The scientific innovations of the Chicago School are the subject of this article. Chicago positive economics is not a set of tenets or propositions, but an approach to economic research. It can be characterized as a “scientific paradigm” in the sense of Thomas Kuhn’s The Structure of Scientific Revolutions (1962) or a “scientific research program” in the sense of Imre Lakatos’s The Methodology of Scientific Research Programmes (1978).
The Chicago Paradigm (or Chicago Research Program) is derived from the hypothesis that markets will equilibrate because competition will drive decision makers to allocate the resources under their control efficiently. Once markets have cleared it is no longer possible to improve the economic position of anyone without worsening that of someone else. This result emerges out of standard price theory and is known as Pareto optimality. It was also the consensus view among economists since Adam Smith until being disrupted by Keynes’s General Theory in the 1930s.
Understanding Economics for Enlightened Citizenry
The assumptions necessary for attaining Pareto optimality are not believed to hold exactly, but only as a “good approximation”. In the Chicago Paradigm, as opposed to the Keynesian one, the deviations from Pareto optimality are treated as random disturbances of no significance for understanding the economic phenomena under study.
A hallmark of Chicago applied research is its persistent use of the “good approximation” assumption. Any apparent inconsistency in empirical findings with implications for the theory is interpreted as anomalous and requiring one of the following actions:
(i) re-examine the data to reverse the anomalous finding;
(ii) improve and augment the variables in the model to account for the anomalous finding;
(iii) alter the postulate of rationality to accommodate observed behavior that is inconsistent with the theory;
(iv) place the finding on the research agenda as a researchable anomaly.
Chicago adherents prefer to focus attention upon (i) and (ii) and, failing a quick resolution, move to (iv), but pay little attention to (iii). By contrast, non-Chicago adherents consider all possibilities and show no strong pre-disposition to neglect (iii). The Chicago Paradigm avoids choosing (iii) not for dogmatic reasons, but because it is believed to be less productive for scientific enterprise.
Chicago economists faulted Keynes because in trying to account for massive unemployment in the Great Depression, he chose (iii). The Chicago aversion to the Keynesian approach reflects more than a desire to have research directed by a correct theory; it also reflects a concern with achieving and maintaining intellectual influence in the teaching of economics to student and other non-economists. The objective is to have others think about economics in terms of “correct” models; make the “right” assumptions; and ask the right questions.
Understanding good economics is important for enlightened citizenship. The economics profession in general and Chicago in particular consider the teaching of correct economic principles to be an important part of its activity, and Keynes’ General Theory represented a fundamental challenge to the standard theory of markets. Chicago had to meet the Keynesian challenge head on.
Tight Monetary Policy Deepened Recession
The crucial departure in Keynes was a “new concept of equilibrium” that permitted less than full employment of resources to exist; in other words, markets had stopped equilibrating. There were unemployed workers who were unable to obtain employment even though they were willing to accept the same pay as those employed, or even less, and were no less productive. Both Knight (1937) and Viner (1936) argued this innovation in the General Theory was unacceptable.
The Chicago School tackled three specific challenges. First, Milton Friedman took on the lack of a theory behind the Keynesian consumption function. He derived a theory of consumption from basic economic principles that showed the impact of fiscal stimulus in an economic recession had to be small. Therefore, Keynesian fiscal stabilization policy had little traction. This lesson unfortunately was forgotten by Obama’s economic advisers 3 years ago when they sought to stabilize the US economy through fiscal stimulus.
Second, Friedman overturned the Keynesian assumption of money illusion, whereby people mistakenly equate having more pieces of money with possessing greater wealth and ignore the effects of foreseeable inflation. His joint study of the monetary history in the United States with Anna Schwartz demonstrated that a stable one-to-one relationship existed between money supply and prices in the long run, but not between money supply and real GDP.
Their work also identified that tight monetary policy deepened the economic recession that started in 1929 and turned it into a Great Depression. For Friedman, it was the failure of the Fed policy that precipitated the Great Depression and there was no need to resort to ad hoc Keynesian theories for an explanation.
In so doing, Friedman revived the old “Quantity Theory of Money” developed by David Hume in 1748. Friedman, following Hume, recognized that increasing money supply had a short run effect on stimulating real GDP, but the timing of the effects was variable. He argued that the short run effects were difficult to pin down because it depended in part on the expectations of companies and individuals in the economy, which are in turn affected by their perceptions of what the government will do to stabilize the economy.
Friedman argued that in the long run, there was no trade-off between unemployment and inflation. For this reason, he advocated that government should adopt a fixed monetary rule to minimize policy uncertainty effects as the best stabilization policy. Indeed he supported a constitutional amendment to adopt a binding fixed monetary rule.
Friedman’s ideas became the inspiration for subsequent work by Edmund Phelps (Nobel Laureate 2006) on tradeoffs between inflation and unemployment, Robert Lucas (Nobel Laureate 1995) on rational expectations theory, and Finn Kydland and Edward Prescott (Nobel Laureates 2004) and Thomas Sargent and Christopher Sims (Nobel Laureates 2011) on macroeconomic dynamics.
Friedman’s ideas were vindicated by the stagflation during the oil crisis where unemployment and inflation co-existed, a situation that could not be explained using Keynesian ideas. In the financial meltdown of 2008, the Treasury and Fed decided to prevent the collapse of the banks and to subsequently adopt quantitative easing. Thus they avoided repeating the policy mistakes of the Depression. The influence of Friedman’s ideas probably prevented the US from experiencing a 25% unemployment rate this time as compared to what happened in the 1930s. These measures have saved a lot of wealth, jobs and lives.
The third challenge that the Chicago School took on was vindicating price theory, which had been attacked by Keynesians. The one-price competitive market has been the paradigm for the theory of price determination since Adam Smith. George Stigler (Nobel Laureate 1982) showed that equilibrium implies not a single price, but a distribution of prices whose dispersion is related to the cost of acquiring information-search. Thus in the presence of search cost the existence of multiple prices was shown to be compatible, even required, by efficiency. This finding also extended the range of price theory’s applicability to such phenomena as search, turnover, and frictional unemployment. Stigler showed that observed or measured unemployment can be consistent with equilibrium in the labor market. The theory of search inspired the work on labor market frictions by Peter Diamond, Dale Mortensen and Christopher Pissarides (Nobel Laureates 2010).
Coase Theorem’s Far Reaching Change
Chicago innovations in economic theory are “paradigm preserving” or “paradigm extending”. They extend the theory of markets to behavior previously considered intractable to economic analysis. Some key examples illustrate this:
(1) The Coase Theorem — before 1960 economic externalities were thought to cause losses to injured parties that exceeded the gains to those causing them. Ronald Coase (Nobel Laureate 1991) pointed out that under the maintained hypothesis that everyone is optimizing, and in the absence of transaction cost, the failure of an injured party to induce (i.e., bribe) his injurers to desist implied that the marginal cost to the injurer, of desisting, was greater than the marginal benefit (of non-injury) to the injured.
In a sense, the Coase theorem is simply a creative redefinition of transaction cost; nevertheless it altered the way in which economists view externalities. It is now recognized that externalities are negative outputs produced jointly with positive outputs, whose “consumers” must be compensated as the property rights of injurers and injured and the laws of liability determine.
What Coase did was to expand the concept of transaction and commodity to include purchase and sale of the right to inflict losses. This has enabled economists to apply standard price theory to the analysis of the economic consequences of alternative assignments of property rights (and of tort liability) and even to explaining how such rights are assigned.
Coase’s work has inspired the application of economics to numerous new fields — economic analysis of law, economics of governance and organizations (exemplified by the work of Elinor Ostrom and Oliver Williamson, Nobel Laureates 2009), and economic theory of institutions and their historical evolution (exemplified by the work of Douglass North, Nobel Laureate 1993).
(2) Human Capital— Gary Becker (Nobel Laureate 1992) gave the idea that education and training may be treated as capital and greatly sharpened formulation which made it possible to consider time used for study and in acquiring work experience as proxies for investment in human capital. This led to a coherent theory of the distribution of personal income and schooling as investment.
(3) Allocation of Time and Application to Non-Economic Behavior — Becker’s theory of the allocation of time explicitly introduced “time” as an additional resource and from this was developed a new approach to household consumption analysis. A wide range of phenomena hitherto beyond the reach of economic analysis could now be studied.
Becker also proposes to treat preferences as stable. Such an assumption implies that changes or differences in behavior are to be attributed solely to changes in technology or in resource endowments that cause shifts in relative factor prices, but not to exogenous shifts of tastes. In doing so, he precludes using the reason or excuse that “preferences have changed” as an explanation of human behavior. Becker goes on to make it clear that he regards the economic approach as comprehensive, applicable to all human behavior.
Adding the assumption of stable preferences to the Chicago Paradigm increases both its predictive power and its vulnerability to refutation. Becker’s augmentation invites application of economic theory to subject matter that economists, and others, have hitherto regarded as non-economic, for example, marriage, fertility, divorce, the legal system, accidents, discrimination, early childhood development, crime and punishment, drug addiction, etc. The invitation has been widely accepted by economists at Chicago and elsewhere.
Controversies Over Monopolies
(4) The Survivor Principle — Extensive use of the “survivor principle” is characteristic of the Chicago Paradigm. Stigler used it to explain the distribution of firm sizes. Firms were not identical and had different sizes due to different scale economies. Stigler showed that in a competitive industry different firms employed resources of different qualities. Firms could therefore be efficient over a considerable range of sizes. Industry expansion was met through both increases in the number of firms and the growth of incumbent firms, with some firms exiting. His study relaxed the requirement that all firms must be identical in a perfectly competitive industry.
Stigler’s work on industrial organization led him to be less critical of market monopolies. He concedes that monopoly is possible, but contends that its presence is much more often alleged than confirmed. When alleged monopolies are genuine, they are usually transitory, with freedom of entry working to eliminate their influence on prices and quantities within a fairly short time period. Normatively, Chicago economics says monopoly is bad; but positively, it says it is of infrequent occurrence and limited impact. The Chicago Paradigm is that most of what appears to be monopoly is eliminated by free entry; and when this fails it is primarily because of regulatory barriers to entry due to acts of government protection.
The Modigliani-Miller Theorem (Nobel Laureates 1990) that underpins the Efficient Markets Theorem is a variation of the Chicago Paradigm and has driven the finance research program. The strong position argued that markets were always efficient and there was no problem — an extreme position — that was not shared by all or even most Chicagoans. The weaker notion that markets, particularly financial markets, usually work pretty well, and that it’s very hard to beat them by investing against them, is still a very powerful result and is widely accepted by most economists.
Bubbles have been recognized by Friedman and others, because there are phenomena that are hard to explain without thinking it is a bubble. Economists working in macro theory have had difficulty deriving these bubbles from any reasonably rational set of actors that are somewhat forward looking, although there are models that can do it now; but it is still an analytical challenge for the Chicago Paradigm. For Chicagoans this is an item to be placed on the research agenda as a researchable anomaly.
Prizes for the Chicago School
(5) Quantitative Economic History — Robert Fogel (Nobel Laureate 1993) pioneered the application of standard price theory and empirical analysis to re-examine the findings and conclusions of historians who had studied American and European economic history. He and his colleagues came out with startling conclusions that overturned established interpretations of the past and introduced new techniques and standards of interpretation to historical studies. Their work showed that markets generally worked even in the historical past, and introduced to economists unfamiliar with history a new understanding of how economies worked.
The most controversial work by Fogel and his colleagues was their reinterpretation of American slavery. They showed the system of slave plantations was economically more efficient than family farms and was not about to collapse at the time of the Civil War; indeed the war triggered their collapse and the end of the slave system. Fogel also showed that the economic status of blacks who were freed suffered when slavery ended — such has been the price of freedom. Fogel survived criticisms of being a racist and an apologist for slavery because his science could not be faulted; and perhaps because he had married a black woman and was an active member of the Communist Party (USA) during his youth for a decade.
(6) Surplus Labor in Traditional Agriculture — T W Schultz’s (Nobel Laureate 1979) work Transforming Traditional Agriculture (1964) delivered a decisive blow to the idea that there was an unlimited supply of surplus labor in traditional agriculture. This belief, which has been influential in development economics, holds that the marginal product of labor in agriculture is zero because this labor is in surplus; hence it is possible to fuel urban industrial production by transferring labor there without suffering losses in agriculture. Schultz provided empirical evidence from natural experiments to show that the idea of surplus agricultural labor was a figment of the imagination of urban scholars who had no idea how agriculture worked. In doing so, he demonstrated that the Chicago Paradigm worked since the idea there was surplus labor implicitly assumed markets were not in equilibrium.
Since 1970 when the Nobel Prize in Economics was instituted a total of 42 awards with 67 awardees have been given out – 16 of the awards and 25 of the awardees have been associated with work directly traceable to research driven by the Chicago Paradigm. This is an impressive record over the four decades of this Nobel Prize.