Friday, June 08, 2007

Simpler explanations

Maybe my understanding of what constitutes neoclassical economics is too crude, but I do not see why Crooked Timber of Marginal Revolution come up with such complicated "heterodox" reasons for the existence of economic profits ("surplus") in the economy.

Crooked Timber sets up the (non) problem here:
A large part of my interest in heterodox economics derives from one major problem with neoclassical economics. In my opinion, it’s a big enough embarrassment to the profession that somebody ought to have done something about it, and the fact that more or less nobody is interested in even trying is bad enough that I am prepared to overlook an awful lot of misbehaviour on the part of heterodox economists, because at least they are, in general, trying. I’m even prepared to tentatively advance this “anomaly” in neoclassical economics as being constitutive of the difference between orthodox and heterodox economics, as currently practiced.

The anomaly I’m talking about is that neoclassical economics, in both macro and micro forms, nearly invariably works on the basis of models in which there are no profits.
Marginal Revolution tackles this (non) problem by invoking Schumpeter, Mises, and Hayek:
Is the explanation for profits monopoly power? Not really. Or rather, the better way of phrasing it is that most profits are a return to innovation and entrepreneurship. Innovation and entrepreneurship typically bring some market power but disequilibrium monopoly has very different implications for policy than equilibrium monopoly.

Here's some intuition. Textbook neoclassical economics says profits and losses are zero. The standard monopoly story can explain profits but not losses. The return to entrepreneurship/dynamic economy/creative destruction story that I am telling can explain both profits and losses.

Thus Davies is correct, profits do suggest a role for heterodox economics but it's not the paleo-Keynesian/Marxist heterodoxy that gets the boost but the Austrian heterodoxy of Mises, Hayek and Schumpeter.
In my second or third intro-to-econ class at U Chicago, we were told that in a competitive equilibrium, price is set by the marginal firm (ie. the firm that has the highest marginal cost of production). If prices fall any further, that firm goes out of business because its marginal cost of production is now higher than the price it can charge, so it starts losing money of every widget it sells.
However, the marginal firm is just the worst firm in the market, there are lots of better firms as well, and all of those have (by definition) marginal costs below price, and so make (some) economic profits. I believe that this type of economic rent was called Ricardian rent, but I may be remembering wrong.

So there you have it -- that mysterious bogey man "profits" explained, as well as other "weird facts" like variance in profitability within an industry,

The point is that bog standard classical economics has a perfectly good mechanism for profit (at around the observed levels) without having to reach into wacky. The heterodox crowd, on the right and the left, would be easier to take seriously if they didn't always go for the glamorous explanation.


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