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[log in to unmask] (Mohammad Gani)
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Fri Mar 31 17:18:47 2006
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   Why is it so hard to do the intellectual history of economics?-John Womack  
  
   To  do intellectual history, one must possess the depth and breadth of  
   knowledge to judge others. May be most of us are not well prepared for this.  
  
   To illustrate the issue in keeping with the threads topic, let us consider  
   one of the most commonly used instances of equilibrium. It is the idea that  
   the equality of demand and supply denotes a state of equilibrium.  Now,  
   suppose that I was to decide if economists before us did make intellectual  
   progress in respect of this equilibrium concept.  I have a sad report: we  
   inherited failures.  The likely reader is party to the same failings.  To  
   overcome the failings, we have to work much harder, and there is resistance  
   to that. It is just too challenging to do hard work for intellectual history  
   to discover our own ignorance.  
  
   There are three sections below: preliminaries, the context of equilibrium,  
   and an extremely brief sketch of intellectual history.  
  
   1. Preliminaries. This is not an attempt to reconstruct economics, but an  
   exercise in historical scholarship that tries to go beyond the dictionary  
   and to chase deeper meanings.  We are trying to find out what meanings our  
   predecessors wished to convey, and whether we are able to understand those  
   concepts about equilibrium.  
  
   Let us put a few basic things out of the way. First, the idea of balance on  
   a scale or in an accounting book has very superficial similarity to the  
   notion of equilibrium in science. Equilibrium is not simple equality (say of  
   weights in a scale or values in an account), but a name for a state of  
   causal determination. It must refer to a causal process which terminates  
   opposing forces. Thus the mere equality of demand and supply is not the  
   focal point in the analysis: the equality determines some variable, and the  
   notion of equilibrium is a tool to convey a constructed sense of causality  
   regarding that variable.  Whether there is intellectual something is to be  
   found in the construction of sense. Have we articulated what the REALITY  
   seems to MEAN in a causal sense?  
    Secondly, only a specialized expression of equilibrium refers to a state of  
   rest, because the general causal meaning includes a dynamic process.  Thus  
   we need to know not just what happens when demand is equal to supply, but  
   also what happens when they are not equal. A scientist must consider the  
   concept of stability of equilibrium, and must be prepared to narrate the  
   dynamic process of change that leads back to the same original state of rest  
   or finds a new one. In short, the deeper definition of equilibrium must make  
   a clear contrast with the non-equilibrium condition. We must be able to  
   narrate how a state of non-equilibrium makes a transition to a state of  
   equilibrium.  
    Thirdly, the economist must be able to articulate the worldview, that is,  
   describe  the  economic  universe within which the particular event of  
   equilibrium is to occur.  My skeletal review concerns this element.  The  
   shallow and narrow worldview we have inherited makes it hard for us to  
   perceive the deeper and wider meaning.  We end up discovering our own lack  
   of intellect below.  
  
   2. The context of equilibrium:  
   What is determined when demand is equal to supply? Obviously, demand and  
   supply are here the determining variables, and when these two are equal,  
   they together determine some other variable, which is neither demand nor  
   supply.  The sorry story is that there is much confusion regarding what is  
   determined by this equality.  Micro says it determines price and macro says  
   it determines output (albeit at the aggregate level) and nothing says what  
   all these may mean.  
  
   To clarify this and to achieve a deeper meaning, we must fully specify the  
   context to define the event which we are describing.  As I see it, the full  
   description  must  include  at least four different sets of conditions  
   affecting four different sets of variables in the event of exchange in which  
   the demand for one good is matched by its supply. In other words, equality  
   of demand and supply is one of four equalities, all of which must be present  
   to constitute the equilibrium. These four concepts are: output, price,  
   value, and income.  
  
   To make the points sharp and clear, let us define these four terms and  
   connect the actions of production, consumption, buying (demand), selling  
   (supply), paying, receiving, earning and spending.  This preliminary may be  
   tedious but it is necessary to explicate the meaning.  
  
   Output: Output is the quantity of a real good. Demand is the quantity of the  
   output the buyer is able and willing to buy at a given price and income.  
   Supply is the quantity of output the seller is able and willing to sell at a  
   given  price,  cost, and resource endowment.  Suppose that the good in  
   question is X. Then let Xd denote its demand and let Xs denote its supply.  
   When Xd=Xs, the equilibrium OUTPUT  X^ is determined.  
  
   Please note: It is absolutely out of question for demand and supply of an  
   output to determine price, because price must enter as a predetermined  
   parameter in the demand and the supply functions. Price along with income  
   determines demand, and not the other way round.  And then again price along  
   with cost determines supply and not the other way round.  
  
   Price: The price of x is the quantity of its payment y per unit of x.  Thus  
   suppose that the buyer of x buys a quantity Xd and pays with a quantity Ys.  
   Then  the  (real) price of x is Ys/Xd.  It must be a ratio between two  
   different goods that pay for each other. In the same transaction, the (real)  
   price of y must be given by the ratio Xs/Yd.  For convenience, and without  
   any loss of meaning, we will convert the prices into units of numeraire, and  
   call them nominal price.  
  
   There is something extremely serious about the definition of real price. It  
   must establish its connection with payment, namely, real price must be  
   defined  as  the  quantity of payment. It must not be confused with an  
   arbitrary and imaginary numeraire.  For example, if the buyer pays for meat  
   with bread, the real price of meat must be quoted as the quantity of bread  
   per unit of meat and nothing else. However, to compare values of several  
   different kinds of things, one good may be taken as the numeraire, and then  
   the prices be used to convert all goods into units of the numeraire good.  
   The key point: a genuine price defined independently of the numeraire must  
   exist before the numeraire can be used to compute values.  We must learn to  
   separate price from value. That is nominal price is not really price, but is  
   nominal unit value. We should not use the term nominal price any more, but  
   call it nominal value. We should reserve the term price for the ratio Py/Px  
   where Py is the nominal unit value of y etc.  
  
   Now, when demand and supply are equal, the equality determines output and  
   does not determine price. Let us see how price is determined then. We begin  
   by defining value.  
  
   Value:  The  standard  definition of the value of a real good x is the  
   (nominal) price of x multiplied by the quantity of x.  To arrive at this, we  
   must  agree that the buyer must pay the seller. One of the fundamental  
   institutional rules of exchange is that the value of the payment must be  
   precisely equal to the value of the good. Thus if the buyer buys Xd, then  
   the value of what he buys is given by Vx=Px*Xd. Suppose that he pays with  
   Ys, whose price is Py. Then it is necessary that the value of payment Vy=  
   Py*Ys is precisely equal to the value of the good he buys. We see that  
   Vx=Vy, or Px*Xd. =Py*Ys.  
  
   The equivalence relation Vx=Vy, determines the (relative) price of x in  
   terms of y. The buyer and seller must negotiate a price which makes the  
   proposed payment equal in value to the proposed sale.  It is not equality of  
   demand and supply that determines price, but the equality of value of the  
   good and the value of the payment that determines price.  
  
   The most dramatic difference between the first equality Xd=Xs, and the  
   second equality Px*Xd. =Py*Ys is that the (relative) price (Py/Px) may very  
   well allow entrepreneurs to exist: the market price can be higher than the  
   (relative) marginal cost and lower than the (relative) marginal benefit.  
  
   In a proper sense, the buyer of x must be also a seller of y. Using this  
   concept, we see that we must have Px*Xd. =Py*Ys as well as Px*Xs. =Py*Yd.  
   Both equivalence relations refer to the identical outputs if and only if  
   Xd=Xs, and Yd=Ys. That is, we can say that both x and y are payments for  
   each other, and the exchange requires equivalence of payments. Our inability  
   to understand the second equality (of values) trapped us into the endless  
   loop of Says Law.  
  
   Income: Lastly, we need to see that the buyer of x spends what the seller of  
   x earns, and vice-versa. If the market had just this one transaction between  
   x and y, the income of the seller of x would be Vx, and the income of the  
   seller of y would be Vy.  If there are more than two agents, the income is  
   the sum of values of all payments earned by the seller (including sales to  
   himself).   This  income  must  be equal to expenditure first for each  
   individual and then for all of them together, requiring two independent  
   equalities.  
  
   Equalizing income and expenditure at the individual level must involve the  
   use of money precisely when the income from sale of real goods is just equal  
   to the expenditure on real goods, if there is indirect exchange. To achieve  
   equality of aggregate income with aggregate expenditure, the goods on sale  
   must now be broadened to include future and past goods for which payments  
   are  made  in  the  current  period.   The third and fourth equalities  
   respectively involve money and bonds (debts and credits).  
  
   If one is unaware of three out of four equalities in this equilibrium, how  
   would one do an intellectual history?  
  
   3. History of Our Intellectual Progress (?????): Now, if we look back at our  
   intellectual  history, we can see that we have made a soup of all four  
   concepts mixed together, habitually confusing price with output, output with  
   value, and value with income. And by God, we have just no idea that indirect  
   exchange  requires  a  transfer  of claims on real payment by using an  
   artificial payment such that ones customer of real good compensates ones  
   supplier of real good, all strictly within the current period, and precisely  
   when there is no debt at all. As it turns out, we have no idea that the  
   buyer actually pays the seller, and that the payment may involve money,  
   which is different from debt.  
  
   Did we make any progress? Consider just four famous authors:  
  
   Smith: What impression do we get from Adam Smith about this demand=supply  
   equilibrium?  In a rather vague way, we suppose that if there is say excess  
   supply, it pushes the price down until demand is equal to supply. If there  
   is excess demand, it pushes the price up.  But what is there behind the  
   change  in  the  price? Price is not an external variable that changes  
   autonomously: it is chosen by buyers and sellers through some bargain. The  
   whole matter of intermediation is missing from Smith.  
  
   My suspicion is that Smith did not have a clear view of the distinction  
   between the different conditions to determine output, price, value, and  
   income. Here are the main reasons for my suspicion.  
  
   First, the notion of unintended consequence arose because Smith forgot all  
   about payment. The butcher surely does care only about his own profit, and  
   does not intend to give any benefits to the meat consumer. That is, the  
   buyers  benefit  is unintended by the seller. But that is not all. The  
   consumers benefit is intended by the buyer, and intended so strongly that he  
   actually pays for it. No, it is certainly not unintended by the sole person  
   to whom it is a matter of concern. The seller does not consume the good and  
   hence  his lack of intention of deriving the benefit of consumption is  
   entirely irrelevant. Unintended consequence is certainly at odds with the  
   notion that human beings intend something through their economic actions,  
   but this notion takes a central place in the Mengerian construction of the  
   spontaneous origin of institutions.  
  
   Secondly, we see no clear sign that Smith has made a sharp distinction  
   between autarky and trade. The price is set by visible people who must be  
   seen as entrepreneurs (buyers, sellers), even if they are also optimizers  
   (producers, consumers). Neither Smith, nor anybody after him (including  
   Menger and Mises) ever made the necessary distinction between the optimizer  
   who has a given budget and cannot  gain anything, and the entrepreneur, who  
   creates  new  wealth by way of exchanging something of lower value for  
   something of higher value. If there is trade between x and y, it must mean  
   that the seller of x sells x and buys y because he can get more of y by  
   exchanging   his x with somebody than if he himself were to substitute  
   production of y for x.  
  
   Thirdly, neither Smith nor anybody after him ever clearly distinguished  
   direct trade (barter) from indirect trade. Amasa Walker is the only author  
   known to me who had an idea of indirect exchange, and J.B. Say surely did  
   not. If there was explicit consideration of indirect exchange, Smith could  
   have seen the necessary role of the pure intermediary, who sells but does  
   not produce, and buys but does not consume. The intermediation process must  
   be portrayed precisely to describe the equilibrium.  
  
    I see that neoclassical economics has not learned how to derive a demand  
   for something by entrepreneurs who do not consume it. Nor is there a supply  
   by an entrepreneur who does not produce it. Do we really know what demand is  
   when an intermediary is able and willing to buy without an intention to  
   consume it? Does the merchant affect the price when he buys the good, and  
   again when he sells it? Since the merchant is not the producer, why would he  
   care about marginal cost? And since he is not the consumer, why would he  
   care about marginal benefit (marginal utility converted into numeraire  
   units)? When we talk about price, do we exclude the merchant from his acts  
   of buying and selling?  
  
   Smiths neglect of payment disabled him from seeing either price or money  
   because these are aspects of payment: price is the quantity of payment while  
   money is a kind of payment (from among four different kinds of payments).  
   This disability has stayed with us.  
  
   Fourthly, individual demand in a single transaction between one buyer and  
   one seller, total demand of all customers from one seller, and aggregate  
   demand of all buyers from all sellers are not the same things, and they  
   require different sets of equalities to achieve systemic equilibrium of the  
   market.  The same for supply. Do classical and neoclassical treatments make  
   enough distinction to precisely identify the nature of demand and supply? Do  
   we know what demand we are talking of? Apparently, we do not. If we did, we  
   would see money as a necessary element in computing total demand facing one  
   seller, and also see credit in computing aggregate demand, where money is  
   absolutely different from credit.  In short, we did not understand what was  
   being discussed under the name of equilibrium.  
  
   Alfred Marshall: What did we learn from Alfred Marshall?  Consider the  
   following indictment.  
  
   The standard diagram in which a single good is shown in one axis and the  
   nominal price is shown in the other axis is completely missing the all  
   important issue of payment.  The demand curve in the standard diagram is  
   based on a predetermined income and price. The supply curve is based on  
   predetermined technology and endowments (giving marginal cost) and price.  
   Then the intersection shows where the demand is equal to supply. It shows  
   the equilibrium output of one good, but cannot show the price. The price is  
   the quantity of the other good y which pays for x, and this other good is  
   absent  in the picture. In a partial equilibrium model, the price is a  
   parameter, not a choice variable.  
  
   Missing  an  essential part in partial equilibrium model is a route to  
   intellectual degradation. This degradation allowed us to swallow the idea  
   that  when demand for x is equal to supply of x, somehow this equality  
   determine the price y/x, although both demand and supply themselves are  
   based on predetermined price, and there is just nothing said about y.  
  
   Let us remember that the optimizer is a price taker and cannot possibly  
   change the price. Who then changes the price?  Is it possible for demand to  
   increase and lead to a higher price? If the buyer buys more and also pays  
   more per unit, where is his larger income coming from?  In the same way, the  
   seller cannot possibly increase the supply and cut down the price. How is he  
   going to bear the loss from such an action? Neoclassical economics has no  
   excuse to forget that demand is an optimal quantity chosen under given  
   prices and incomes, and it cannot possibly change without a change in either  
   price or income or both.  
  
   The  confusion can be removed if we make the following observation. An  
   extraneous shock of new knowledge or discovery of new endowment may reduce  
   marginal cost such that the supplier can expand supply at the old price or  
   reduce price at the old supply level or a combination of both. This would be  
   optimal if the income of the supplier increases. Thus the real income of the  
   producer  of x may increase by virtue of a technological innovation or  
   equivalently an increase in resource endowment. And with added income, the  
   buyer of y (the seller of x) can buy more at the old price, or pay a higher  
   price at the old level of demand or a combination thereof. In short, an  
   increase in demand cannot occur independently on its own. An increase in  
   income  can increase both demand and price. Also, supply cannot change  
   autonomously at all. But an autonomous change in marginal cost resulting  
   from technological progress can change both the supply and the price. In  
   short, no change in price is possible without a prior autonomous change in  
   marginal  cost through technological innovation or change in endowment  
   (working  through  an  enlarged supply, then an enlarged income of the  
   supplier, successively in a multiplier fashion.) That is, the idea that  
   excess supply reduces price is utterly unclear: what can it possibly mean?  
   The meaningful statement is that lower marginal cost can enlarge supply and  
   cut down price. In the event of an error, the seller may have to absorb a  
   loss by cutting down the price.  
  
   Says Law: Says Law has always been unintelligible, because it confuses  
   output with its value. Suppose that the supplier of x wants to buy something  
   y whose value must be equal to the value of x.  The equality of the values  
   of  two goods cannot mean equality of demand and supply. Indeed, it is  
   plainly absurd to equalize the supply of x with the demand for y. It is  
   however not absurd, but is essentially tautological if the supply of x is to  
   mean the creation of demand for x, in which case, the buyer is identically  
   the seller, and there is no market at all.  Outside autarky, it is plainly  
   absurd to suppose that the supply of x by John creates the demand for x by  
   Paul (when John is NOT Paul).  
  
   So what did we understand by a statement such as supply creates its own  
   demand? Did we mean that the supply of x creates the demand for x? Clearly,  
   the aggregate value of all goods supplied must be equal to the aggregate  
   value of all goods demanded. But this statement says absolutely nothing  
   about market clearing at all, and is not about either supply or demand, but  
   only about value.  
  
   The all important issue of whether the seller of y wants to buy x when the  
   seller of x wants to buy y is entirely left unexamined. Says Law holds under  
   barter, which is extremely rare. But it must fail in indirect exchange. Thus  
   if the seller of x wants to buy y, but the seller of y does not want to buy  
   x, barter is not possible between x and y. However if the seller of z wants  
   to buy x, and the seller of y wants to buy z, then an indirect exchange is  
   possible if and only if a tool to transfer claims exists. The transfer of  
   claim is necessary because the seller of x sells it to someone from whom he  
   does not buy anything (of z) back, and wants to buy y from someone to whom  
   he cannot sell x. In that case, he is connected to two different people: a  
   supplier (of y) and a customer (of x). His customer (seller of z) must  
   compensate  his supplier (buyer of z). The tool that accomplishes this  
   transfer is a device called money. Says Law fails if money is missing in  
   indirect exchange.  
  
   Equality of demand and supply is not enough; it is further necessary to  
   achieve coincidence of offer and acceptance of payment.  Sadly, under the  
   crippling misguidance of Smith, Say and Mill, the otherwise brilliant Jevons  
   drowned into the depth of error about double coincidence.  The term double  
   coincidence is an expression that specifies that the buyer pays the seller  
   in every transaction, whether or not money is used.  Suppose that the seller  
   of x wants payment in money, then the buyer of x must pay with money and  
   nothing else, that is, there must be double coincidence between the good x  
   and money. Then one would see that procuring money is a real problem under  
   indirect exchange. It is too complicated, and I must ask the reader to  
   download an article on market clearing as noted below.  
  
   Marshalls  famous  pupil  desperately tried to define demand properly,  
   resorting to an essentially unintelligible notion of effective demand.  
   Keynes needed to make a sharp distinction between ability to buy as given by  
   the real good x that the buyer of y possesses, and the ability to pay, as  
   given by his command of z with which he can pay for y, because x is not  
   accepted in payment for y.  Money is possible and necessary only under  
   indirect exchange, and this was never made clear by anybody: Smith, Say,  
   Mill, Marshall and Keynes all failed to consider the matter of payment.  
  
   Frisch: Of the many terms coined by Ragnar Frisch, macroeconomics has become  
   a  major  hit.  The  division  occurred  because people just could not  
   differentiate price from output. Microeconomics says that equality of demand  
   and  supply  determines price, while macroeconomics says that the same  
   equality determines output (albeit in the aggregate). Says Law must get the  
   most credit for this disaster: it confused the value of demand (price times  
   output, Px*X) with demand (output X only).  
  
   The confusion is created by a monumental failure to connect the individual  
   to the market. This connection must be made through the payment relation.  
   Once payment is included, microeconomics is identical with macroeconomics,  
   and trade theory is identical with monetary theory.  There are four separate  
   and independent equalities in the equilibrium of the market, each determined  
   by a separate set of determining conditions. Equality of demand and supply  
   is one of them. The second equality is that of the values of the two goods  
   that pay for each other in each transaction. The third equality is the  
   budget balance of each individual. The fourth equality is between aggregate  
   income and aggregate expenditure. All of these must be neatly put in one  
   compact model. It is easier done than said, if we ever care to define our  
   terms.  
  
   Now, would we want any more of going beyond dictionary to understand the  
   deeper meaning of the terms we use?  
  
   Apology: A deep history cannot be done in shallow articles like the present  
   one.  The  readers may check the following articles for more elaborate  
   treatment of the same set of issues. (Best if read in order.)  
  
   1.   On   Autarky   and   Trade   "The   meaning   of   gainful  trade  
   [1]http://ideas.repec.org/p/wpa/wuwpit/0405007.html  
   2.    On    Market    Clearing:     "Money    in    Market   Clearing,  
   [2]http://ideas.repec.org/p/wpa/wuwpma/0410009.html  
   3. On Equilibrium: "Equality of Demand and Supply Neither Determines Price  
   Nor Clears the Market," [3]http://ideas.repec.org/p/wpa/wuwpmi/0405007.html  
   4.   On   Micro-Macro   distinction:   "Micro   Takes   Over   Macro,"  
   [4]http://ideas.repec.org/p/wpa/wuwpma/0404012.html  
  
  
   Mohammad Gani  
  
 

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