The neoclassical model

When discussing The Emergence of Capitalist Economics II at the Adam Smith's Lost Legacy blog, Gavin Kennedy writes

[...] we are treated to an account of the usual Ricardian corn model, regarded by some economists as illustrative of the inner workings of a capitalist economy, upon which the seeds of the profession’s love affair with models were planted in 1817.

YHT also link Adam Smith to the problems with which the corn model is lined up to discuss and which the late 19th-century mathematical school went on to separate economics even further from the real world, leading to the fantasies of General Equilibrium and much of microeconomics as we know it today.

I find myself asking, if GE and much of microeconomics is just a bunch of fantasies, how did we come to these fantasies? If we assume, as economists normally do, that those like Ricardo, J S Mill, Marshall, Jevons, Menger, Walras, Knight and many others, who developed the neoclassical model were not stupid, then why does neoclassical economics look the way it does, there has to be a reason. Ether I'm wrong and all these economists were just morons as many critics seems to suggest or they were rationally attempting to answer some question. So, if neoclassical economics is the answer, what was the question? This is something those who just want to complain about microeconomics don’t ever seem to ask. And even less answer.

I would argue there are two possible answers to my question: one theoretical, the other empirical.

From the theoretical side as has been pointed out by Demsetz (1982, 1988a and 1995) the fundamental preoccupation of neoclassical economists is with the market and the price system and hence little, or no, attention gets paid to either the firm or the consumer as separate, significant, economic entities. Firms and consumers existed as handmaidens to the price system. In Demsetz's view the interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. Butler (2007: 25-6) briefly sums up mercantilism in the following way:

[...] it measured national wealth in terms of a country's stock of gold and silver. Importing goods from abroad was seen as damaging because it meant that this supposed wealth must be given up to pay for them; exporting goods was seen as good because these precious metals came back. Trade benefited only the seller, not the buyer; and one nation could get richer only if others got poorer. On the basis of this view, a vast edifice of controls was erected in order to prevent the nation's wealth draining away - taxes on imports, subsidies to exporters and protection for domestic industries. [...] Indeed, all commerce was looked upon with suspicion and the culture of protectionism pervaded the domestic economy too. Cities prevented artisans from other towns moving in to ply their trade; manufacturers and merchants petitioned the king for protective monopolies; labour saving devices such as the new stocking-frame were banned as a threat to existing producers.

The free trade versus mercantilism debate was, to a large degree, about the proper scope of government in the economy and the model it gave rise to reflects this. The question implicitly at the centre of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? The mercantilists would (surely) answer "yes" but Adam Smith famously answered "no". Smith

[ ... ] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' - would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature. (Butler 2007: 27-8.)

[Note that according to Smith the government has three duties: "[t]he first duty of the sovereign, that of protecting the society from the violence and invasion of other independent societies [...]". Smith (1776: Book V, Chapter 1, Part First, page 689). "The second duty of the sovereign, that of protecting, as far as possible, every member of the society from injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice, [...]". Smith (1776: Book V, Chapter 1, Part II, page 709). "The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those publick institutions and those publick works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expense to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain" Smith (1776: Book V, Chapter 1, Part III, page 723).]

For Smith, markets are the most prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. For economists, the 200 years following Smith involved a search for conditions under which the price system would not descend into chaos.

The formal (neoclassical) model that arose from this search is one which abstracts completely from any form of centralised control in the economy. [For Adam Smith this would be an abstraction too far. Smith knew of the importance of institutions to the proper functioning of the market economy.] It is a model delineated by "perfect decentralisation". Decentralised insomuch as authority plays no role in coordinating resources, the price system does the work. Note that the neoclassical model is often described as one of "perfect competition" and one reason that the emphasis on the firm and the household diminished as the model developed was that the neoclassicals placed a growing emphases on the concept of market competition and thus less emphases was given to firms and households. As McNulty (1984: 240) explains "[t]he 'perfection' of the concept of competition, beginning with the work of A. A. Cournot and ending with that of Frank Knight, which was at the heart of the development of economics as a science during the nineteenth and early twentieth centuries, led on the one hand to an increasingly rigorous analytical treatment of market processes and on the other hand to an increasingly passive role for the firm." For Knight "[p]erfect competition is conditioned by the existence of a set of assumptions, the most important of which are the following: (1) "a perfect market for productive services [ ... ], that is, uniform prices over the whole field" (1921[a], 316); (2) complete rationality and perfect knowledge by free and independent individuals; (3) "perfect mobility in all economic adjustments, no cost involved in movements or changes" (1921[b], 77); (4) "virtually instantaneous and costless" exchange of commodities (1921[b],78); (5) "perfect, continuous, costless intercommunication between all individual members of the society" (1921[b], 78); (6) perfect divisibility of commodities; and (7) "an indefinitely large number of competing organizations, each of the most efficient size" (1921[a], 316)." (Marchionatti 2003: 58).

Again, authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets - prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. Thus the neoclassical model gives a set of sufficient conditions under which the price system alone can achieve equilibrium.

Foss and Klein (2005: 6-7) argue that there is the possibility of an empirical reason for the way the neoclassical model considers the production side of the economy, at least. In short, the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. So treating firms as if they were all small may have been a reasonable approximation to a large section of the economy of the time. But they also point out that such an explanation is not wholly convincing. Large firms have existed since at least the time of Adam Smith and the classical economists knew this. Mokyr (2002: 122-3) summarises manufacturing in the U.K. before the Industrial Revolution by noting that,

[...] large plants were not entirely unknown before the Industrial Revolution. For instance, Pollard (1968) in his classic work on the rise of the factory, mentions three large British plants, each employing more than 500 employees before 1750. Perhaps the most ``modern" of all industries was silk throwing. The silk mills in Derby built by Thomas Lombe in 1718 employed 300 workers and were located in a five-story building. After Lombe's patent expired, large mills patterned after his were built in other places as well. Equally famous was the Crowley ironworks, established in 1682 in Stourbridge in the Midlands (not far from Birmingham), which at its peak employed 800 employees. [...] In textiles, supervised workshops production could be found before 1770 in the Devon woollen industry and in calico printing (Chapman 1974).

Also chartered companies were well known as witnessed by Adam Smith's negative assessment of chartered companies in general and the East India Company in particular, contained in the Wealth of Nations.

A more precise, and more defendable, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently. Thus analysing anonymous "firms" may not have been a bad approximation to the empirical realities of the time. As an approximation to "anonymous firm" production - that is, fully price-decentralised production - consider the case of rife manufacture in Birmingham, England in the 1860s,

[o]f the 5800 people engaged in this manufacture within the borough's boundaries in 1861 the majority worked within a small district round St Mary's Church. [...] The reason for the high degree of localization is not difficult to discover. The manufacture of guns, as of jewellery, was carried on by a large number of makers who specialized on particular processes, and this method of organization involved the frequent transport of parts from one workshop to another.

The master gun-maker-the entrepreneur-seldom possessed a factory or workshop. [...] Usually he owned merely a warehouse in the gun quarter, and his function was to acquire semi-finished parts and to give these out to specialized craftsmen, who undertook the assembly and finishing of the gun. He purchased materials from the barrel-makers, lock-makers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture makers, and, if he were engaged in the military branch, from bayonet-forgers. All of these were independent manufacturers executing the orders of several master gun- makers. [...] Once the parts had been purchased from the "material-makers," as they were called, the next task was to hand them out to a long succession of "setters-up," each of whom performed a specific operation in connection with the assembly and finishing of the gun. To name only a few, there were those who pre-pared the front sight and lump end of the barrels; the jiggers, who attended to the breech end; the stockers, who let in the barrel and lock and shaped the stock; the barrel-strippers, who prepared the gun for rifling and proof; the hardeners, polishers, borers and riflers, engravers, browners, and finally the lock-freers, who adjusted the working parts. (Allen (1929: 56-7 and 116-7), quoted in Stigler (1951: 192-3).)

Such a method of production would be a guide to the way production would take place under a functioning version the neoclassical model of the "firm".

Thus whether we see the neoclassical model as a set of conditions under which the price system alone can prevent decent into chaos, more formally conditions under which equilibrium can be achieved, or as an approximation to a large section of the economy of the time, the neoclassical model makes more sense than many of its detractors would permit.