rug, instead of being dealt with.

The Neo-classical theory has many Implications about the labor market that are plainly in conflict with direct and clearly observable empirical evidence

MOST GLARING CONTRADICTION: There is no involuntary unemployment:

  • Everyone who wants to work at going wage can find work
  • If someone is unemployed, it is because he does not WANT to work at going wage.

Is this consistent with our observed reality? All of us know people who want to find work at going wages, but cannot.

MAJOR PUZZLE: How is it the theories overwhelmingly in conflict with empirical evidence continue to be believed, advocated and taught?

ONE PART OF THE ANSWER: This is due to a Dramatic Change in Methodology which took place in early 20th century, in two steps. First the Schmoller’s German Historical School, which grounded theory in observations and historical experience, lost out to the (pseudo)-scientific approach of Menger’s Austrian School. For details see: Hodgson: How Economics Forgot History. Second, Logical Positivism put the last nails in the coffin of sensible methodology via a deep mis-understanding of scientific methodology, which became widely accepted as the way to do social sciences in early Early 20th Century

Standard Scientific Methodology, used by all classical economists (especially Marshall): look at reality; build theories on this basis. Reject theories if empirical experience contradicts theory. Rebuild NEW theory which CAN explain empirical evidence. The problem with this standard methodology is that it does not lead to certainty. A theory is just a guess about the causes for the observed phenomena – we guess that the invisible force of gravity causes the elliptical orbits of the stars. Philosophers of science sought to show that science was certain. In order to force this desired result, they distorted the methodology of science.

Logical Positivists start out with the conviction that:

  • Science leads to TRUTH. It is the ONLY way to arrive at TRUTH.

The goal of Philosophy of Science is to prove this, by hook or crook. This forces us to remove guesses about the unobservable mechanisms from the picture. The positivists did this by “translation” – all statements about unobservables were re-interpreted to be identical to their observable implications. Thus to talk about gravity is just a shorthand for the observed elliptical orbits. To talk about the unobservable preferences of the heart is just shorthand for talking about the observed choices. In fact this strategy fails. Unobservables are essentially involved in science and cannot be parsed out. This was established by philosophers, and led to the spectacular crash of logical positivism. The logical defect in replacement of preferences by choices has been pointed out by Stanley Wong in The foundations of Paul Samuelson’s revealed preference theory. However, the news of collapse of logical positivism has not reached economists and foundations of modern economic theory are solidly based on positivist understanding of science. This understanding is explicitly articulated by Lionel Robbins: Founder of Modern Economics, based on Scarcity

Positivist Methodology for Economics, due to Robbins:

Cooter, Robert, and Peter Rappoport. “Were the Ordinalists Wrong About Welfare Economics?” Journal of Economic Literature, vol. 22, no. 2, 1984, pp. 507–530., This article shows that Robbins scarcity definition REPLACED earlier conception of economics. They label the older concept the Material Welfare School, and say that this was based on Measurable Utility. Using diminishing marginal CARDINAL utility, the material welfare school advocated Re-distribution of Wealth – additional money provides far greater utility to the starving person than to one who already has a lot.  This implications disappears when cardinal utility is Replaced by Ordinal Utility. The Scarcity Definition considers the inability to listen to Bach’s 9th to be just as a much a manifestation of scarcity as the inability of a family to buy food and medicines for their children. Cooter and Rappoport argue that material welfare, and associate cardinal utility is observable and measurable, and therefore Lionel Robbins re-definition DOES NOT REPRESENT Scientific Progress

What did Lionel Robbins propose, as a new Axiomatic Methodology for economics?

“The propositions of economic theory, like all scientific theory, are obviously deductions from a series of postulates. And the chief of these postulates are all assumptions involving in some way simple and indisputable facts of experience…”

NOTE that there is no possibility of error here. We start with certainties, and we build with logic – there is never any need to resort to observations. This is in dramatic contrast with genuine science, where we start with observations, and empirical data has primacy – in case of conflict we modify theories, instead of revising the data.

HISTORICAL PRECEDENT: The struggle between axiomatic certainties of Euclidean Geometry and the observation based but uncertain theories of Science is an ancient battle which persists to this day.

The switch is from Deduction which is certain to Induction which is always uncertain.

Greek Science was axiomatic/deductive. Based on giving theories primacy over observations. Natural Science developed by Muslims – based on giving primacy to observations and experiment over theories.

Practitioners of science learned how to do it in apprentice-like fashion, just like we learn languages without learning grammar. However, Philosophers of Science, starting with Bacon, never correctly understood – to this day – “What is This Thing Called Science?

COMING BACK TO LABOR MARKET, after this discursion into methodology of science:

  • Axiomatic Theory of supply and demand leads to Full Employment Equilibrium as a theorem

Keynes rejected the axioms on the grounds that they conflicted with the empirical evidence:

It is not very plausible to assert that unemployment in the United States in 1932 was due either to labour obstinately refusing to accept a reduction of money-wages or to its obstinately demanding a real wage beyond what the productivity of the economic machine was capable of furnishing. Wide variations are experienced in the volume of employment without any apparent change either in the minimum real demands of labour or in its productivity. Labour is not more truculent in the depression than in the boom; far from it. Nor is its physical productivity less. These facts from experience are a prima facie ground for questioning the adequacy of the classical analysis.

He went on to ask: How can we create a theory in which the employment levels can fluctuate, as we observe? This is the essence of the scientific method – instead of creating theories by mental thought processes, we create theories to match observed phenomena. See post P9: Keynesian Unemployment

Keynes consider all possible ways to reconcile empirical evidence with classical theory of the labor market:

  1. Lower Frictional Unemployment
  2. Decrease in dis-utility of labor
  3. Increase in Productivity of Labor
  4. Exogenous decline in price of consumer goods, increases real wage.

However, Keynes observed that the Labor Market experienced fluctuations WITHOUT any change in these 4 factors. He came to the conclusion that Observations DISPROVE axioms

This lead to the Scientific Necessity: Re-think Axioms – However, Keynes found that economists do not react in this way to a contradiction between axioms and observations. As he said:

The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non-Euclidean geometry.

Economists are wedded to their axioms of behavior. If human behavior does not match axioms, instead of changing axioms, we insult the humans by calling them irrational. Varian starts out his text by saying that the following two principles will be taken as fundamental axioms for building economic theories – these axioms are not subject to challenge by empirical evidence

  1. OPTIMIZATION – [Overwhelmingly Rejected by empirical evidence]
  2. EQUILIBRIUM – [Global Financial Crisis makes plain that this does not hold]

Despite massive empirical evidence to the contrary, Varian proceeds to build his theories around these axioms.

SIMILARLY: Keynes argues that theory of the labor market is built around Two Axioms:

Axiom 1: As firms hire labor, MPL decreases. Firms keep hiring until MPL equals wage. (Demand for Labor)

Axiom 2: Laborers suffer dis-utility from laboring, which increases as amount of labor increases. So they offer labor until Marginal disutility of labor equal the real wage. (Supply of Labor)

KEYNES accepted the first axiom, but rejected second axiom, built Keynesian theory to replace it. The primary motivation for developing Keynesian theory was to explain Involuntary Unemployment – This phenomenon cannot be explained within classical theory based upon the two axioms above (and equilibrium.

Why was this extremely plausible idea NEVER accepted by economists? To understand this, we have to go behind the scenes, and look at the Ideological Battles which motivate economic theories.

What Keynes is saying is that: Free Markets will not eliminate Unemployment. Government must intervene to help the unemployed

Free Market Ideologues like Hayek, Friedman, founder of Chicago School have a firm a priori ideological commitment, not subject to empirical examination that: All government interventions are harmful. Accordingly they set out to RE-ESTABLISH pre-Keynesian theory.

  1. There is a natural rate of unemployment – back to EQUILIBRIUM concept
  2. Interventions can affect unemployment only temporarily, with harmful long run effects.
  3. Money is Neutral

Impact of Keynes: In the aftermath of the Great Depression, some of the insights of Keynes, suitably modified and de-toxified, were reluctantly accepted by economists. However, many of the major ideas of Keynes never made it to the textbooks, and remain unknown to this day. As the linked article shows, just government support for labor, and a full employment policy, was enough to cause an increase in the wage share of labor and a corresponding decreases in the wealth share of the top 0.1%. As this was unacceptable to the wealthy, a counter-revolution was plotted to re-instate the pre-Keynesian classical theories which support the wealthy. There were many co-ordinated elements in the plan to Rebuild Classical Theory from the ground up. Milton Friedman was at the heart of this effort. He started out by re-painting the Great Depression as being caused by in-ept monetary policy, rather than by market failure. He also re-instated the Quantity Theory of money, which made money neutral (disappearing it from the models) contrary to Keynes who had insisted on its central significance.

Peter Temin, Lessons from the Great Depression (Cambridge, MA: MIT Press, 1989); Barry Eichengreen, has provided sound and thorough empirical evidence against Friedman’s idea that monetary policy caused the Great Depression. Further evidence is provided by the failure of monetarist attempts to stop the recent Great Recession through Quantitative Easing, based on Friedmanite policies.  Nonetheless, as detailed in Economic Theories as Ideology, Power )especially financial power), and not empirical evidence, determines which theories come to dominate the scence. One aspect of this power was the setting up of a fake Nobel Prize by private bankers: The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, which started out handing prize after prize to Chicago School economists, and succeeded in altering their status from an eccentric minority to the established and hegemonic majority.  Friedman and Hayek, both arch-enemies of Keynesian thought, and ideologues of the free market, received the Riksbank version of the Nobel prizes early on.  Similarly in 2010 Peter A. Diamond  — Dale T. Mortensen — Christopher A. Pissarides won the Nobel prize for a search theory explanation of Unemployment – this is basically a glorified form of the idea of frictional employment, which has been examined and rejected by Keynes as a possible source of the high and long duration unemployment in the Great Depression. Similarly Nobels were awarded to Bob Lucas, Ed Prescott, and Tom Sargent who removed all Keynesian elements from macroeconomics, and returned the field to pre-Keynesian days, which fail to recognized the existence of unemployment, and fail to include money and banking as relevant factors in the macroeconomy. As Paul Romer has written in The Trouble with Macroeconomics:

For more than three decades, macroeconomics has gone backwards. The treatment of identification now is no more credible than in the early 1970s but escapes challenge because it is so much more opaque. Macroeconomic theorists dismiss mere facts by feigning an obtuse ignorance about such simple assertions as “tight monetary policy can cause a recession.” Their models attribute fluctuations in aggregate variables to imaginary causal forces that are not influenced by the action that any person takes.

END OF LECTURE OUTLINE: 90m Video Lecture available from link below:

  1. David Chester said:

    The so called “natural level of unemployment” is a variable during the business-cycle. It is not natural at all, but is caused by the amount of speculation in land values and the inclination for banks and landlords to withhold useful sites from use. This greedy withdrawal is harmful to national progress because the competition for rights of access to sites that are in use causes their cost or rent to be increased above the past amounts. This results in the produce becoming more costly. In turn this means that the same goods that previously were less expensive are now finding fewer buyers and there is less demand capable of being met. This means that there is a reduced amount of work needing to be put into making these items of goods and the associated services.Thus speculation in land values creates unemployment. If there were no speculation at all in land values, then the amount of prosperity would be greater due to the demand being more fully satisfied and the greater amount of labor being properly used.

  2. This sounds wonderful!

    Note, however, that diminishing marginal utility was a mathematical construct, and that ‘utility’ remained undefined as a pleasure/satisfaction OR a benefit. This has led to extremely woolly thinking that basically says a consumer cannot receive a benefit without also being satisfied. Which, in turn, has meant that ‘tastes’/’preferences’, throughout economics do not permit an individual to ‘consume’ anything they would, in fact, prefer not to. By simply putting in a constraint that measured benefits, well-defined, have some lower limits where having insufficient benefits from consumption are associated with serious costs to life-forms (or, alternatively, not being able to get enough of a critical input can lead to serious damage to a firms operations), it is rather simple to show that maximizing preferences carries ‘disutility’ :: in terms of use-value and possibly even survival, much less health :: and cannot be a rational choice if life-forms or firms have needs. You can also show how budgets must change when nominal prices change, if, indeed, budgets can change.

    As for the macro side, create a population with, say, five different ‘preference’ functions, five different income distributions within each ‘preference-population’ and five different starting budgets for a rivalrous set of goods that can bring similar objective benefits to consumers , but subject to the constraint that there is some basic minimum each consuming agent must have before it can be plausibly said that well-being emerges. If you do this you will be able to show that it is implausible for those with insufficient objective utility to be subjectively satisfied..and that it is also generally impossible to derive a market ‘demand’ curve that takes into account the nominal budget changes that occur in response to nominal price changes amongst these goods.

    Kudos to you.

  3. Thanks for the compliments and for the suggestions. Actually I have done this recently — I re-analyzed the Varian model of supply and demand for rentals, and showed how the “equilibrium” does not exist, and also, would not be considered “efficient” because housing is a necessity. Similarly, I had students play an experimental agricultural economy game with two crops cotton and wheat, where wheat is necessary for survival. Again, existence of a basic need completely destroys market equilibrium concepts.

  4. That looks like a pretty good course, though I might have issues with it–it may leave some things out i’d include (and i’m just an amateur in econ—most of it i know i learned coming from ‘complexity theory’ because it overlaps–eg I see you studied with Duncan Foley who i ran across in a journal article in which he applied to statistical mechanics’/maximum entropy formalism to propose statistical as opposed to general equilbrium in economics. That may be one of those most well known early papers though it goes back to Durlauf in 90’s, Kirman in 80’s and and Follmer in 70’s. (i am half an amateur historian so i read stuff that goes back to 30’s or even before. These are origins of ‘econophysics’–alot of Indians do this as well currently).
    I think one can recoincile classical and marxian theories of value (labor versus utility theories). (One thing i also wonder given i hear news about pakistan, etc how ‘normal ‘ life is there — sometimes i hear about terrorism, other times sporting events and science, but maybe thats what pakistanis hear about usa–mix of normalcy and chaos.

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