Ha-Joon Chang - Economics - The User's Guide

A more minor yet important modification came in the 1930s, in the form of the compensation principle. The principle proposes that a change may be deemed a social improvement even when it violates the Pareto criterion (in the sense of there being some losers), if the total gains for the gainers are large enough to compensate all the losers and still leave something behind. By allowing them to endorse a change that may hurt some people (but can fully compensate for their damages), the compensation principle has allowed Neoclassical economists to avoid the ultra-conservative bias of the Pareto criterion. Of course, the trouble is that the compensation is rarely made in reality. [77] Despite the fact that it was going to hurt US workers in industries like automobile and textiles, many Neoclassical economists advocated the NAFTA, the free-trade agreement with Mexico and Canada, on the ground that the national gains from increased trade are more than enough to compensate those (and other) losers. Unfortunately, the losers have not been fully compensated, so the outcome could not be called a Pareto improvement.

The counter-revolution: the renaissance of the free-market view

With these modifications, there was no reason for the Neoclassical school to remain committed to free-market policies any more. Indeed, between the 1930s and the 1970s, many Neoclassical economists were not free-market economists. The current state of affairs in which the predominant majority of Neoclassical economists are of free-market leaning is actually due more to the shift in political ideology since the 1980s than to the absence or the poor quality of theories within Neoclassical economics identifying the limits of the free market. If anything, the arsenal for Neoclassical economists who reject free-market policies has been expanded since the 1980s by the development of information economics, led by Joseph Stiglitz, George Akerlof and Michael Spence. Information economics explains why asymmetric information– the situation in which one party to a market exchange knows something that the other does not – makes markets malfunction or even cease to exist. [78] In Akerlof’s classic example of ‘the market for lemons’, given the difficulty of ascertaining the quality of used cars before purchase, prospective buyers will not be willing to stump up good money even for what is a truly good second-hand car. Given this, owners of good used cars will shun the market, lowering the average quality of cars further, leading, in the extreme case, to the disappearance of the market itself. See G. Akerlof, ‘The market for “lemons”: quality uncertainty and the market mechanism’, Quarterly Journal of Economics , vol. 84, no. 4 (1970).

However, since the 1980s, many Neoclassical economists have also developed theories that go so far as to deny the possibility of market failures, such as the ‘rational expectation’ theory in macroeconomics or the ‘efficient market hypothesis’ in financial economics, basically arguing that people know what they are doing and therefore the government should leave them alone – or, in technical terms, economic agents are rational and therefore market outcomes efficient. At the same time, the government failureargument was advanced, to argue that market failure in itself cannot justify government intervention because governments may fail even more than markets do (more on this in Chapter 11).

Precision and versatility: the strengths of the Neoclassical school

The Neoclassical school has some unique strengths. Its insistence on breaking phenomena down to the individual level gives it a high degree of precision and logical clarity. It is also versatile. It may be very difficult for someone to be a ‘right-wing’ Marxist or a ‘left-wing’ Austrian, but there are many ‘left-wing’ Neoclassical economists, such as Joseph Stiglitz and Paul Krugman, as well as very ‘right-wing’ ones, like James Buchanan and Gary Becker. To exaggerate only slightly, if you are clever enough, you can justify any government policy, any corporate strategy, or any individual action with the help of Neoclassical economics.

Unrealistic individuals, over-acceptance of the status quo and neglect of production: limitations of the Neoclassical school

The Neoclassical school has been criticized for assuming too strongly that people are selfish and rational. From soldiers selflessly taking bullets for their comrades to highly educated bankers and economists believing in the fairy tale of never-ending financial boom (until 2008), there is simply too much evidence against this assumption (see Chapter 5 for details).

Neoclassical economics is too accepting of the status quo. In analysing individual choices, it accepts as given the underlying social structure – the distribution of money and power, if you will. This makes it look at only choices that are possible without fundamental social changes. For example, many Neoclassical economists, even the ‘liberal’ Paul Krugman, argue that we should not criticize low-wage factory jobs in poor countries because the alternative may be no job at all. This is true, if we take the underlying socioeconomic structure as given. However, once we are willing to change the structure itself, there are a lot of alternatives to those low-wage jobs. With new labour laws that strengthen worker rights, land reform that reduces the supply of cheap labour to factories (as more people stay in the countryside) or industrial policies that create high-skilled jobs, the choice for workers can be between low-wage jobs and higher-wage ones, rather than between low-wage jobs and no jobs.

The Neoclassical school’s focus on exchange and consumption makes it neglect the sphere of production, which is a large – and the most important, according to many other schools of economics – part of our economy. Commenting on this deficiency, Ronald Coase, the Institutionalist economist, in his 1992 Nobel Economics Prize lecture, disparagingly described Neoclassical economics as a theory fit only for the analysis of ‘lone individuals exchanging nuts and berries on the edge of the forest’.

One-sentence summary: Capitalism is a powerful vehicle for economic progress, but it will collapse, as private property ownership becomes an obstacle to further progress .

The Marxist school of economics emerged from the works of Karl Marx, produced between the 1840s and the 1860s, starting with the publication of The Communist Manifesto in 1848 (co-authored with Friedrich Engels (1820–95), his intellectual partner and financial patron) and culminating in the publication of the first volume of Capital in 1867. [79] The remaining two volumes were edited by Engels and published after Marx’s death. It was further developed in Germany and Austria and then in the Soviet Union in the late nineteenth and the early twentieth centuries. [80] Before the Russian Revolution, the leading Marxist economists were Karl Kautsky (1854–1938), Rosa Luxemburg (1871–1919) and Rudolf Hilferding (1877–1941). The key Soviet Marxist theorists were Vladimir Lenin (1870–1924), Yevgeni Preobrazhensky (1886–1937) and Nikolai Bukharin (1888–1938). More recently, it was elaborated in the US and Europe during the 1960s and the 1970s.

Labour theory of value, classes, and production: The Marxist school as the truer heir of the Classical school

As I mentioned earlier, the Marxist school inherited many elements from the Classical school. In many ways, it is truer to the Classical doctrine than the latter’s self- proclaimed successor, the Neoclassical school. It adopted the labour theory of value, which was explicitly rejected by the Neoclassical school. It also focused on production, whereas consumption and exchange were the keys for the Neoclassical school. It envisioned an economy comprised of classes rather than individuals – another key idea of the Classical school rejected by the Neoclassical school.