Alfred Marshall Attacks the “Perfect Knowledge Assumption,” BUT Sees Horizontal Demand Curves as a “Ruling Fact” in the Economy

Alfred Marshall, on this as in on so many other issues, was an eclectic tangle of confusions and inconsistencies, varying in his editions of his Principles (1st ed., 1890). There were two basic and conflicting strains in Marshall here. On the one hand, he had a position close to the classicists: considering free competition as a broad relationship holding throughout the market, and not feeling the need to make the definition of competition narrow and rigorous. In fact, he expressly attacked the doctrine of “perfect competition” in his eighth edition, and said that a negatively sloping demand curve to a firm was compatible with competition. The term “monopoly” was used but not precisely defined, but presumably referred to a single seller of a commodity.

On the “perfect knowledge” assumption in perfect competition, Marshall was properly caustic: 

we do not assume that competition is perfect. Perfect competition requires a perfect knowledge of the state of the market.... [I]t would be an altogether unreasonable assumption to make.... The older economists, in constant contact as they were with the actual facts of business life, must have known this well enough; but, partly because the term “free competition” had become almost a catchword... they often seemed to imply that they did assume this perfect knowledge.

On the other hand, Marshall, too, was influenced by mathematical economists to some degree, and therefore by Cournot. In the third edition of his Principles, he introduced the Cournot idea that the horizontal demand curve for the firm was the ruling fact in the economy, and that the falling demand curve was the exception. Here was the disastrous concession that perfect competition, or pure competition (the horizontal demand curve), while perhaps not necessary to the whole economy or even ideal, was the ruling case in the economy. This position appeared particularly in Marshall’s famous Mathematical Appendix, which was heavily influenced by Cournot.

—Murray N. Rothbard, “Competition and the Economists,” Quarterly Journal of Austrian Economics 15, no. 4 (Winter 2012): 403-404.

The French Mathematician Antoine Augustin Cournot Founded Modern Monopoly and Perfect-Competition Theories

Meanwhile, unheralded and unrecognized at the time, the French mathematician Augustin Cournot, founded not only mathematical economics but also modern monopoly and perfect-competition theories, in his Principes in 1838. To make things easy for using the calculus in dealing with profits, revenues, and costs of a business firm, Cournot defined competition as that situation where price does not vary with the quantity of the good produced: i.e., where the demand curve for the firm is horizontal, or “perfectly elastic.” Not only did Cournot thus found the basic axiom of perfect competition theory, he also believed that such a condition only obtains where the number of firms is large, and that when firms are fewer, “oligopoly” ensues. Cournot worked out a theory of “duopoly.”

Thus, with Cournot, the seeds of modern perfect-competition and monopolistic-competition theories were already set, as well as modern mathematical economics: “competition” only occurs when the demand curve for the firm is horizontal; this takes place only when the number of firms in the industry is very large; a smaller number leads to “monopolistic” situations of “oligopoly,” etc. Of course, a single firm in an industry, where the demand curve is of course falling, Cournot defined as a “monopoly.”

—Murray N. Rothbard, “Competition and the Economists,” Quarterly Journal of Austrian Economics 15, no. 4 (Winter 2012): 400-401.

Simpson (2014) on Methodological Objections to the Real Business Cycle Theory (Post 2 of 2)

I will make one last point on methodology before I start addressing specific RBC theories. RBC theorists, like Keynesians, use perfect competition in their analysis. The difference is that while Keynesians claim that the characteristics of perfect competition are not met (i.e., markets are “imperfect”), RBC theorists claim that they are and that fluctuations are a part of  competitive equilibrium and market clearing economic activity. RBC theorists accept the same false premise as Keynesian economists, they simply claim that the premise holds. RBC theorists, like Keynesians, need to reject the false premise and (among other things) embrace the sound theory of competition.

In a sense, RBC theory is worse than Keynesian “sticky price theory.” The Keynesians are right to claim that the characteristics of perfect competition do not hold in reality because these characteristics have nothing to do with the nature of competition. The RBC theorists are not deterred by this and claim that the business cycle consists of natural fluctuations within a perfectly competitive equilibrium. While it may seem plausible that expansions are consistent with market clearing economic activity, it is more difficult to believe this for contractions. This is the case in particular for severe contractions. Are we to believe that the recession of the early 1980s, the recession of 2008–9, and even the Great Depression were fluctuations in which markets cleared?

—Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 81-82.

Simpson (2014) on Methodological Objections to the Real Business Cycle Theory (Post 1 of 2)

Real business cycle (RBC) theories are nonmonetary explanations of the business cycle. Supporters of RBC theory claim that business cycles arise due to changes in real factors, instead of monetary factors, in the economy. The focus is on alleged causes of the business cycle that emanate from places other than changes in the supply of money and spending. Further, such cycle theory assumes markets are always in equilibrium (i.e., they always clear, even during recessions and depressions).

Probably the most popular version of RBC theory claims that changes in the level of technology affect the economy such that it causes fluctuations in output and employment (i.e., a business cycle). The claim is that a new invention will increase productivity and bring on an expansion in the economy as the use of this invention becomes widespread. Likewise, technological regression will cause a decrease in overall production in the economy, thus creating a contraction. . . .

__________

Let me start with a criticism pertaining not to the content of RBC theory but to the methodology of RBC theorists. RBC theorists often simply attempt to mimic the movement of variables during business cycles, such as unemployment and output, using mathematical equations.  They believe that this somehow makes their “theory” valid. However, simply being able to mimic a phenomenon does not provide an explanation for why that phenomenon occurs. To explain a phenomenon one must be able to show logically what factors are causing that phenomenon to occur.

One may be able to mimic changes in output, unemployment, interest rates, the money supply, and so on and one may even be able to obtain the correct relative changes in these variables; however, unless one can show why these variables are changing or why a change in one variable causes a change in another, one does not have an explanation for the movements. In fact, one does not have a theory at all for why the phenomenon occurs. One merely has an intellectually empty imitation of variables. . . . 

In addition, curve fitting data, or what contemporary, mainstream economists might call “calibrating” a “model,” does not provide an explanation of why the variables in the “model” change. It does not identify the causal factors involved. One needs a logical explanation grounded in the nature of the phenomenon and entities being studied to understand why variables move as they do.

—Brian P. Simpson, Remedies and Alternative Theories, vol. 2 of Money, Banking, and the Business Cycle (New York: Palgrave Macmillan, 2014), 79, 81.

Few Saw the 2007-08 Crisis Coming Because Most DSGE Models Exclude Key Variables Like Loose Credit

Since the mid-1950s, macroeconomic theorizing evolved from what has been aptly called ‘hydraulic Keynesianism’ into dynamic stochastic general equilibrium (DSGE) models of the economy. In the process, this type of theorizing has come to dominate mainstream economics, absorbing both Keynesians and neoclassicals within the same methodological paradigm. Neoclassicals insist that changes in monetary conditions can have no effect on real outcomes, whereas Keynesians invoke ‘price stickiness’ and other rigidities to come to different conclusions.

Despite longstanding and convincing objections to the DSGE model, on the eve of the financial crisis of 2007–08 it commanded almost universal support within the mainstream of the economics profession. The unquestioning nature of this support has been compared by Roger Koppl to John Stuart Mill’s endorsement of the cost-of-production theory of value shortly before its overturning by the marginalist revolution in the last quarter of the nineteenth century.

The credibility of mainstream macroeconomic thinking has been fatally undermined, not yet by an alternative theory but by its inability to explain either the proximate or the underlying causes of the crisis of 2007–08. Nor has it been able to offer any explanation for the unexpected duration of the subsequent recession. It is widely acknowledged that the proximate cause of the financial crisis was a loss of confidence on the part of some major financial intermediaries in the ability of counterparties to meet their obligations. Hence the ‘credit crunch’ by which this loss of confidence was transmitted to the real economy.

The more fundamental origins of the crisis are to be found in the loose credit and regulatory policies that were pursued in earlier years, permitting an unsustainable boom in house and other asset prices. Neither of these factors appears among the list of variables specified in most DSGE models, so it is not surprising that few academics or policymakers ‘saw the crisis coming’.

—David Simpson, “What’s Wrong with Keynesian Economics?” in What’s Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 203.