A Non-Mathematical Critique of Neoclassical Demand Theory

[Invariance]

Introduction:

People on this forum, both leftists and rightists alike, talk of the 'laws of supply and demand' 'equilibrium' and other such dogmas as if they were unassailable truth. This is far from the case.

In the following posts I hope to point out the logical errors and absurdities involved when neoclassical economics, or modern economics, attempts to aggregate many individual’s demand curves into one big demand curve which they hope to prove maximises welfare. I will assume the reader has no prior knowledge of modern economics. Therefore, I will first explain the theory, and then criticise it. I will also assume that the reader has no prior knowledge of mathematics beyond simple addition etc and the ability to read a graph. There are mathematical critiques of the theory, but I think they would be unintelligible to most. If someone would like me to write a mathematical critique I will.

I will assume that the consumer follows the neoclassical model of rationality, that they maximise their utility. However, as I have pointed out in this thread (http://www.revleft.com/vb/irrationality-rationality-t106590/index.html?t=106590), it is patently clear that they in fact do not. Nevertheless, we will assume their assumptions work, and then show that the theory is still internally inconsistent. The bulk of this material, as well as a number of diagrams, come from a book called Debunking Economics by Steve Keen; I take no credit for the originality of these ideas. Unlike most shaky areas of economics, some economists are aware of the problems in this area. However, like the best of zealots they continue to preach the same dogma.

[Invariance]

Background Philosophy:

It is useful to begin at the philosophy behind the economic dogma. Economic theory postulates that the best social outcomes must result from individual self-interest via the mechanism of the market. Typically the proof of this is encapsulated in Adam Smith's metaphor of the invisible hand (which was in fact made in the context of the advantages of domestic investment over foreign investment, even though he argued that unregulated trade was superior to regulated trade, and even though Adam Smith was a customs official).

However, the background lay not in Smith but in Jeremy Bentham, and perhaps even further back if we were to go. Bentham's theory is known as utilitarianism, it claims that our behaviour is governed by the calculus of pleasure and pain:
Nature has placed mankind under the governance of two sovereign masters, pain and pleasure. It is for them alone to point out what we ought to do, as well as to determine what we should do. On the one hand the standard of right and wrong, on the other the chain of causes and effects, are fastened to their throne. They govern us in all we do, in all we say, in all we think: every effort we can make to throw of our subjection, will serve but to demonstrate and confirm it. In words a man may pretend to abjure their empire: but in reality he will remain subject to it all the while.

An action then may be said to be conformable to the principle of utility, or, for shortness sake, to utility, (meaning with respect to the community at large) when the tendency it has to augment the happiness of the community is greater than any it has to diminish it.
Hence, the measure of happiness (or pain) could be objectively measured. This presented insurmountable difficulties - trying to measure something so subjective in an objective way. Along with this, economics borrowed the methodological individualist approach, going from the analysis of the individual to society. The economy is simply equal to the sum of its parts, according to Bentham and modern economics:
It is in vain to talk of the interest of the community, without understanding what the interest of the individual is. A thing is said to promote the interest, or to be for the interest, of an individual, when it tends to add to the sum total of his pleasures: or, what comes to the same thing, to diminish the sum total of his pains.
Now, on to this pile of nonsense we know as economics.

[Invariance]

From the Individual:

The starting point was the individual. Each commodity, according to the theory, yields a certain number of underlying units of satisfaction we call 'utils.' Additional units of a given commodity result in a positive, but falling, additional utils. Looking at the following table:

Table of Consumption of Bananas:

http://f.imagehost.org/0658/New_Picture_1.jpg

we can see that additional bananas don't give as much 'happiness' as previous bananas; the change in total utility is known as marginal utility and the belief that this falls as consumption rises is known as the 'law of diminishing marginal utility.'

[Invariance]

We can set up a table with two commodities, along with a 3D graph. It is, however, impossible to provide a geometric picture for more than two commodities.

http://f.imagehost.org/0552/New_Picture.png

Here we see the combined utils from consuming two commodities; a banana and a biscuit. We can see this graphically in the following picture:

http://f.imagehost.org/0066/New_Picture_1.png

[Invariance]

However, by postulating an objective measure in something as subjective as personal satisfaction, the cardinal concept objectively measuring utility gave way to an ordinal notion. Cardinal refers to the ability to attach a precise quantity to something, e.g 'this banana gives me 4 utils', versus the ordinal concept which refers to the ability to rank things, e.g. 'I like this banana better than that tomato.'

Hence the height of the utility hill could no longer be specified. The basic concept was that the hill had to slope upwards but at a diminishing rate:

http://f.imagehost.org/0638/New_Picture_2.png

[Invariance]

Naturally, the consumer was to get as high up the utility hill as she could, to maximize her utility. However, since the height could no longer be speciefied numerically, the 3D perspective would later be dropped and the linked points of equal utility into curves; the contours of the utility hill, looking something like this:

http://f.imagehost.org/0065/New_Picture_3.png

On this graph we can see that points which give equal levels of utility are the same height, hence a consumer should be, funnily enough, 'indifferent' to them.

[Invariance]

However, for the curves to be smoothed out, i.e. removing the kinks, a number of assumptions were made, as set out by Paul Samuelson in 1948. These were:
1. Completeness: If presented with a choice between two different combinations of goods, a consumer can decide which one she prefers or can decide that she is indifferent to them; she gets the same level of satisfaction from each.

2. Transitivity: If combination A is preferred to combination B, and B to C, then A is preferred to C.

3. Non-satiation: more is always preferred to less. If combination A has all but one commodity as B, and more of that one than B, then A is preffered to B.

4. Convexity: The marginal utility a consumer gets from each commodity falls with additional units, so that the indifference curves are convex in shape.
There are other assumptions, and they often go by different names. If you would like to read how unrealistic they are, click here (http://www.revleft.com/vb/irrationality-rationality-t106590/index.html?t=106590). However, for the purposes of this exercise, we will assume that they work in all their pathetic glory. With these assumptions, we will end up getting a 2D figure like this:


http://f.imagehost.org/0225/New_Picture_4.png

Those curved lines mark are known as indifference curves; lines which mark the number of goods a consumer would be indifferent between. So, looking at the graph we can see that if the consumer has little of Good Y, she has a lot of Good X to make up for it, and vice versa.

[Invariance]

Deriving Individual Demand Curves:

So, the consumer wants to get as much of a commodity as she can, yet we know there must be restrictions; the consumer's income. So, the next step is to combine indifference curves with a plot of the consumer's income and prices to determine what a consumer will buy at a given set or prices.

The consumer's income is shown by a straight line which connects all the quantity of bananas she could buy if she spent all her income on bananas, and the quantity of of biscuits she could buy if she spent all her income on biscuits. If the consumer's income was $500,and biscuits cost her 10 cents each, then should could purchase 5000 biscuits. If bananas cost $1 each then she could purchase 500 bananas. The straight line connecting these two points is known as the budget line. It simultaneously represents the prices of biscuits and bananas and the consumer's income.

What happens if the consumer's income changes?

http://f.imagehost.org/0989/New_Picture_5.png

Well, in this picture we can see that if the consumer only bought commodity X, she would buy 30 units of them. If she only bought commodity Y, she would buy 60 units of them. As the consumer's income grows the budget line moves out in a parallel fashion; it shows that the consumer can now buy more commodities.

[Invariance]

What happens if a commodities' price changes, the other remaining constant? Well, the budget line would 'swivel.'

http://f.imagehost.org/0588/New_Picture_6.png
Here, we see that Good Y has become more expensive - before, if we were to spend all our money on Good Y we could purchase 10 units, now we can only purchase 5; the price has effectively doubled, whilst Good X's price has remained constant.

[Invariance]

Next we combine the indifference curves with the budget line and we get a point where they intersect and at this point the consumer maximises her utility:

http://f.imagehost.org/0704/New_Picture_7.png
Here we can see that at point E the indifference curve is tangent to the budget line. This is the bundle the consumer should purchase, according to modern economics.

[Invariance]

However, what we are interested in is getting a demand curve which shows how demand for a commodity changes as its price changes.

http://f.imagehost.org/0645/New_Picture_8.png
Here we can see what happens as the price of the good changes - we have the budget curve which changes as X Good X becomes cheaper, we have the indifference curves being tangent to those budget lines at positions E1, E2 and E3, and if we link them all together we get the demand curve for an individual. We can now see that as the price falls, demand for the good rises.

Edit: Ignore the white area in the second figure, its just the picture playing up.

[Invariance]

However, economists realised that as people's incomes rose their spending habits would necessarily change:

http://f.imagehost.org/0263/New_Picture_9.png

Its difficult to read the text, but the labels show, from left to right: (a) necessary good, (b) inferior good, (c), luxury good and (d) neutral good. These shapes show how demand for a given class changes as a function of income. Necessities (e.g toilet paper) take up a diminishing share of spending as income grows, inferior goods (e.g baked beans) whose actual consumption declines as income rises, luxuries (e.g. art) whose consumption takes up an increasing share of income as income increases and lastly what economists call 'representative' or neutral goods. Unfortunately, there are no examples of representative goods because there aren't any - spending on such a commodity would constitute the same percentage of income as a person rose from poverty to wealth, and there is no such commodity which occupies the same proportion of a homeless person's expenditure as it does a billionaire's.

This concludes the analysis of the individual, (although I have ignored minor topics which bear no relevance to the purposes of our discussion). Next economists attempted to aggregate from the individual to society. This is where the theory of demand starts becoming absurd.

[Invariance]

Going from the Individual to Society - where it breaks down:

The next step was to go from the individual to the market demand curve. This involved aggregating all the individuals in society to achieve one big social indifference curve which would show the preferences of all consumers and enable economists to show a market economy consisting of selfish utility-maximising individuals which would maximise the welfare of all.

However, for all their efforts they proved the contrary. That if consumers' tastes are allowed to take any form which satisfies the conditions of individual rationality, then it will not be the case that collective behaviour is rational. Individual rationality requires that if A is preferred to B when both are affordable, then A must necessarily provide more utility than bundle B. However, no such thing applies to a social indifference map. Therefore, they proved that the output level chosen by a market economy does not maximise social welfare. A market demand curve doesn't have to behave identically to to a single individual's demand curve; it is plausible to demonstrate that an individual demand curve slopes downward, the same cannot be said for a market demand curve where in some places it may be flat, or even slope upwards.

Don't take my word for it. In Varian's Microeconomic Analysis (a well known mathematical advanced microeconomics textbook), Varian states: 'Ultimately...the aggregate demand function will in general possess no interesting properties...The neoclassical theory of the consumer places no restrictions on aggregate behaviour in general.'

But why this stark admission?

One individual's indifference curves are the contours on a map of a utility hill that the individual climbs by consuming. Since, however, utility is subjective, the actual height of the hill cannot be specified because utility cannot be quantified - there being no objective measure. Economic theory ignores the question of where consumers tastes come from and assumes that income (budget line) and tastes (indifference curves) are independent, hence each individual's utility hill can be treated as constant.

However, the same cannot be said for the social utility hill. For example, if income is redistributed between individuals then there is no way to say whether this results in a greater or lesser degree of utility, since what gives great utility to one may give very utility to another. Therefore, there are numerous social utility hills, one for each distribution of income.

[Invariance]

Why?

Firstly, because the distribution of income between individuals changes the weighting of each individual in the aggregate called society. Secondly, any one individual's purchases will alter as her income grows. This wouldn't be an issue if income was fixed, but economic theory argues that the price system determines the distribution of income - but t be able to construct a market demand curve you have to alter prices (as we did above). There will, therefore be a different social indifference map for every different set of prices. The social budget line and the social indifference surface are therefore interdependent, since every set of prices will generate a different social utility hill. This would look like the following:

http://g.imagehost.org/0830/New_Picture_10.png

With the price ratio given by the budget line I, the highest indifference curve society can attain is the curve X, and B1 bananas are consumed. The changed in price ratio from I to II generates a new distribution of income and hence a new social utility hill. The highest indifference curve society can reach is now Y but since it comes from a completely different social utility hill there's no way of knowing whether this involves a higher or lower level of social utility.

[Invariance]

If we link the intersections together we get an 'Engels' curve like the following:

http://g.imagehost.org/0969/New_Picture_3.jpg

Clearly this curve shows lots of places where the slope of the curve changes abruptly rather than smoothly as you move from one individual to another. This will mean that the slope of the budget line will be able to vary substantially at the kink points in the curve without changing the quantity of bananas demanded.

The problem is that any change in prices will change incomes and while this will not shift an individual's preferences (according to economic theory), it will shift society's preferences as they depend on distribution of income.

[Invariance]

So what?

Economists, instead of proving that the interests of the community can be summed up as the interests of the individual members who compose it, proved that only under hightly restrictive conditions could social welfare be treated as the sum of its individual members. These were:

1. The distribution of income was fixed and ‘Engels’ curves must have a constant slope; or
2. Engels curves must have a constant slope, and they all have the same slope.
The first restriction was unacceptable since it contradicts the economic theory of income distribution which argues that relative incomes are determined by the price system. Hence, the adoption of the second restriction. The meaning of the first part of that restriction is that the ‘Engel curves’ must be straight lines, so that commodities are neither luxuries nor necessities. However, as I stated earlier there would unlikely be any commodities which fall into this category. Yet, economists maintain that increasing the income of a single consumer by, say, a factor of 10, increaser her consumption of all commodities by the same factor.

This is even more extreme than the first restriction; every consumer has to spend the same proportion of each new dollar of income the same way, which means that all consumers must have the same tastes. Which means that society must either be comprised of one individual or a multitude of clones. And this is from the theory which proudly proclaims the uniqueness and authority of the individual!

[Invariance]

Unfortunately, this is not something I have just made up. To quote my mircroeconomics book, Microeconomics – a Modern Approach, Andrew Schotter, 3rd ed., 2001, page 68:
‘When a consumer has homothetic preferences, all goods are superior and purchased in the same proportion no matter what the consumer’s income. In a world where all consumers have homothetic preferences, we might think of rich people as simply expanded versions of poor people. The tastes of such rich people do not change as their incomes change. They allocate their incomes exactly the way they did when they were poor. They just buy proportionally more of each good as their income grows.’
In effect, Schotter is saying that if Bill Gates spent 10% of his income on pizza when he just another university computer science nerd, then he now spends 10% of his total income on pizza. In other words, he spends hundreds of millions on buying pizza for his own consumption.

Alternatively, the poor man who happens to get rich (we all know how often that happens!) did not change his spending habits at all – he still lives in a cardboard box (just an extremely large one). Likewise, the rich man spends the same amount he did on healthcare when he was poor – none. Going from the opposite direction, how many pieces of art work would a poor person have if they spent the same proportion that a wealthy person spends on art? A thousandth of a Mona Lisa?

[Invariance]

Individual indifference curves, therefore, cannot take any allowable shape and still enable economists to treat society as the sum of the individuals in it. Instead they must generate shapes like those in the following diagram:

http://g.imagehost.org/0083/New_Picture_4.jpg

The neoclassical theory of consumer demand collapses to this: if the market economy has only one consumer, and that consumer only ever consumes one commodity, then individual utility can be summed to yield social utility.

Yes, 1 consumer (or a multitude of clones) who consumes 1 commodity now equals society.

This is what economists call aggregation.

[Invariance]

Further Comments:

Economists are aware of this problem:
First, when preferences are homothetic and the distribution of income (value of wealth) is independent of prices, then the market demand function (market excess demand function) has all the properties of a consumer demand function...Secondly, with general (in particular non-homothetic) preferences, even if the distribution of income is fixed, market demand functions need not satisfy in any way the classical restrictions which characterize consumer demand functions...The importance of the above result is clear: strong restrictions are needed in order to justify the hypothesis that a market demand function has the characteristic of a consumer demand function. Only in special cases can an economy be expected to act as an 'idealized consumer.' The utility hypothesis tells us nothing about market demand unless it is augumented by additional requirements.
Shafer, W. & Sonnenschein, H., (1982). 'Market demand and excess demand functions', in K.J Arrow and M.D Intiligator (eds), Handbook of Mathematical Economics (Vol. 2), North-Holland, Amsterdam.

These strong restrictions are that consumers are all identical, consuming identical commodities.

Economists often ignore the absurd things they say. For example:

The necessary and sufficient condition quoted above is intuitively reasonable. It says, in effect, that an extra unit of purchasing power should be spent in the same way no matter to whom it is given (!)

Gorman, W.M (1953) 'Community preference fields', Econometricia 21: 63-80.
and

Two criteria will be considered which lead to the possibility of aggregation: (1) identical preferences (hence identical demand functions), and (2) proportional incomes...

Chipman, J.S (1974) 'Homothetic preferences and aggregation', Journal of Economic Theory, 8: 26-38.

Generally these conditions are known as the Sonnenshein-Mantel-Debreu conditions or the SMD conditions.

[Invariance]

Proving what you Deny/Conclusion:

The irony is, of course, that economics has proved precisely what it what it opposed. It proved that society is more than the sum of its parts.

Even more ironic is that the criticism of trying to aggregate utility from individuals in an objective manner was constructed by its supporters!

Economists originally used this aspect of their theory to argue against any social reform which aimed to redistribute wealth from the rich to the poor, since we couldn't possibly know (according to their theory) whether this would result in a greater social welfare, since taking a banana from one rich person whom derives a great benefit from it and giving it to a poor person who derives little benefit from it would be contrary to social welfare! The defence of inequality backfires, making it impossible for them to construct a demand curve. If the market demand curve depends upon the distribution of income, if a change of prices will alter this distribution of income, and if this does not result in an equilibrium between supply and demand, then economists cannot oppose a distribution which, for example, favours the poor over the rich.

They have proved that the only meaningful way to analyse society is by class, as Smith, Ricardo and Marx did.

If we are to progress further we may well be forced to theorize in terms of groups who have collectively coherent behavior. Thus demand and expenditure functions if they are to be set against reality must be defined at some reasonably high level of aggregation. The idea that we should start at the level of the isolated individual is one which we may well have to abandon.
Kirman A, (1989) 'The Intrinsic Limits of modern economic theory: the emperor has no clothes', Economic Journal, 99: s129-s139.

Marxist, feminist, neo-Ricardian, and post-Keynesian schools sometimes take this approach.

[Invariance]

After this I will post a critique of supply theory/(diminshing)marginal productivity.

[Lynx]

Is this what is taught at business school?
Are these used by actual businesses to set the price of a commodity?

[Invariance]

Is this what is taught at business school? Minus the critique and pointing out the absurdity of its propositions, yes.


Are these used by actual businesses to set the price of a commodity? Combined with their analysis of the 'laws of supply', economists argue that that is how prices are set and should be set to maximise profit. Capitalists, unfortunately, have more sense than to listen to economists; one study showed that 95% of examined businesses did not set price where marginal cost equals marginal revenue (Eiteman and Guthrie, 1952) - that is the empirical worth of marginalism for you. But the problems with the supply theory, perfect competition, equilibrium, critique of monopoly etc weren't the topic of this thread. It purely concerns the absurd requirements to 'aggregate' the 'utils' of many consumers into a social demand curve.

[вор в законе]

Vinnie, the law of "demand and supply" is an axiom, a simplification of the reality if you would prefer in order to reach to some conclusions about the reality and how the world works. Anyway apart from the first post I haven't got to read what you wrote, I will though, it seems interesting.

By the way, check this article (if you haven't already), you might appreciate it.

http://www.ft.com/cms/s/0/8d56f42a-6777-11db-8ea5-0000779e2340.html?nclick_check=1

[Nwoye]

i really enjoyed reading that thanks. however, i don't know if i agree with your conclusion. it seems that any attempt to calculate aggregate demand of any group of people fails on the basis of what you have pointed out - and that doesn't change even if you calculate it based on class.

btw, are you an economics major?

[Invariance]

Hopefully I'll be able to post that critique of the 'law of supply' tonight or tomorrow. Since I've got a couple of minutes to spare, however:


Vinnie, the law of "demand and supply" is an axiom I disagree. Not even economists argue that the supply and demand model is an axiom. An axiom is an unproven proposition which is considered self-evident. An axiom, for economists, would be their assumptions regarding consumers as selfish, rational etc, from which they can derive an individual demand curve. The a priori propositions would be the 'psychological' assumptions of selfishness, and the individual demand curve a posteriori.


a simplification of the reality if you would prefer In order for something to be a simplification of reality it must accurately depict reality. Economic theory doesn't.

For example, a competitive market, amongst other things, is considered by economists one in which the entry into and exist from a market is 'free'; there are no barriers to entry or exit. Thus, firms outside the industry can move in at any time to take advantage of "above-normal profits", if they exist.

However, this is totally inconsistent with the assumption of a short-run where some factor of production is fixed which is required to get what economists call diminishing marginal productivity, which in turn generates a rising marginal cost and therefore tells a firm how much to produce to maximise profit.

So, here we have a situation where economists argue that firms inside the industry cannot alter their capital equipment during the short run, but at the same time other firms can enter in the industry and build a factory, i.e. not suffer from diminishing marginal productivity. What logic!

And I haven't even mentioned Sraffa's 1926 critique, which tears apart diminishing marginal productivity from head to foot. To factory owners, marginalism is 'the product of the itching imaginations of uninformed and inexperienced arm-chair theorisers.' (Lee, 1998). Worse still, the static nature of the theory, emphasising maximising profit now, ignores the fact that a firm must grow to survive. If industrialists did follow economic theory, they would make losses. Its not a simplification of reality, but a complete distortion of it.


in order to reach to some conclusions about the reality and how the world works. One of those conclusions being that government interference in the market is detrimental to society. This is why economists argue against minimum wage laws in order for society to be 'better off.' Maybe you should take note of those conclusions and what they mean for workers, and then talk about how they are a 'simplification of reality' and 'how the world works.'


By the way, check this article (if you haven't already), you might appreciate it.

http://www.ft.com/cms/s/0/8d56f42a-6777-11db-8ea5-0000779e2340.html?nclick_check=1 Thanks.