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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

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In my paper entitled “Empirical Evidence Against Neoclassical Utility Theory: A Survey of the Literature,” I have argued that neoclassical utility theory acts as a blindfold, which prevents economists from understanding simple realities of human behavior. The paper provides many examples of this phenomenon, which I will illustrate briefly with one simple example in this post.

Consider the two player Ultimatum Game. The Proposer (P) has ten dollars in single dollar bills. He makes an offer of $m to the Responder (R), which allows him to keep $(10-m). The responder can either Accept or Reject. If Responder Accepts than P get $10-m, and R get $m as proposed; it is convenient to denote this outcome as (P:10-m,R:m). If Responder Rejects, then both get $0: (P:0,R:0)

Here are four predictions made by Game Theory, based on utility maximization behavior.

  1. Responder will be indifferent between the two choices Accept and Reject if he is offered $0.
  2. Responder will Accept an offer of $1, resulting in outcome (P:9, R:1). R prefers 1 to 0.
  3. Proposer believes that Responder is a Utility Maximizer; that is, he will behave in accordance with propositions 1 & 2 above.
  4. Proposer will therefore offer $1, as it maximizes his share at $9. If he offers $0, the outcome is uncertain because both responses A and R are possible maximizing responses, which is why an offer of $1 is the unique utility maximizing offer.

All four of these propositions are false. Furthermore, every layman will easily be able to see that all four of these propositions are false. However, economists have great difficulty in seeing that they are false and in understanding why this is so. This is because economic theory teaches economists to “think like economists” which means modelling humans as being homo economicus: cold, selfish and callous (Vulcans, for short). This makes economists unable to understand real human behavior. As everyone (except economists) knows, the responder will reject the offer of $0; he will not be indifferent between accept and reject. Empirical studies conforming to our intuition about human behavior show that in situation 2, the vast majority of responders will reject the offer of a 10% share, preferring to get $0 rather than accepting injustice or an unfair offer.

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Before proceeding with Re-Reading Keynes, I would like to clarify the issue of exogeneity and endogeneity, which he understands, but most of his followers failed to understand.  This is to clarify a segment of a phrase he uses in describing the four ways in which level of employment can increase within the framework of the classical theory of economics. The fourth factor listed by Keynes appears somewhat mysterious in the original text:
(d) an increase in the price of non-wage-goods compared with the price of wage-goods, associated with a shift in the expenditure of non-wage-earners from wage-goods to non-wage-goods.
== in the previous post (P9: Theory of Employment) I re-stated this as an exogenous increase in real wage, to clarify what Keynes wanted to say. However, (d) above is what Keynes actually wrote, and I want to explain why Keynes wrote in this way. This involves an excursion into the supply and demand model, and the concepts of exogeneity and endogeneity.
What Keynes is saying here is that if there is an increase in demand for luxury goods consumed by aristocrats, and an associate decrease in demand for necessities purchased by laborors, then the real wage will rise and that will increase employment. Keynes is very careful to create a scenario in which the real wage rises due to EXOGENOUS factors shift in demand by non-wage earners — the aristocrats.  What Keynes understood is something basic which is not understood by modern economists like Varian when they discuss the supply and demand model — ONE CANNOT CONTEMPLATE VARIATIONS IN AN ENDOGNEOUS VARIABLE (because endogenous variables are not free to move; they can only change if some of the exogenous variables which affect them change). This means that asking what consumers will demand if the price changes is a WRONG question — prices are endogenous and they cannot change by themselves. An increase in price cause by shortfall in supply would lead different consequencs from an increase in price caused by an upward shift in the demand. If a consumer is asked what he will do when the price changes, he should ask WHY did the price change, because his response to the price change DEPENDS on cause of the price change. He cannot provide a response to the question without learning about the cause, and whether or not this is a temporary or permanent change.

 

Comments on Varian: Intermediate Microeconomics. Chapter 1, which sets up a simple supply and demand model.

Brief Summary of Post:

These comments are about the first few pages of the chapter. Quotes from Varian are in italics. Criticisms are made in this post about the concepts of models, optimization, equilibrium, and the concept of exogeneity, as dealt with by Varian. Models are used without explicit discussion of the relationships between model and reality, which is essential to understanding how models work. For an extended discussion see my lecture on Models Versus Reality. The post explains why optimization, taken is tautological by Varian, is false as a description of consumer behavior. For an extended discussion of the conflict between axiomatic theory of consumer behavior and actual human behavior, see my one hour video: Behavioral Economics Versus Neoclassical Economic Theory.  Similarly, the decision to study only equilibrium behavior handicaps economists, making them blind to disequilibrium events like the Global Financial Crisis.

Detailed Discussion

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Part 2 of Lecture on Spirituality and Development: Friday, 27th Jan 2017 by Dr. Asad Zaman, VC PIDE — for Students of Religion & Development Paper, Center of Development Studies, University of Cambridge. Link for part 1: Spirituality . 50m Video lecture:

OUTLINE OF LECTURE:

  1. The meaning of development has varied dramatically across time, space, cultures.
    1. When Britannia ruled the Waves:
      Development definition suited Britain: Sea-Power, Coal Mines, Industry, Climate, Race
      No entry for “democracy” in Encyclopedia Brittanica, 1930
    2. Post-War Rise of USA
      Initial Definition: Democracy, GNP per capita – both criteria serve to ensure leadership of USA.
    3. Later, some Oil Economies had Higher GNP/Capita than USA
      So REDEFINE Development to include Income Distribution, so as to keep US on top
    4. Later, Switzerland, Japan and some other Scandinavian countries had Higher Wealth + Lower Gini. How to measure development to ensure USA is on top? Answer: Redefine Development to include Infrastructure
    5. Conclusion: Definition of Development Changes to suit the powerful. Criteria are chosen to ensure that the powerful are on top.
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Friday, 26th Jan 2017: Lecture by Dr. Asad Zaman, VC PIDE to students at University of Cambridge, Center of Development Studies for Religion & Development paper. 40 minute video recording of lecture on you-tube

Part 1: “What Is Spirituality?”:  Modern Secular thought takes spirituality and religion to be diseases which affect weak minds not properly trained in the scientific method. Part I of this lecture explain why this view, which is based on positivist ideas, is seriously mistaken. OUTLINE of this lecture is given below

Separate Lecture Part 2:” What is Development” focusing on how spirituality affects how we think about development and how to achieve it.

  1. Standard Modern Answer
    1. Spirituality is a literary term, used to spice up poetry and novels.
    2. It is like Phlogiston, Unicorns, Ghosts, Souls, God
    3. It is one among many medieval beliefs, like flat Earth, which have been proven wrong.
  1. Why don’t we understand spirituality?
    1. Because we have been trained to think like Logical Positivists, EVEN though this philosophy has been proven wrong! Key wrong positivist beliefs:
    2. Unobservables do not matter for science
    3. Science explains the observable patterns. It may postulate things like atoms, gravity, but this is just for convenience. Existence of gravity is not part of scientific assertion.
    4. Kant: Thing-In-Itself is not knowable, not relevant for science. Wittgenstein: Wherof one cannot speak, thereof one must be silent. ALSO, The human body is best picture of the human soul (That is, observables matter, unobservables don’t)
    5. SCIENCE is the ONLY source of valid knowledge.

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jobsThis is the 9th Post in a sequence about Re-Reading Keynes. In chapter 2 of General Theory, Keynes wishes to develop a theory of employment. He claims that classical economics does not have a theory of employment, because it assumes that all resources will be fully employed. But the theory that unemployment will always be 0% – except for frictional – is not a theory which can explain observations of high and persistent unemployment. Taking this post-Depression observation for granted, the question arises how we can create a theory in which the labor resources can be utilized at different levels. In order show that classical theory cannot explain the observed fluctuations in the level of employment, Keynes lists the four possibilities under classical theory which could create a change in the quantity of labor being employed:

  1. A more efficiently organized labor market, which find faster matches between the unemployed and job opportunities, would lower frictional unemployment and increase employment.
  2. A decrease in the disutility of labor would mean that laborers would be willing to accept lower wage offers, which would lead to expansion of the employment.
  3. An increase in the productivity of labor would bring greater rewards to the employers and induce them to hire more labor at a given wage.
  4. An exogenous decline in price of consumer goods purchased by laborers would increase the real wage and thereby employment. Exogenous means that demand for these goods by non-laborers decreases, causing the price decline.

These factors constitute the classical theory of employment in the sense that the variations in the equilibrium quantity of labor can only be brought about by varying these four factors. Keynes argues for the necessity of radical revision in the classical theory by showing that employment levels following the Great Depression cannot be explained by these factors.

Keynesian theory is going to be built around the rejection of the 2nd Postulate: labor is supplied until the marginal disutility of additional units of labor is exactly offset by the real wage. This means that the fourth possible explanation based on changes in real wages is not valid. The evidence for this is the NON-FUNDAMENTAL argument of Keynes. Laborers react to cuts in nominal wages by going on strike. They do not respond similarly to general increases in the price of consumption goods. It follows that the decision to offer labor is not a function of the real wage.

The Scientific Method: There is a huge amount of confusion regarding the nature of science and the scientific method. See for example, the best-selling, widely used textbook by Chalmers: “What is this thing called science?” for clearing up many widespread myths. Making minimal claims, I would argue that an important aspect of science is the revision of theories to match discordant observations. Contrary to Popper, observations in conflict with theories do not falsify the theory. Rather, they create a puzzle, an anomaly in Kuhn’s terminology. This is a challenge for researchers to find a modification of the theory which will explain the anomaly. If all such attempts fail, or such attempts create a degenerating research program which adds ad-hoc assumptions without explanatory power, to protect core axioms of the theory [Like Ptolemaic astronomy], then situation becomes ripe for a scientific revolution.

The fundamental conflict between classical theory and empirical observation is the existence of involuntary unemployment:

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.

Just like observations of elliptical orbits conflict with the circular orbits assumptions of Ptolemy, so the above observation of Keynes conflicts with the standard postulates of economic theory (both pre-Keynesian and modern economics) about the labor market. Once we have an observation in conflict with our fundamental theory of the labor market, we have two options which are routinely used in science.

OPTION 1: (Normal Science) Work on finding ways to explain these conflicting observations while retaining the postulates. The standard explanations for lower equilibrium employment would follow the FOUR possibilities that Keynes has listed. These are all the possibilities available which allow for changes in the volume of employment in a way consistent with the classical postulates of the labor market.  He rejects all of these possible explanations in the paragraph above. Another possibility is that strong unions keep wages above equilibrium; he discusses and rejects this possibility elsewhere. In the above passage, he indicates that Labour is not more truculent in the depression. This does not end the possibilities. It is part of normal science to look at the situation carefully and try to find other ways to create a compatibility between the observed long and persistent unemployment and the postulates.

OPTION 2: (Kuhnian Revolution). Keynes became convinced that the classical postulates for labor market CANNOT be reconciled with the observation of large fluctuations in volume of employment, as well as the observation of different reactions of labor to cuts in wages and rise in price levels. Therefore, he proposes to overthrow the second postulate, while retaining the first one. This really is a revolutionary step, because it amounts to rejecting Supply & Demand theory in the Labor Market. It also amounts to rejecting the efficacy of the free market mechanism in the labor market. These ideas are sacred ideologies – for example, when David Card published research showing that raising minimum wages did not lead to increased unemployment, “It cost me a lot of friends. … (economists) became very angry … They thought that in publishing our work we were being traitors to the cause of economics as a whole.” Keynes is also aware that his revolutionary ideas might anger some people, and lose him some friends:

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. Something similar is required to-day in economics. We need to throw over the second postulate of the classical doctrine and to work out the behaviour of a system in which involuntary unemployment in the strict sense is possible.

(Non)-OPTION 3: (Ostrich Mode) One can try to explain it away, or revise core theories, but the option to ignore, or to assume away, empirical evidence is not available to scientists. Yet this is precisely the route that was followed by macro-economics since the 1970’s. This is why Romer has said that the Chicago School ignored basic principles of science. What Romer fails to realize is that the entire edifice of modern economics is based on an anti-scientific methodology in which validity of statements is determined by authority and reputation, and not by consistency with empirical evidence. The Nobel Prize in 2010 seeks to re-habilitate the “friction” explanation (modernized as search theory) for unemployment, which Keynes rejected because it was obvious that the frictions remained the same while the volume of employment fluctuated. Anti-scientific hostility to empirical evidence was reflected in the response by mainstream journals to my paper “The Empirical Evidence Against  Neoclassical Utility Theory: A Review of the Literature” [with Mehmet Karacuka] International Journal for Pluralism and Economics Education Vol. 3 (4)  2012, p 366-414. This paper provides overwhelming empirical evidence against the vaunted micro-foundations of economics. Referee’s reports from the leading Economics Journals did not say that the paper was wrong, but rather that it was too insulting to economists. Given strong evidence of dramatic conflicts between the models and reality, scientific methodology would demand an urgent search for alternative bases for a theory of consumer behavior, which is at the foundation of all modern economic theory. Instead, a few token behavioral economists are hired to deflect criticism, while homo economicus continues business as usual within mainstream economics departments. Since criticisms of economic methodology conflict with ideological commitments, I have criticized econometric methodology, which is less charged emotionally. In my paper, Methodological Mistakes and Econometric Consequences, I have shown how contemporary methodology of econometrics is based on logical positivist ideas and is deeply flawed.

The upshot of all this is that the Keynesian Revolution was aborted before it got started. Keynes observed that empirical evidence of behavior of laborers conflicts with the standard homo economicus model of rational behavior of laborers; this conflict strikes at the root of modern economic theory. In an extremely ironic twist, instead of accepting his insights, economists rejected Keynesian theory on the very grounds that it is not compatible with rational behavior of laborers – when this incompatibility was the raison d’etre of Keynesian theory.

To continue his analogy, Keynes told the Euclidean geometers that your axioms conflict with observations, so let us drop the parallel postulate, and instead use another axiom which is compatible with what we see around us. The Euclideans rejected this theory on the ground that it lacks “micro-foundations” — meaning that it is not compatible with the Euclidean parallel postulate, which is the foundation of Euclidean thought, and cannot be questioned.

ideologyinequalityEven though very few people have more than a vague idea about them, macroeconomic theories deeply affect the lives of everybody on the planet. Writings of Piketty, Stiglitz and many others, as well as personal experience of the 1% — 99% divide, have created increasing awareness of the deep and increasing inequalities which characterize modern capitalist economies. However, the link between inequality and macroeconomic theory has not been pointed out clearly. The fact that since the 1970’s top corporate salaries have increased by 1000% while the average worker only earns 11% more is closely linked to the revolution in economic theory that occurred over the 70’s and 80’s. We will try to sketch some parts of the complex and coordinated efforts which led to the emergence of theories which provide the invisible foundations and the enabling environment for this inequality.

The oil crisis of the early 70’s destroyed the consensus on Keynesian macroeconomics, and created the opportunities for ideologies disguised as economic theories to emerge. Chicago school economist Robert Lucas attacked the dominant Keynesian theories which argued that governments must play an important role in eliminating unemployment. Guided by free market ideology, Lucas created macroeconomic theories which suggested that government interventions are always harmful. Some elements of the Lucasian methodology provided genuinely superior alternatives to defects in existing Keynesian models. However, other elements were bizarre. Even though unemployment is a painful reality to vast numbers of people, defender-of-free-markets Lucas argued that this was a free choice. According to Lucas, the Great Depression was really the Great Vacation, where vast numbers of people suddenly decided to stop working in order to enjoy leisure. This, and many other strange assumptions of the Lucasian alternative led famous economists like Robert Solow to say that to engage in a serious discussion with the Chicago school would be analogous to discussing technicalities of the Battle of Austerlitz with a madman who claimed to be Napoleon Bonaparte. For example, Solow wrote that “Bob Lucas and Tom Sargent like nothing better than to get drawn into technical discussions, because then attention is attracted away from the basic weakness of the whole story. Since I find that fundamental framework ludicrous, I respond by treating it as ludicrous – that is, by laughing at it – so as not to fall into the trap of taking it seriously and passing on to matters of technique.”

Recent remarks of eminent economist Paul Romer, a student of Lucas, regarding the dramatic failures of contemporary macroeconomic models have generated shock waves which continue to reverberate among economists. Romer wistfully suggests that if Solow had engaged with the Chicago school, instead of subjecting them to sarcasm, contempt and ridicule, they might have been amenable to reason. Lucas, Sargent, and their followers responded to hostile attacks by closing ranks, ignoring all who disagreed with them, and giving up on basic scientific principles such as using evidence to evaluate models.  Even though Romer criticizes Solow for ridiculing Lucas, he also finds it difficult to take the macroeconomic theories of Lucas and Sargent seriously. Since these models remove essential real factors like money and unemployment from the picture, Romer writes that modern macroeconomic models are reduced to using mythical objects like phlogiston and gremlins to explain real world economic events. What is frightening about this is that these models, which have been blamed for their inability to see the looming global financial crisis, continue to be used by Central Banks for monetary policy decisions throughout the world.

The mystery of how ludicrous theories which invoke mythical objects and causes, came to dominate the scene is not easily resolved. One important element in the success of the Chicago School was their lack of scruples. Stigler, one of leaders of free market thought at the Chicago School, explained that “… new economic theories are introduced by the technique of the huckster” (a door-to-door peddler who sells fake items as if they were genuine}. He defended this intellectual fraud on the grounds that a warrior against ignorance must subordinate the lesser truths to his quest to spread the grand truth. The grand truth, or the ideological conviction, that governments must not intervene in free markets guided the development of modern macroeconomics at the hands of Lucas, Sargent and Prescott. Ideological convictions of the Chicago School are impervious to facts – they ignore the long lines of the unemployed at the soup kitchens, and the strong empirical evidence of correlations between tight monetary policies and high unemployment.

A second crucial element was the creation of an artificial Nobel Prize in economics. Private financiers and bankers who stood to gain massively from the spread of free market theories of the Chicago School decided to purchase respectability for them. The bankers donated funds to create a prize in Economics in 1968 which was deceptively and fraudulently named after Alfred Nobel: “The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel”. The conditions and methods for granting the prize were made to resemble the genuine Nobel prizes sufficiently to deceive the masses into thinking that this was one of the genuine Nobel prizes. After creating an imitation Nobel prize, the Swedish bank proceed to award about half of all of them to Chicago School economists, giving half to assorted others to maintain a semblance of objectivity. This has resulted in a tremendous rise in the prestige of Chicago school doctrines, catapulting them from an eccentric minority to the entrenched and dominant orthodoxy in economics.

This intellectual revolution, the displacement of Keynesian economics by the Chicago School, has been used to justify economic policies to enrich the wealthy, and caused massive damage to the general public. As policies based on free market theories have been enacted globally, wealth has concentrated in the hands of the top 1%, while the fortunes of the bottom 90% have been declining. Seeing that the economic system in place has led to reduction in job opportunities and incomes, and rising costs of necessities like education and health facilities, the bottom 90% have expressed their discontent and desire for radical change in the form of Brexit and Trump. However, fundamental change requires addressing the root cause of the problem, replacing defective ideology based macroeconomic theories with more empirical and evidence based theories.

Published Express Tribune, 9 Jan 2107. My author page on LinkedIn. Other works: Index .Related articles: Economic Theory Creates our World and our Worldview. The Fairy Tale of GNP per Capita.