I would like to start this series of columns with a brutal display of intellectual honesty: despite my PhD in Economics, I do not understand many fundamental features of the economy and the way economic science tends to handle it.
First up: I do not understand how economics gets away with ignoring marketing and advertising. We are taught that preferences are given and stable, so that prices and income are the only variables we need to take into account in order to understand changes in a person’s consumptive choices. But if this is so, marketeers are wasting huge sums of money (the USA average being 2.27% of GDP annually during the period between 1984 and 2005) in a doomed quest to change our consumptive choices without changing prices. So either consumers are not as rational as the theory purports them to be, or the marketeers and companies hiring them are a particularly dumb brand of stupid and it would only take one enlightened entrepreneur in each sector to wipe out the wasteful competition.
The best mainstream response to this apparent disconnect between theory and reality I have heard of, is that although advertising does not change our preferences, it changes the information we act upon. So, if certain individuals have a preference for – say – fat-free foods, the ad informing them that a particular brand of lollipops is indeed fat-free, will entice them to make different choices (assumed the consumer is unaware that all lollipops are in fact fat-free), without however changing the individual’s underlying preferences. This argument however fails to explain the particularly low information-density of much advertising and does not explain the millions spend by many companies on things like celebrity endorsements. Moreover, when we see changes in consumptive choices occurring that cannot be explained by changing income or prices, it is empirically impossible to distinguish between these two possible causes. The consumer’s information may have changed or his or her preferences. There is no way to tell. So this escape route is not very illuminating to say the least.
Secondly, Sonnenschein (1972), Mantel (1974) and Debreu (1974) have all proven mathematically that even if individual preferences are indeed stable over time, this in itself is insufficient for the models to generate (predict) a unique market outcome (equilibrium) in terms of traded volume and price. Such models could only do so if two additional conditions (known as the SMD conditions) hold: (1) all individuals have the same tastes (i.e. identical preferences), that, (2), do not change with income (Keen, 2011, p. 57; cf. Sonnenschein, 1972). Thus, in contrast to what you may have been told, stable market equilibria can only be attained when a brutal Orwellian thought police sees to it that our desires are fully equalized. This implies that stability in market economies is theoretically incompatible with individual freedom. So now you know why the term representative consumer is so often invoked. But I have yet to find a technique that allows heterogeneous preferences to be summarised into a single consumer representing us all or, alternatively, a comprehensive rebuttal of Sonnenschein (1972), Mantel (1974) and Debreu (1974)’s argument. But if neither this technique nor the required rebuttal exists, how can we still defend teaching and developing theories invoking individual rationality?
Thirdly, our continued usage of the theories underpinning the rising shape of the supply curve is no less puzzling. A survey conducted in 1982 among ‘200 medium-to-large US firms, which collectively accounted for 7,6 percent of America’s GDP’ (Keen, 2011), found that ‘only 11 percent of GDP is produced under conditions of rising marginal cost’ (Blinder 1998) and there is no reason to believe that this number will be substantially higher today. In fact, there is evidence to the contrary as companies have only increased in size, which would be untenable if their marginal costs are rising, but would be totally understandable if marginal costs generally keep falling indefinitely. But if this is true, markets tend towards oligopoly, as Robinson has already argued a long time ago (1969). The upshot of all this is that markets that are left unchecked are unlikely in theory to be stable or welfare-enhancing. Or have I misunderstood the theory? I am open to rebuttals. In fact, I would welcome them.
Finally, the macro-economic policies that seem defendable if seen through the prism of supply and demand models, more often than not fail to deliver the expected results. Ever since the 80’s the world has started to resemble our model ideal much more closely, but world economic growth has fallen from an average of a little more than 3% in the 1960’s and 70’s to a measly 1,4% between 1980 and 2002 (World Bank; cf. Chang 2012). The countries escaping this faith, such as China, South Korea and Taiwan, have generally refused to follow economists’ advice of limited government intervention, lowering inflation and reducing trade restrictions (Chang 2012).
All in all then, much economic theory seems to be theoretically unjustifiable and empirically falsified. Of course a theory can never be comprehensively dismissed by a falsifying instance as it is always possible to blame extraneous factors. But if we blame extraneous factors for much of our economic experience since the early 80’s, the theory, if not wrong, in the very least has proven to be a very poor guide to understanding practical affairs and shaping economic policies. But perhaps all the people I referenced, as well as yours truly, have misunderstood the data, the theory or both. Please enlighten us if we did.
I feel that all the questions above are important and must be asked and if possible, answered. But I do not feel that exposing my ignorance on them disqualifies me as an economic scientist. On the contrary, there is almost universal agreement within the scientific community that any scientific investigation must start with asking the right questions, that all answers are fallible and that their weaknesses must be ruthlessly exposed. So ignoring those questions in both research and education, is much less scientific than the brutal honesty displayed here. I sure hope the comment section will be flooded with arguments showing the questions above have actually been answered a long time ago. I’d much rather be publicly crucified as an economic ignoramus than live with the nagging feeling that I am wasting my life (and the lives of the students I teach) peddling mathematized nonsense.