[academic] An Explanation and Evaluation of Neoclassical Economics

20 October 2016

SOC 120

An Explication and Evaluation of Neoclassical Economics

The question of the ideal relationship between public actors and private actors within the market and society is critical to our future. The question merits attention as the livelihoods of all members of society are inextricably tied to it. Understanding that society consist of different segments with unique and often conflicting interests, it must be recognized that a simple answer is necessarily out of reach and that severe contest is to be expected. It is important to note that the precise configuration of private and public power is dynamic, constantly changing period to period. A keen historical awareness is therefore fundamental to the process of articulating new answers to this timeless question. Many historians point to the period following World War II to the 1970’s as the era of embedded liberalism. (Evans and Sewell, Jr. 35) The period of the 1970’s to the present moment can alternatively be described as neoliberal, a vision that relies heavily on neoclassical economics. In light of the recent financial crisis and increasing inequality and uncertainty in American and abroad, it is critical that we examine neoclassical economics and subject it to thorough evaluation. In doing this, we might once again find stability and progress, fashioning an alternative private-public configuration that can address the unique, present historical moment and the challenges it poses. In this paper, I first detail the two basic principles which underly neoclassical economics- those being 1) the dynamic of competition and 2) utility maximizing actors that make rational decisions on the basis of complete information. Having established these central ideas, I then briefly delineate the implications of these principles for the private-public relationship, as well as argue that there is empirical evidence for a clear disconnect between the neoclassical model and real market behavior. The paper concludes with a limited exploration of how State policy affects the structure of the market. I briefly describe some examples of policies prescribed under the neoclassical and political-cultural model.

The efficient allocation of resources is purported to be best accomplished through the ‘self regulating’ free market.  The first assumption central to this neoclassical perspective is the dynamic of competition. The dynamic of competition is rooted in a conceptualization of the market as a location in which many different actors exist. These actors both buy and sell. They are anonymous to each other. It is useful to think about these actors as part of two broad groups, buyers and sellers. In reality, any individual is typically engaged in both, but this categorization is analytically useful. Many agents are attempting to accumulate capital through profitable transactions. These transactions occur when a particular demand of the buyer can be satisfied. Because there are multiple sellers, they are constantly attempting to sell their item at a cheaper price. This can be accomplished through streamlining their marketing, optimizing the supply chain, or superior innovation in the production process. This attempt to lower their offered price in order to beat their competitors is ongoing and recurring. In this way, the dynamic of competition is always in effect and mandates ever increasing efficiency. Consequently, prices are always decreasing, and consumers are able to buy cheaper goods. Fligstein however, criticizes the perfectly competitive markets of neoclassical economics, noting that “In contradiction to theories of competitive markets, many markets have complex and stable social structures based on repeated interactions of buyers and sellers and on the status and reputation of market participants. It is also clear that firms have very different internal configurations that reflect these social processes.” (Fligstein 7)

The second assumption crucial to the theory of self regulating markets, is the existence of individual actors maximising utility through rational choices. At any given time there are always a variety of suppliers. Each supplier may have differences in offered products as well as price. Rational choice conveys that the buyer possesses the ability to identify his various options and then evaluate them. Weintraub writes, “The neoclassical vision thus involves economic “agents,” be they households or firms, optimizing (doing as well as they can) subject to all relevant constraints.” (Weintraub) This principle is a crucial component of the first assumption discussed above, which posits the existence of competition. If a customer cannot compare a variety of options and is limited in its vision, the seller may not have an incentive to offer better prices as the transaction is guaranteed regardless.

Having explicated the two fundamental assumptions of neoclassical economics, I now delineate their implications for the appropriate role of the government and private companies. I also adduce empirical evidence for the inapplicability of these assumptions to real market behaviors.

The assumption of perfect competition implies that State action is ineffective and inferior to private action. State action is theoretically limited by its inability to read and understand market conditions like private actors, as well as frequently sheltered from competitive forces and hence likely to be inefficient. Private firm action, is theoretically not subject to these sorts of limitations. Empirical evidence however complicates this simple portrait of firms as perfectly competitive. Competition in many markets have been altered due to the rise of corporate capitalism.The rise of corporate capitalism is unaccounted for in the neoclassical model. Irving Kristol writes, “Moreover, the large corporation not only seemed to be but actually was a significant deviation from traditional capitalism. One of the features of the large corporation –though more a consequence of its existence than its cause – was its need for, and its ability to create, "Orderly markets.”" (129) Companies like Coca-cola and Pepsi have formed oligopolies. (Fligstein, The Architecture of Markets Lecture) The existence of oligopoly in the case of beverages is perhaps a relatively harmless case. But in the case of insurance companies, consumers can no longer find affordable insurance and millions of Americans face health crises. It is apparent that the neoclassical model does not account for non-competitive behavior like mergers. The merger movement of the 80’s consolidated large corporations despite no real efficiencies to be gained. These mergers were primarily motivated by financial gains to be had through a short term increase of the company’s valuation in the financial market. Neoclassical economics cannot explain this type of market behavior. The conflict of interests that rating agencies experience is another example of market behavior that cannot be described simply as competitive. Rating agencies are paid per rating. (Fligstein and Goldstein, 49) If an investment bank does not like the rating given, they can simply move to the next competitor. The nature of the relationship between the rating agency and investment bank introduces a conflict of interests. This example illustrates how competition does not necessarily create conditions for self regulation.

The assumption of actors making rational choices implies that there is no need for industry regulation and consumer protection. The financial crisis of 2008 however, is a clear example of how irrational choices can occur due to incomplete information, and the therefore corresponding need for oversight. The crisis involved a variety of actors- 1) institutional investors 2) investment banks 3) rating agencies 4) individuals taking out mortgages. (Fligstein, "The Alphabet Soup of Mortgage Products”) Each of these actors were not necessarily making rational decisions. The institutional investors were purchasing securities on the basis of a rating agency’s accreditation. These investors however had no way to actually evaluate the integrity of these securities, and the underlying mortgages that made up these bonds. Likewise, the investment banks were not only profiting on the the processing fees, but they were also purchasing these dubious securities. Though they were closer in proximity to the rating process, they were still unable to understand that the rating system was flawed, and that mass defaults would lead to a subprime mortgage meltdown, leading to heavy losses for all mortgage security holders. When the bubble collapsed, as a whole, the financial structure was destabilized and many parties assets were eviscerated, institutional investors and banks alike emerging from the crisis with extreme debt. Short term gain policies were pursued despite the long term destructive effects. In this instance, actors did not have complete information and therefore were making risky transactions which might in retrospect, be considered irrational.

Having discussed the core ideas of neoclassical economics and provided empirical critiques of their assumptions, the question still remains of how these theoretical ideas are translated into legislative practices by the State, thereby affecting the structure of the market. To understand State practices within the neoclassical paradigm, it is useful to examine the Reagan administration. Reagan’s administration encountered stagflation in the 1970’s. As a response to simultaneously increasing unemployment and inflation, a combination that broke down the Phillips Curve so critical to Keynesian models, neoliberal policy prescriptions rooted in neoclassical principles became prominent. As opposed to simply deficit spending, Reagan deregulated a variety of industries and cut taxes on corporations. Capital regulations were also lifted giving banks a freer hand. (Investopedia, “Reaganomics)

The political cultural approach recognizes that reality is more complex and that one cannot simply apply a fixed rule in order to determine the balance of market and State. It recognized the embeddedness of the market and the presence of incumbents in the field who aggressively seek stability. This necessitates that the State take up a regulatory role on a case by case basis. The Securities Exchange Commission was created in order to ensure that bad bonds were not issued and to protect investors. A prospectus must be filed which details the sources of revenue and the precise assets and liabilities that the company holds. Following the most recent financial crisis, the Dodd-Frank act required stress tests to be conducted on all banks in order to enforce long term strategic management. (The White House. "Wall Street Reform: The Dodd-Frank Act.")

In this paper, I have clarified the fundamental role of the principles of the dynamic of competition, and utility maximizing actors that make rational decisions on the basis of complete information in neoclassical economics. Practical implications of these principles were described and an effort was made to demonstrate the inapplicability of this theoretical model and its principles to the real market. Finally, the manner in which State policy affects the structure of the market under the neoclassical and political-cultural model was explored. It is clear that neoliberalism- and the neoclassical economics on which it is built- fails to grasp the complexities of twenty first century capitalism, and that a new vision of the relationship between private and public actors is necessary.

Works Cited

Fligstein, Neil. "The Alphabet Soup of Mortgage Products." Berkeley. 13 Oct. 2016. Lecture.

Fligstein, Neil, and Adam Goldstein. "The Anatomy of the Mortgage Securitization Crisis." Markets on Trial: The Economic Sociology of the U.S. Financial Crisis: Part A Research in the Sociology of Organizations (2010): 29-70. Web.

Fligstein, Neil. The Architecture of Markets: An Economic Sociology of Twenty-first-century Capitalist Societies. Princeton: Princeton UP, 2001. Print.

Investopedia. "Reaganomics." Investopedia. Investopedia, 23 Mar. 2004. Web. 21 Oct. 2016.

Kristol, Irving. "On Corporate Capitalism." Schumpeter’s Market (1975): 124-41. National Affairs. Web. 20 Oct. 2016.

Weintraub, Roy. "Neoclassical Economics." , by E. Roy Weintraub: The Concise Encyclopedia of Economics. Library of Economics and Liberty, 21 Oct. 2016. Web. 21 Oct. 2016.

The White House. "Wall Street Reform: The Dodd-Frank Act." The White House. The White House, 20 Oct. 2016. Web. 21 Oct. 2016.