December 24, 2023

by Stephen Stofka

I will start off this week’s letter with a look at the assumptions of neoclassical economics. I will finish up with some thoughts on the contributions of Robert Solow, a Nobel laureate who died this week at the age of 99. His growth model was built on neoclassical foundations and is still a workhorse of intermediate level macroeconomics.

In the late 19^th century, several economists blended mathematics and utility theory to separate the study of economics from political economy. They thought that they could study human behavior with the same quantitative analysis that physicists and engineers used to make predictions about the mechanical world. To make their analysis consistent with established mathematical principles they made several assumptions regarding both consumer choice and the production process. I’ll begin with consumer choices.

The first assumption was that individual choice making was rational. This meant that people had preferences for some goods over others and could construct bundles of goods that would maximize their utility, or satisfaction. These preferences were consistent and independent of circumstances like income. For instance, a person might not be able to afford a steak but they preferred steak to ground beef. The ordering of preferences was complete. A person either preferred this bundle of goods to that bundle of goods, or preferred that over this, or considered them equal.

In order to predict human behavior, the neoclassicals assumed that humans behaved predictably. Behavioral economists challenged those assumptions as unrealistic. We may try to optimize our satisfaction but our lives are a series of circumstances partly determined by our prior choices and circumstances. Because of this our preferences change. Our “priors” introduce biases into our decision making that sabotage our attempts to maximize our utility. We want to put a decision behind us so we may shorten a lengthy examination of options and choose something just to have it done. This is known as decision fatigue. The choice of a hotel room while on vacation might be an example. Ratings systems address this fatigue.

A second assumption was that the market clears, balancing supply and demand so that there is no surplus or shortage. At this equilibrium is the market clearing price. A surplus or shortage would introduce some serial correlation into the price analysis and raise the likelihood that errors in the data were not random. A third assumption was that people form expectations by reducing the errors in prior expectations. This was later formalized as a concept called rational expectations but it was based on the idea that people optimized their satisfaction. These assumptions interpret human behavior so that our behavior is amenable to mathematical modeling and statistical validity. How realistic are they? The law of inertia models motion under the assumptions that there is no gravity or friction.  Although unrealistic, it is the basis for accurate prediction. In 1966, economist Milton Friedman wrote “The Methodology of Positive Economics,” a seminal paper asserting that a valid test of an assumption was not how likely or reasonable it seemed but its ability to enable accurate prediction.

In analyzing the production process, the neoclassicals assumed that the proportions of the factors of production were consistent. If the production costs for an industry were half labor and half capital, they were always in those proportions. In order to make production amenable to differential analysis, the neoclassicals pretended that production was continuous and incremental, even when it was seasonal or halting. They assumed that the output from production was constant, or constant returns to scale. X number of inputs went into the production function in certain proportions and the same Y output came out. The neoclassicals assumed that savings were automatically turned into investment. When the Great Depression of the 1930s showed that the process was not automatic, the neoclassical analysis could not explain it.

The neoclassicals failed to predict the extraordinary growth in productivity during the twentieth century. In the thinking of some economists, growth was inherently uneven and would introduce market instability that made it more difficult to reach equilibrium. In 1956 Robert Solow and Trevor Swan independently published papers that introduced a model where technological innovation enhanced labor productivity. The higher productivity led to higher savings rates which led to a higher rate of investment. Policies that encourage investment would lead to more efficient use of that investment and a steady rate of economic growth.

Like the neoclassical economists, the Solow-Swan models assumed that savings were turned into investment. With that increased investment, companies adjusted the mix of capital and labor used in production. The ratio of capital (K) to labor (L) inputs, the K/L ratio, kept increasing. In a medium term of like ten years, higher savings and investment led to higher economic growth. But greater investment increased depreciation costs so that savings and depreciation rates competed with each other. In the long-term of two or more decades, their models described a steady state of balanced growth. Capital, effective labor and economic output would approach the same rate of growth.

In their steady state model, technological innovation was an exogenous factor, meaning that it was not generated or explained by the model. In studying developing countries, other economists realized the importance of property rights protection. Policies and institutions must encourage investment and afford some assurance that the fruits of R&D research will be protected. Without this sense of security, investors must account for the risk that their research will be copied and the resulting loss of profits will impact projections of long term cash flows. This dampens investment in those countries with low property rights protection. Consequently there is a low amount of R&D investment and the people within those countries become stuck in a trap.

Nobel laureates are recognized for their contribution to a field of study. Their ideas and their analytical approach became an incubator for more research, more questions, discussion and controversy. As growth theory and development economics have evolved, they have incorporated the ideas of Robert Solow. He was born in the early 1920s when electricity was ushering in large gains in mechanical productivity. He died when those same electrical currents are powering a revolution in information processing. His birth and death are the bookends of a century of transformation.

///////////////

Photo by Mike Hindle on Unsplash

Keywords: neoclassical economics, consumer, production, steady state, growth theory, Solow