E. K. Hunt on Equilibrium Prices in Neoclassical Economics

E. K. Hunt in his book the History of Economic Thought: A Critical Perspective (2002; although a new edition [Hunt and Lautzenheiser 2011] is now available, I quote from the 2nd edition) identified three problems with neoclassical theory:

(1) its conception of the entrepreneur,

(2) its conception of the nature of production, and,

(3) its conception of the process by which markets supposedly attain their competitive equilibrium prices (Hunt 2002: 373).

In particular, problem (3) above is directly relevant to the alleged “economic (mis)calculation” problems that so concern Austrians.

Hunt discusses point (3):

“The third principal obfuscation of neoclassical theory was its conception of the process by which competitive equilibrium prices were determined. In this theory, each consumer, each owner of a factor of production, and each entrepreneur were passive ‘price takers.’ All prices were determined by the competitive market completely independently of the actions taken by any individual or business firm.

Despite the considerable amount of attention that this problem received after the publication of Walras’s Elements, the neoclassical theorists did not substantially improve on Walras’s attempts to solve it. They could assert that these equilibrium prices were arrived at through a process of ‘groping,’ but they were never able to give any convincing empirical or theoretical argument to show that such groping would not take the economy farther away from equilibrium rather than closer to it. They could rely on Walras’s useful fiction of the crier [that is, the Walrasian auctioneer – LK], but such an obvious resort to a useful fiction as a deus ex machina designed simply to hold the theory together reduced the effectiveness of the theory’s ideological defense of free market capitalism.

In the more esoteric literature of professional journals, the neoclassicists demonstrated that the existence of such a set of equilibrium prices was not logically impossible, given their initial assumptions. This demonstration was taken as a reasonable justification for the textbook practice of simply assuming that this set of equilibrium prices existed and was known to ail individuals and business firms.

This was a particularly critical assumption because the three pillars of the neoclassical ideological defense of free market capitalism were the marginal productivity theory of distribution …, the invisible-hand argument, and the belief, held purely on faith, that the free market forces of supply and demand automatically and efficaciously take the economy to a full employment equilibrium … . None of these three ideological props for capitalism could be defended if the market did not automatically create equilibrium prices.” (Hunt 2002: 374).

This analysis conveys how fundamentally bound up the argument for free markets is with the idea that real world markets do have a tendency to create equilibrium prices in each commodity market.

Of course, the metaphor of the Walrasian auctioneer was always a most bizarre and unrealistic part of the neoclassical theory, because prices in a market economy are most decidedly not formed by some auctioneer clearing markets in a centrally organized auction. What can you say about a pro-free market model that analyses decentralised market activities as if they were overseen by some kind of central planner? (which is what the Walrasian auctioneer really is).

While one can point to certain flexprice markets where traders or business people do need to adjust prices rapidly to clear their stock, such as producers and wholesalers who sell perishable goods (e.g., fresh seafood), or alternatively to clearance sales that retailers hold to clear stock, other markets have prices set. The latter are fixprice markets. The empirical reality is that in many fixprice markets businesses engage in price administration or price setting. They are price makers, not price takers. And this is before we even get to the issue of prices as set by oligopolies, cartels and monopolies.

Many firms quite deliberately set prices. They act to ensure their survival and grow their business and market share. By looking more at the long-term state of demand, the price of many products is often not affected by short-term changes in demand. Short-term increases in demand can be met by holding stocks of their product and by having excess capacity. The most important cause of price adjustments are changes in the costs of factor inputs and wages.

Empirical studies show that, outside given limits, businesses find that variations in their set prices produce no significant change in sales volume, and, above all, when prices are cut, this does not necessarily lead to changes in short term market sales (Gu and Lee 2012: 462). And experiments with prices adjusted downwards to a significant extent show that this causes a severe blow to profits, so severe indeed that enterprises quickly abandon such experiments (Gu and Lee 2012: 461).

Prices set by businesses are not equilibrium prices. As Lee says, “administered prices are not market-clearing prices and nor do they vary with each change in sales (or shift in the virtually non-existent market or enterprises ‘demand curve’)” (Lee 1994: 320, n. 18).

The neoclassical and Austrian view (or at least a view held by some Austrians) of universal supply and demand dynamics governing all prices which gravitate to their equilibrium values thus becomes untenable.

Curiously, the existence of fixprice markets and its implication for economics was taken up by the Austrian economist Ludwig Lachmann:

“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).

The lesson Lachmann learnt, however, was never learnt by Mises, Rothbard and other Austrians who continue to analyse most prices unrealistically in terms of demand curves and equilibrium prices.


BIBLIOGRAPHY

Gu, G. C. and F. S. Lee. 2012. “Prices and Pricing,” in J. E. King, The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 456–463.

Hunt, E. K. 2002. History of Economic Thought: A Critical Perspective (2nd rev. edn.). M.E. Sharpe, Armonk, N.Y.

Hunt, E. K. and M. Lautzenheiser. 2011. History of Economic Thought: A Critical Perspective (3rd edn.). M.E. Sharpe, Armonk, N.Y.

Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.

Lee, F. S. 1994. “From Post Keynesian to Historical Price Theory, Part 1: Facts, Theory and Empirically Grounded Pricing Model,” Review of Political Economy 6.3: 303–336.