After the publication of John Maynard Keynes’s General Theory of Employment, Interest and Money (1936), the study of economics gradually divided into two parts: microeconomics and macroeconomics. The economic theory of markets, where supply and demand would be balanced through competition, was discredited as an adequate foundation for informing the study of macroeconomics.

 

Keynesian macroeconomics began with the premise that markets are not equilibrating, and, therefore, prices have ceased to perform their central function of balancing supply and demand. Leading economists in major universities across Europe and America took up this idea to develop macroeconomic models based on prices not adjusting in the presence of either excess demand or excess supply.

 

The study of microeconomics, however, continued to adhere to the theory that prices did indeed adjust to balance supply and demand – in other words, that micro markets equilibrated. The study of economics thus came to operate with two theories that were essentially contradictory. Being schizophrenic became a normal state for economists and economics students from the 1940s to the 1960s.

 

Classical Theory Challenged

 

The idea that markets equilibrate can be traced from Adam Smith’s Classical approach to economics through to Alfred Marshall’s Neo-Classical approach – an accumulation of over one hundred and fifty years of theorizing and cumulative wisdom. Keynesian economists were ecstatic about the iconoclastic message of Keynes’ General Theory.

 

The experience of massive unemployment during the Great Depression was accepted as proof on the macroeconomic scale that markets had failed to equilibrate. Some economists extended this idea to micro-markets to examine whether competition was imperfect, inadequate or had also failed. The theories of imperfect competition (by Joan Robinson of Cambridge University) and monopolistic competition (by Edward Chamberlain of Harvard University) were such examples.

 

For Frank Knight and his students at the University of Chicago, Keynesian economics presented three challenges. First, the idea that prices cannot equilibrate markets meant that the economic theory of markets was an inadequate or erroneous description of how the economy functions. It was therefore a flawed theory. Second, if markets could not clear autonomously then extensive government intervention in numerous aspects of economic life would be required and justified, thereby weakening the basis of a free economy and a free society. Third, the separation of economics into two parts – microeconomics and macroeconomics – requiring separate theories for each part meant economics did not have a robust unified theory of the economy. Such division contradicted the basic principles of what a scientific theory should embody. 

 

The Chicago school tackled Keynes on several fronts to argue against his interpretation of the economy. The first objection was that Keynesian economics made the theory of markets a wrong positive theory of the economy. The second objection was normative because Keynesian economics promoted government intervention; there was probably a more pronounced statist tendency among the first generation of Keynesians, some of whom became enamored with socialism and economic planning in the immediate post World War II era. The third objection was a methodological complaint. Chicago economists insisted that for economics to be a proper positive science there should be only a single theory – prices can either clear markets or they cannot. Their function cannot vary with circumstances. This article mainly deals with the methodological issue.

 

Hypothesis Tested Against Evidence and Experience

 

Chicago’s methodological approach to the study of positive economics was articulated in Milton Friedman’s 1953 essay, “The Methodology of Positive Economics.” Friedman argues positive economics is a body of systematized knowledge concerning “what is” and normative science is concerned with discussing criteria of “what ought to be.” The two are totally distinct.

 

Friedman accepted Karl Popper’s conception of science. The ultimate goal of a positive science is the development of a “theory” or “hypothesis” that yields valid and meaningful predictions about phenomena not yet observed. Such a theory is, in general, a mixture of two elements. In part, it is a “language” designed to promote systematic and organized methods of reasoning. In part, it is a body of substantive hypotheses designed to abstract essential features of complex reality.

 

Viewed as a language, theory has no substantive content; it is a set of tautologies. Its function is to serve as a filing system for organizing empirical material and facilitating our understanding of it. Mathematical models are commonly used in science because mathematics is a precise and logical language.

 

Viewed as a body of substantive hypotheses, theory is to be judged by its ability to predict accurately those phenomena it intends to explain. Only factual evidence can show whether it is “right” or “wrong” or, better, tentatively “accepted” as valid or “rejected.” The only relevant test of the validity of a hypothesis iscomparison of its predictions with experience. The hypothesis is rejected if its predictions are contradicted (or contradicted more frequently than predictions from an alternative hypothesis); it is accepted if its predictions are not contradicted. Great confidence is attached to it if it has survived many opportunities for contradiction. Factual evidence can never “prove” a hypothesis; it can only fail to disprove it, which is what we generally mean when we say, somewhat inexactly, that the hypothesis has been “confirmed” by experience.

 

Friedman proceeds on this basis to claim that the “correctness” of a hypothesis in positive economics must be judged on the basis of whether its predictions are verified and not on whether the assumptions it makes are “plausible”. He asserted in effect that assumptions do not matter; only predictions do.

 

Conceptions of Rationality Contested

 

This is a very important claim. The idea that markets would equilibrate to balance supply and demand rested on the hypothesis that competition among individuals and firms in the market would clear markets. Rational firms would have incentives to increase supply in response to rising prices in a situation of excess demand. Similarly, rational firms would have an incentive to decrease supply in response to falling prices in a situation of excess supply. The driving forces behind competition were of course the assumptions that profit maximizing behavior of firms and utility maximizing behavior of individuals.

 

At one time there was considerable disagreement over the meaning of the word “rational.” It was thought to variously suggest an outdated psychology, lightning-fast calculation, hedonistic motivation, and other presumably unrealistic behavior. Keynesian economics assumed human behavior was not always rational and hypothesized the existence of “money illusion” and “animal spirits”. In the past it was customary to ridicule the assumption of rational maximizing behavior. Critics dismissed economic theory in general and the theory of equilibrating competitive markets in particular as being flawed or erroneous. Even today there are many such critics that hold this view.

 

Consider, for example, how a tree arranges its branches and leaves. A biologist could propose to construct a mathematical model of a tree which has an objective to maximize exposure to sunlight for the purpose of photosynthesis. To attain its objective the tree would have to arrange its branches and leaves in a particular manner. The maximization outcome could be simulated on a computer. The predicted virtual pattern of branch and leaf arrangements could be recorded and compared with the actual arrangements observed for real trees.

 

The biologist’s model could be verified or rejected depending on how tight the model’s predictions conformed to the facts. The model of the biologist could be adapted to make two different sets of predictions for trees grown in the northern hemisphere and those in the southern hemisphere. And these two sets of predictions could also be tested. You and I would probably agree that actual trees do not “reason” and is capable of solving the biologist’s mathematical model. On the other hand, you and I would probably not find fault with the biologist for making use of such an assumption to construct such a model. And if the model succeeded in predicting the arrangement of the branches and leaves of trees, we would consider this to be a good scientific model of tree “behavior” and would not be troubled by the idea that the biologist had made an “implausible” assumption about tree behavior.

 

In the economic world, observed facts are necessarily finite in number; but the number of possible hypotheses is infinite. If one hypothesis is consistent with the available evidence, an infinite number of hypotheses are also consistent.The choice among alternative hypotheses equally consistent with the available evidence must to some extent be arbitrary, though there is general agreement that relevant considerations are suggested by the criteria “simplicity” and “fruitfulness,” themselves notions that defy completely objective specification.

 

Truly important and significant hypotheses are likely to have “assumptions” that are wildly inaccurate descriptive representations of reality, and, in general, the more significant the theory, the more unrealistic the assumptions. The reason is simple. A hypothesis is important if it “explains” much by “little”. That is, if it abstracts the common and crucial elements from the mass of complex and detailed circumstances surrounding the phenomena to be explained and permits valid predictions on the basis of these alone. To be important, therefore, a hypothesis must be descriptively false in its assumptions; ittakes account of, and accounts for, none of the many other attendant circumstances, since its very success shows them to be irrelevant for the phenomena to be explained.

 

Chicago chose to adopt rational maximizing behavior as the assumption to underpin the economic theory of markets. They considered it to be a particularly “fruitful’ assumption for predicting a wide range of phenomena and also because it is “simple”.

 

The Chicago reasoning for why markets will clear under competition was reformulated by University of California Los Angeles economist Armen Alchian with the assumption of the “survivor principle”. In its weak form, the survivor principle says that competition will lead to the selection of lower cost methods for performing any task. The strong form of the survivor principle holds that at any moment the expected cost of the method actually in use will be “close” to that of the least cost method available. This was also accepted as a Chicago theory of markets.

 

No Evidence of Discrimination in Hong Kong Markets

 

The “survivor principle” can be applied to many contexts. Private firms in a competitive market that practices discrimination, for example either gender or ethnic discrimination, will fail to maximize profits because they will fail to retain productive staff on account of this discrimination. According to the survival principle, these firms would be eliminated from the marketplace because they do not use the least cost method of production. The more vigorous the market competition, the sooner such firms will drop out from the market. This is a prediction that can be empirically tested.  A corollary is that discrimination is more likely to survive in non-competitive markets.

 

In 1976, I performed an indirect test of labor market discrimination in Hong Kong by estimating the differences in hourly wages between single men and women (holding constant individual schooling levels and years of work experience). I discovered that there was no statistically significant difference in the wage rates between the two groups. Similar estimates for the US often revealed a statistically significant difference with single men earning higher wages than single women.

 

This piece of evidence suggests that gender discrimination was unlikely to have existed. Hong Kong labor market and, even if it did, it was unlikely to be more serious than in the US. In 1976 Hong Kong, unlike the US, did not have legislation against discrimination in the marketplace. A reasonable conjecture for why discrimination by gender appeared to be less evident in Hong Kong at this time is that our labor markets were more competitive. For this reason, I have always maintained a healthy skepticism when people claim that there is discrimination in the marketplace in Hong Kong.  

 

Chicago economists work with the hypothesis that markets would equilibrate under competition whether due to maximization behavior or the survival principle. Supply and demand would therefore be balanced and markets cleared. Empirical findings that are anomalous and not consistent with the predictions of market clearing are held with great suspicion and do not prompt them to give up the hypothesis. It motivates them to restructure and extend their model so as to reconcile empirical anomalies with theory. For the Chicago School, innovations in theory are “paradigm preserving” and “paradigm extending” rather than “paradigm shattering”.

 

Rebuilding Classical Theory

 

Keynesian economics was a “paradigm shattering” event in economics; and for this reason the Chicago School also found it necessary to meet the challenge on methodological grounds first. The Chicago methodological approach was to reestablish the use of a single theory for the study of both microeconomics and macroeconomics; and also to expand the predictive power of positive economics.

 

In late 2008, many of my friends told me that economics cannot explain the irrationality of the markets. People were panicking, they were no longer rational, so the assumption of rational behavior could not be right. Maybe it was correct under more normal circumstances, but not this time. Many people said this to me. They sent me books with titles like: The Myth of the Rational Market. I suspect they were glad to tell me I was wrong and that Chicago economics was also wrong.

 

What would Friedman’s methodology say? For a predictive science assumptions like rationality did not matter at all. The only relevant test for economics as a positive science is concerned was its apparent failure to predict such a major event. And for which obviously a lot of work more work needs to be done in economics. This is a failure of the profession and Chicago must share in this scientific failure. But science is neither religion nor truth, just non-rejected theories and hypotheses.

 

Man as Rational and Romantic Being

 

Although the Chicago School assumed rational behavior for its models, it did not assume that people were only rational. Frank Knight had a much more complex and nuanced view of man. He wrote in 1944:

 

That “Man is a Rational Animal” is one of those interesting statements which do not have to be proved.  By the same authority, he is also a groping ignoramus, a fool, and a miserable sinner, quite unworthy of redemption. The list of opposite characteristics could be indefinitely extended, and all the statements would be true, in varying degree and numerous interpretations. But by the same token each is false or, taken singly and alone, is an exaggeration and over-simplification.  Man is certainly a romantic animal. For a general characterization, he is perhaps less distinctively homo sapiens, the knower, than he is homo mendax, the liar, deceiver, hypocrite, actor, pretender, practicer of make-believe. Other animals have ….. an interest in truth; man alone prefers fiction to fact, with respect to the world and especially to himself.  He covers his body with clothes and that is trivial compared to the concealment and misrepresentation of his intellectual, emotional and moral nature in language and expressive behavior.  This is by no means all to the bad.  Insofar as man is wise or good, his “character” is acquired chiefly by posing as better than he is, until a part of his pretense becomes a habit.

 

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