Assuming Away Reality

[image]”To what extent can we believe the conclusions of a model that assumes away the fundamental features of reality as we understand it?”

If you are taking or have taken some of the typical courses in economics, it is quite likely that you asked yourself questions like the following: If an economic model is not like the real world, why should I trust the results of that model? One of the answers I would often get when posing this question goes something like this: Of course the model is not like the real world; it is not supposed to be like the real world. If it were, then it would not be a model!

This response can leave one feeling intellectually inferior or incapable of abstract thinking. One may get the impression that there is something obvious that he or she is missing. Sometimes, the answer would go a bit further: models are simplified representations of reality that we use to better understand that reality. This answer is somewhat more polite, but it still does not tell us how we determined which features of reality were not important enough to be included in the model. Building a model in this way also seems to imply that we already understand the elements of reality and how they are interrelated.

If none of these answers left you entirely comfortable with the currently predominant, Walrasian approach in economics, you may want to look into the works of some of the Austrian economists. Ludwig von Mises, Friedrich Hayek, and Murray Rothbard were the leading figures in this school of thought in the 20th century. Scholars like Mises, Hayek, and Rothbard showed that there are, in all likelihood, more robust descriptions of markets than those contained solely in mathematical general-equilibrium models.

Basic Principles of Austrian Economics

The Walrasian and the Austrian approaches often come to similar conclusions when it comes to the desirability of markets, but they come to these conclusions using quite different paths. The advantage of the Austrian approach is precisely in the path it takes to come to its conclusions — it maintains several key principles that most of us would have a hard time disagreeing with:

Value is in the mind of an individual. It is then by definition subjective and directly unobservable to others.
Value is not a physical quantity. Thus, interpersonal comparisons of utility or value are inappropriate.
All economic activity is a consequence of individual humans acting on their values.

The Walrasian approach often assumes away these principles for the sake of mathematical tractability. This is where the crucial problem arises. To what extent can we believe the conclusions of a model that assumes away the fundamental features of reality as we understand it? This is actually the most common criticism of the neoclassical defense of markets.

You have probably heard many people blaming the current economic crisis on “market failure.” Some would say that markets “failed” because real markets are different from the economists’ “perfect” models. The logic is as follows: since we can’t trust these market models, neither can we trust the actual markets. There is an error in this logic.

For example, if we had a theory that states that 2+2=5 and then we count 2 apples and 2 more apples and determine there are in fact 4, not 5, apples, this contradiction between our theory of addition and the empirical observation would not be an argument against using the operation of addition in our daily lives. Instead, we would go back to our theory of addition to determine where we went wrong. Similarly, realizing that markets do not operate exactly like general-equilibrium models does not imply that markets should be abandoned. Instead, it may be that our model was inadequate to understand the functioning of the market. In fact, there may be other elements, not necessarily products of the market, that contributed to what we labeled “market failure.”

This is where the Austrian approach can help. Austrians argue that precisely those features of reality omitted by our models are what makes actual markets special. More specifically, markets are the means of coping with those “messy” features of reality that do not fit well into the mathematical language of economic models.

Efficient Markets vs. Markets as Indispensible Means of Social Cooperation

The typical neoclassical story about efficient or perfectly competitive markets is that, if some assumptions hold, we can expect markets to be allocatively efficient. This allocative efficiency is interpreted as a set of output and price values that maximize total social welfare. This is often represented by welfare triangles.

Welfare triangles are geometric representations of the benefits from exchange. Figure 1 shows an example. The light blue triangle represents total social surplus. It is said that the competitive equilibrium price and quantity make this area as large as possible.

Figure 1

Competitive equilibrium and social welfare in the neoclassical model

The assumptions that need to hold for this result are often given in different forms, but the following list should provide a relatively complete summary:

Everyone has all the relevant information about everyone else in the society.
All producers in a given industry are small relative to the whole industry.
The consumer preferences can be described by a known and “well-behaved” utility function.
There are no transaction costs.
There are no externalities.

For an Austrian economist, this raises many red flags at the outset. But it is not only Austrians who raise criticism against this formulation. Most government interventions are based on the claim that some of the above assumptions don’t hold, thus making the actual market outcome inefficient and in need of fixing.

However, Austrians raise a different criticism. They claim that this theory is an inadequate description of the market. As an analogy, if you build a theory on the premise that the sky is red, that theory is not going to be very useful for understanding the logical consequences of the fact that the sky is in fact blue.

Austrians throw out the window the first, complete-information assumption in the above list at the outset. This has implications for the other assumptions such as transaction costs and externalities, but this is an issue that contains enough material for a separate analysis.

Hayek based most of his work on deriving the logical consequences of the fact that most of us know very little about most other people. His mentor, Mises, starts with the fact that individual values are not directly observable to others and determines that only through exchange ratios (or prices) can these subjective values take an objectively observable form. Thus, only in a society where private property is exchanged between individuals can resource allocation be guided by human values or preferences.

Hayek uses this idea to illustrate how market prices serve as signals of time-and-place-specific circumstances known only to some individuals and only as bits of dispersed knowledge. For example, when prices are on the rise, consumers know that it is time to look for alternatives, and producers want to produce more of the relatively expensive good without actually having to know all the particular causes of the price increase. Thus, rising prices give both the information and incentives to different individuals to pursue courses of action that make the expensive good relatively more abundant and thus less expensive in the long run. We can see here that instead of grounding their defense of the market on the complete-information assumption, Austrians begin by recognizing the reality of incomplete information.

Views on Competition and Allocation of Production

The second assumption in the Walrasian description of the efficient market is that all producers in a given industry are small relative to the whole industry. Alternatively, if some producers are disproportionally larger than others, there is a departure from the competitive equilibrium, and thus allocative inefficiency arises. In the extreme case, when there is only one producer in a market, there is a monopoly. Monopolies are said to be a problem because the price they charge is too high and the quantity they supply is too low.

Hayek, however, shows that in a world of near-infinite individual diversity, it is highly unlikely that one firm can exclude all other suppliers from the market just by offering the lowest price. In addition, as Rothbard pointed out, all firms compete for the consumers’ money. In this sense, even a monopoly must still compete with the producers of all other goods. For example, if a healthcare provider imposes too high of a cost on the consumer (monetary, bureaucratic, or whatever), the consumer might simply abandon using any healthcare services for the sake of being able to afford a more preferred amount of other goods and services. I haven’t visited a doctor in more than two years simply because it takes too much time and effort for my taste.

Finally, if individual values are indeed subjective and unobservable to an outside observer, claiming that the price that the monopoly charges is too high contradicts the subjective nature of value. Like any other acting individual, producers make choices based on their marginal utility (or value). Because individual values are unknown to others, making claims about correctness of someone’s price has no objective foundation — it just reveals our own value judgment of their price.

Moreover, if one looks around, one can notice that monopoly-like suppliers are generally formed by a state-imposed legal act that limits the ability of other suppliers to access the market. We can look at the supply of road services, healthcare, copyrighted material, and to some degree the supply of agricultural products, and find specific legal acts that limit competition.

For an example of state-imposed restrictions on competition in agriculture, we can look at the primary supply of milk, poultry, and eggs in Canada. The supply of these commodities is limited at the national, provincial, and individual level by production quotas. Only registered permit holders can produce and sell milk, poultry, and eggs and only at the provincially administered prices and quantities. This system is backed by a plethora of acts and regulations. Interestingly, in one of the founding acts, the Farm Products Agencies Act, there is a clause that requires the agencies administering supply management to take into account the principle of comparative advantage in production when allocating production quotas across provinces.

Put plainly, the principle of comparative advantage states that total productivity increases if everyone specializes in what he or she has the greatest relative superiority in compared to others. But how do you knowwhat it is that you do better than others if you are good at many different things and you don’t know how good others are in producing different goods? This is where the Austrian insights come in handy.

For example, we can use some of Mises’s and Hayek’s arguments to show that without markets (or, more precisely, without market prices) economists can’t say much about how to allocate production in a way that takes into account the principle of comparative advantage. In short, this is because economists, like anyone else, don’t have access to people’s knowledge of their own production possibilities and values, which are also in a continuous state of change. As one of the above Austrian principles states, value is in the mind of an individual. It is then by definition subjective and directly unobservable to others.

But, if one looks only at the typically used neoclassical models, one gets the impression that the “correct” spatial allocation of production could be determined from objectively measurable quantities (i.e., regional input ratios, technology, etc.) regardless of whether there is a market process or not. For example, some of the major models classify goods by their objectively measurable labor or capital intensity and then look at the aggregate quantities of capital and labor in a country or a region. Countries and regions with a higher capital-to-labor ratio are then said to have a comparative advantage in capital-intensive goods, and the countries and regions with a higher labor-to-capital ratio are said to have a comparative advantage in labor-intensive goods.

However, in reality, these objectively measurable input intensities and input ratios exist only in the presence of a functioning market. For example, try calculating an aggregate ratio of all capital to all labor in a country in which exchange of private ownership is outlawed — thus, without using market prices. These market prices, according to Mises and Hayek, transform the subjective value in our mind into objective data available to others. If we are not explicit about this, we may misinterpret our models and lose the essence of the economic problem at hand.

This is why Austrians look at comparative advantage differently. First, they attribute it to an individual. Only individuals know their abilities, skills, plans, and potential opportunity costs. Individuals use this knowledge to determine whether to specialize in, say, producing computers or oranges. Second, since one doesn’t have direct access to other people’s knowledge, one needs a means of indirectly accessing that knowledge. This is where exchange of ownership and exchange ratios (or prices) — in short, the market — come into play.

The market is the tool that makes it possible for an individual to determine whether it is better to specialize in the production of apples, computers, or any of thousands of other products. I may have a great potential in many occupations, but depending on the market prices, I may choose one or the other. Market prices will indirectly inform me how others would value my services if I chose one profession compared to another. Thus, in the Austrian framework, the market is the tool for identifying individuals’ comparative advantage in an advanced economy.

Given these insights, the context in which one would use economic models is quite different from the typical Walrasian approach. In this case, one would say that because markets exist, we may, for illustrative purposes, assume that individuals know the relevant economic characteristics of other individuals in the society. In the typical Walrasian approach, the complete information assumption is a precondition for the existence of efficient markets, while in the Austrian approach, the existence of markets is a precondition for the existence of prices that transform subjective and otherwise unobservable valuations of goods produced and owned by a multitude of individuals into objective and observable metrics.

For many neoclassical economists, the market is a tool (only one of the tools) for allocating production and consumption efficiently. Efficiency here is the state of the world where any change would just make things worse. In this theory, such an “optimal” solution can be reached using means other than the market because of lax assumptions about value and knowledge. More specifically, for a person to determine the optimal allocation of resources in an economy outside of the market process, that person needs to know people’s values, skills, potentials, etc. Thus, in such a model, one needs to assume that these qualities exist as objectively measurable and knowable magnitudes.

Austrians, on the other hand, don’t claim that there is anything like this “optimal” allocation of resources, either within or outside of the market. What they do claim is that, if people want to develop an advanced economy, the market is the way to do this. The path to developing such an economy is through constant guidance of resource allocation by people’s values reflected in the market prices. In the market, someone will always be dissatisfied with something, but this is not a bad thing. This dissatisfaction is a motive for action and for the improvement of one’s well-being. It is the driving force of the economy.

Conclusion

There are important advantages in being familiar with the Austrian theory. This theory helps one keep in mind fundamental principles such as the subjectivity of value and the incompleteness of information that form the basis for human action. This approach makes it easier to spot errors in one’s economic thinking. One of the common errors is treating economic models as normative standards for reality rather than loose metaphors and illustrations of the logical conclusions resulting from prior theoretical analysis. This error creates a temptation to “fix” the reality to fit the model. Often times the fix only makes things worse, because it was not the reality that needed fixing. It was, in fact, the economist’s model that did not capture the key features of reality.

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