Growth And The Neoclassical Paradigm

This book is about technological change and economic growth. It is generally acknowledged that the latter is driven mainly by the former. But the motor mechanism is surprisingly obscure and the nature of technological change itself is poorly understood. Part of the problem is that neoclassical microeconomic theory cannot account for key features of technological change. In this chapter we briefly review and summarize some of the difficulties and their origins, beginning with the neoclassical economic paradigm. It has been informally characterized by Paul Krugman as follows:

At base, mainstream economic theory rests on two observations: obvious opportunities are rarely left unexploited and things add up. When one sets out to make a formal mathematical model, these rough principles usually become the more exact ideas of maximization (of something) and equilibrium (in some sense) . . . (Krugman 1995)

This characterization is drastically oversimplified, of course, but it conveys the right flavor.1

At a deeper level, the neoclassical paradigm of economics is a collection of assumptions and common understandings, going back to the so-called 'marginalist' revolution in the 19th century. Again, to convey a rough sense of the change without most of the details, the classical theory of Smith, Ricardo, Marx and Mill conceptualized value as a kind of 'substance' produced by nature, enhanced by labor and embodied in goods. Prices in the classical theory were assumed to be simple reflections of intrinsic value and the labor cost of production. The newer approach, led by Leon Walras, Stanley Jevons, Vilfredo Pareto, and especially Irving Fisher, conceptualized value as a situational attribute (utility) determined only by relative preferences on the part of consumers. This change in viewpoint brought with it the notion of prices, and hence of supply-demand equilibrium, into the picture. It also defined equilibrium as the balance point where marginal utility of additional supply is equal to the marginal disutility of added cost. Thus calculus was introduced into economics.

Neoclassical theory has been increasingly formalized since the 19th century. But, because the economic analogies with physical concepts are imperfect, this has been done in a number of different and occasionally somewhat inconsistent ways. The most popular textbook version of the modern theory has been formulated by Paul Samuelson (1966) and characterized by Robert Solow as the 'trinity': namely, greed, rationality, and equilibrium. 'Greed' means selfish behavior; rationality means utility maximization - skating over the unresolved question of utility measurement - and equilibrium refers to the Walrasian hypothesis that there exists a stationary state with a unique set of prices such that all markets 'clear', that is, supply and demand are balanced for every commodity.

We recognize, of course, that the above assumptions can be (and have been) relaxed, without losing everything. For instance, utility maximization can be replaced by 'bounded rationality' (Simon 1955) and 'prospect theory' (Tversky and Kahneman 1974). Equilibrium can be approached but not achieved. The notion of utility, itself, can be modified to extend to non-equilibrium and dynamic situations (for example, Ayres 2006).

There are, of course, other features of the standard neoclassical paradigm. One of them is that production and consumption are abstractions, linked only by money flows, payments for labor, payments for products and services, savings and investment. These abstract flows are supposedly governed by equilibrium-seeking market forces (the 'invisible hand'). The standard model assumes perfect competition, perfect information, and Pareto optimality, which is the 'zero-sum' situation in a multi-player game (or market) where gains for any player can only be achieved at the expense of others.

The origins of physical production in this paradigm remain unexplained, since the only explanatory variables are abstract labor and capital services. In the closed economic system described by Walras, Cassel, von Neumann, Koopmans, and Sraffa, every material product is produced from other products made within the system, plus exogenous capital and labor services (Walras 1874; Cassel 1932 [1918]; von Neumann 1945 [1932]; Koopmans 1951; Sraffa 1960). The unrealistic neglect of materials (and energy) flows in the economic system was pointed out emphatically by Georgescu-Roegen (Georgescu-Roegen 1971), although his criticism has been largely ignored by mainstream theory. Indeed, a recent best-selling textbook by Professor N. Gregory Mankiw of Harvard describes a simple economy consisting of many small bakeries producing 'bread' from capital and labor (Mankiw 1997 pp. 30 ff.). The importance of this fundamental contradiction seems to have escaped his notice.

This book is not intended as a critique of neoclassical economics, except insofar as it pertains to the theory of economic growth. In several areas we depart significantly from the neoclassical paradigm. The most important of these departures are (1) in regard to the nature and role of technological change, (2) the assumption that growth follows an optimal path and dependence on optimization algorithms and (3) in regard to the role of materials and energy in the theory. But there are some other minor departures as well. We have begun, so to speak, at the beginning, so as to be able to clarify and justify these various departures as they come up in the discussion that follows.

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  • Isabel
    What does neoclassical paradigm mean paul krugman?
    9 years ago

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