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What is the Problem with Neoclassical Price Theory?
Abstract
The article seeks to focus attention on Neoclassical price theory, as one of the two problematic foundations of modern mainstream economics—the other being the theory of distribution. After outlining what is understood to be Neoclassical price theory and noting the various criticisms which it has been subject to from both within and without the school, the article proceeds to argue that its major flaws need to be understood as stemming from how it conceives of the formation of prices in the first instance. Specifically, the article argues that the basic problem with the Neoclassical theory of price is that it abstracts from both production and money in the first instance, such that when these are eventually brought back into the explanation of price it is done so in an inessential manner; one where production and money have no bearing on the findings of the analysis of price which excluded them.
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See, for example, Colander et al. (2009), Kirman (2009), and Reinert (2012).
See Gee (1991) for a short, but instructive, review of the main theoretical propositions of the Neoclassical school.
For excellent accounts of the origins of the Neoclassical school see Dobb (1973) and Roll (1973).
See, for example, Aspromourgos (1986) and Colander (2000).
The important sub-groupings in respect of the explanation of price I take to be the New Keynesians, Walrasians, and Austrians, with the modern incarnations of the latter two schools sometimes having the prefix “neo” applied to them. See Mankiw and Romer (1991), Kreps (1990), and Horwitz (2000) for presentations of the New Keynesian, Walrasian general equilibrium, and modern Austrian versions of Neoclassical price theory, respectively.
Although Neoclassical theories of price refer to commodities, it is taken as given that the same principles apply to the prices of services.
Marshall, it needs noting, used the distinction to argue that prices over the short run are determined more by demand while over the long run they are determined more by costs (see Marshall 1920, Book 5, chapter 3).
Laidler attributes the origins of this view of money to the work of Keynes and Hicks (see Laidler 1990: 2).
The seminal modern Neoclassical explanation of the long-run equilibrium money price level is to be found in the work of Milton Friedman. See especially Friedman (1976, 1989).
The Heterodox school may be defined as essentially a collection of all those approaches to the analysis of the economy which are opposed to current mainstream Neoclassical economics.
See, for example, Hahn (1984) and Clower (1999).
See, for example, Samuelson (1964).
See Kreps (1990: 279-283) for a flavor of the criticism of partial equilibrium theory from within.
See, for example, Kirman (1989, 1992).
See, for example, Hahn (1984), Kreps (1990) and Clower (1999).
See, for example, Shand (1984).
Many of these criticisms are to be found in Keen (2001), Fullbrook (2004, 2008), Lee and Keen (2004), and Benicourt and Guerrien (2008), among others.
See, for example, Moore (1979), Palley (1991), and Wray (2003).
Gee (1991) notes that modern Neoclassical conceptualizations of a pure exchange economy can be traced to the writings of Francis Edgeworth and Léon Walras.
Dissatisfaction with the restrictive assumptions about the behavior of the individual in standard Neoclassical theory, particularly in view of the so-called Sonnenschein-Mantel-Debreu theory demonstrating the impossibility of bargaining between utility maximizing individuals leading to a unique and stable set of prices which would maximize society's welfare, has spawned in recent times a number of offshoots of the Neoclassical school which posit all manner of individual behavior. The new offshoots include so-called evolutionary game theory, and experimental and behavioral economics. However, their point of departure remains a process of exchange divorced in the first instance from production and money.
See, for example, Sinha (2010).
See, for example, Endres on Menger's view of price formation (Endres 1997: 61).
It needs noting that Walrasian general equilibrium theory does not see any signaling role for prices because it is assumed that prices are equilibrium prices given by some invisible hand or auctioneer which balances the quantities of commodities demanded and supplied so as to maximize overall satisfaction (see Hahn 1984: 92).
Emphasis is placed on the reproduction of the commodity as opposed to its production because what matters in the material reproduction of commodities is not their historic costs of production but the material resources required for their future production.
It is interesting to note Milton Friedman's tacit admission of the importance of incomes rather than prices per se in the allocation of resources in his landmark Neoclassical book on prices when he states, “Prices of products in relation to the costs of producing them determine the distribution of resources among industries…” (1976: 9).
See, for example, Stringham (2010).
Endres notes that for Menger “Prices at which transactions occur are formed in ‘price duels’ and distributed within ranges of indeterminacy so that there is no unique market clearing price” (Endres 1997: 61).
See, for example, Lee (1998) on this point.
I take money, whether commodity or paper, to be legal tender issued by the state in a modern economic system. Tokens of money are anything which replaces money in the performance of its various functions, including; medium of circulation, means of settling debts, store of exchangeable worth, and means of purchasing financial assets. Accordingly, they include drafts on notional deposits of legal tender such as commercial bank deposits. Given that the state typically guarantees these notional deposits in most advanced economies, they can be regarded as effectively money. And, the ability of banks to create such deposits means that money creation rests to a large extent with such banks in these economies.
See also Baltensperger (1989).
One might also add that given this view of money as specific exchangeability it is difficult to understand how Neoclassicals are able to see it as emerging historically to facilitate multilateral exchanges.
Money's numéraire function is sometimes referred to as its unit of account function.
For Neoclassicals, when money is a commodity it has two intrinsic values, one which is the satisfaction derived from the particular usefulness of the commodity which is money and the other the services it provides as medium of exchange. It is assumed that individual optimization will cause the two intrinsic values of money to be equated.
This is not to deny that both the value of money and the money prices of commodities can change during the course of this process of circulation, and even because of it (see below).
The favored formulation in Neoclassical econometric analyses is the regression of changes in contemporaneous and lagged money stock on changes in aggregate nominal gross domestic product.
See Nicholas (2011) for an elaboration of this point.