QUICK BITS NO 20
On the limits of the invisible hand
(17 July, 2016 at 13:43 | Posted in Economics
Lars P. Syll posts (16 July) in Economics HERE
“It might look trivial at first sight, but what Harold Hotelling did show in his classic paper Stability in Competition (1929) was that there are cases when Adam Smith’s invisible hand doesn’t actually produce a social optimum.”
At no time did Adam Smith claim that the “invisible hand” did create a social optimum. The statement not only looks trivial; it is worse than trivial. It is absolutely wrong.
“With the advent of neoclassical economics at the end of the 19th century a large amount of intellectual energy was invested [WASTED] in trying to formalize the stringent conditions of obtaining equilibrium and showing in what way the prices and quantities of free competition constituted some kind of social optimum.
That the equilibrium reached in free competition is an optimum for each individual – given prevailing prices and income distribution – was not, however, seen by some economists as making a very strong case for a free market economy per se. It wasn’t possible to prove that free trade and competition gave a maximum of social utility. The gains made in exchange weren’t a manifestation of a maximum social utility.”
In pursuit of maxima the economists concerned lost rouch with reality.
“Knut Wicksell was one of those who criticized the idea of regarding the gain in utility arising from free competition as an absolute maximum. This market fundamentalist idea of harmony in a free market system didn’t live up to Wicksell’s demand for objectivity in science – and “the harmony economists, who endeavoured to extend the doctrine so that it might become a defence of the existing distribution of wealth” were judged severely by Wicksell (Lectures 1934 (1901) p. 39).
Good for Wicksell!
“When propounders of the new marginalist theory – especially Walras and Pareto – overstepped the strict boundaries of science and used it in ascribing to the market properties it did not possess, Wicksell had to react. To Wicksell (Lectures 1934 (1901) p. 73) it was almost tragic that Walras … imagined that he had found the rigorous proof … merely because he clothed in mathematical formula the very arguments which he considered insufficient when they were expressed in ordinary language.”
Walras caught out! Just because “he clothed in mathematical formula the very arguments” that were “insufficient”, let alone nonsense, earned him a salary and helped tp mislead generations of students.
“But what about the Pareto criterion? Wicksell had actually more or less anticipated it in his review (in Zeitschrift für Volkswirtschaft, Sozialpolitik und Verwaltung, 1913: 132-51) of Pareto’s Manuel, but didn’t think it really contributed anything useful. It was just the same old doctrine in a new disguise. To Wicksell the market fundamentalist doctrine of the Lausanne School obviously didn’t constitute an advance in economics.”
From a methodological point of view there are also one or two lessons to learn from this history.
Models may help us to explain things by providing us with a frame/instrument for analysing and explaining the real world. However, to do that, there has to be an adequate similarity between model and reality. Otherwise they cannot function as eye openers that widen our cognitive horizon and make it possible to see and detect fundamental forces/ relations/mechanisms operating in the real world. And — most importantly — we always have to scrutinize the assumptions the models build on and so test their plausibility.
Logic, coherence, consistency, simplicity, and deductively is not enough. Without confronting models with the real world, they are nothing but empty thought experiments — and should be treated as such.
I reproduce the article because it is a rare example of good sense from a modern economist.
It also reminds me of many wasted years studying microeconomics as a student (1965-69)