6 het 2010 extended lecture notes 6, orthodox ecs

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1

Classical Political EconomySmith; Ricardo; Mill

MarxHistorical School

NeoClassical EconomicsJevons – Walras – Menger

Marshall

Keynes

1870

1940

Institutional

Ecs. – Veblen

• builds on; ↔ opposes

Emergence of theoretical strands within economic science 1800-1940

1800

History of Economic Theory 2010/11

Geert Reuten

Lecture Notes 6

ORTHODOX ECONOMICS AFTER 1945Neoclassical Economics: from the Neoclassical Synthesis to Monetarism

and from General Equilibrium Theory to New Classical and

New Keynesian Economics

General Introduction

This lecture provides a schematic overview of the developments in orthodox economic theory

after 1945. The objective is merely to set out wherefrom the other economics courses start theo-

retically (macroeconomics, microeconomics, money & banking, international economics, public

sector economics).

The scheme below summarizes the interconnection of the strands in economic theory as treated

in Lectures 2-5.

Structure of this lecture

A. Neoclassical Synthesis (NCS)B. Monetarism (MON)

C. Neoclassical Microeconomics: General Equilibrium Theory (GET) and after

D. New Classical Economics (NwC)

E. New Keynesian Economics (NwK)

F. On the gradual falling apart of the Neoclassical Economics mainstream

G. Schematic summary

Appendix: Debates – the case of the Cambridge–Cambridge Capital Controversy (CCCC)



2

General Remarks

With the discussion of the strands that emerged between about 1945 and 1980 we get to the cur-

rent Orthodox Economics (until recently indicated by the term Neoclassical broadly). In their

diversity these strands may be considered to constitute the ‘mainstream’ of economics. The pur-

pose of this lecture is to indicate their interconnection – matters of content are restricted to that

purpose. (In the first part of Lecture 7 this orthodox mainstream will briefly be contrasted with

current heterodox strands.)

• Both the “Neoclassical Synthesis” (A) and the neoclassical “General Equilibrium Theory” (C)

emerge in the 1950s. However the Neoclassical Synthesis reaches dominancy before General

Equilibrium Theory.

• The period 1950-1980 can be characterised as the highlight of Neoclassical theory as a sys-

tematic whole. At the same time however, it gets contested, not only from the side of the het-

erodox streams (as one might expect) but increasingly also from inside.

o On the exact periodisation of these matters opinions diverge. Landreth & Colander

mostly emphasise the precursors and the ‘beginning of the end’ (1950s ?). I rather em-

phasise ‘dominance’ so that the falling apart for Neoclassical microeconomics emerges

not before 1980, and that for macroeconomics not before the end of the 1990s – L&Cshare this last view:

“In the late 1990s and early 2000s, there was no generally accepted approach to macro-

economics. It was a field in chaos.” (page 386)

o See also the remarks about periodisation in Lecture 3. L&C agree that for the teaching

programmes at especially the bachelor level the neoclassical dominance reaches till to-

day.

(A) THE NEOCLASSICAL SYNTHESIS (NCS)

1. Introduction

Around 1945, most economists believed that the economy would lapse back into a depressionsoon after the restoration (continuation of the Great Depression of the late 19th century and the

Depression of the 1920s and 30s).1

→ Climate right for active steering of the economy by the government (i.e. steering rather

than just legislation and provision of infrastructure).

This provides the background for the “Neoclassical Synthesis” (NCS) and the corresponding

economic policy. (The full name is: Neoclassical-Keynesian Synthesis; however, it is also called

“Neo-Keynesian economics”).

Principal economist: Paul Samuelson. He was both a prominent researcher – 2nd Nobel Prize

1970 – but also the author of the standard textbook Economics. This book was used all over the

world from ±1950-1980; 1st edition 1948. In the 1955 edition he baptises the name: “grand neo-

classical synthesis”.The years 1950-1980 were not only the heyday of Neoclassical Economics in general, but

particularly also of the NCS. Nevertheless the theoretical infringement starts by the 1970s. In

terms of economic policy the microeconomic turn to deregulation and the roling back of the State

starts by 1980 (also called neoliberalism). However, the macroeconomic policy influence lasts

much longer – in a way even till today, be it rarely in terms of an active discretionary steering but

rather in terms of automatic stabilizers.2 (‘Rarely’: the financial-economic crisis that developed

from 2008 provided an impetus to renewed active steering.)

1

The problem formulation in Sweezy's underconsumption theory – see lecture 7 – fell in line with this idea.2 The current theoretical basis for it is in the so called ‘New Keynesian Economics” – see E. Unfortunately economists

are not very original in their name givings.



3

2. NCS characteristics (macroeconomics) Some of “Keynes’” ideas are fitted, and so in fact transformed, into the neoclassical framework.

Whether this can rightfully be called a “synthesis” is a matter of debate till today. This ‘adapta-

tion’ of Keynes occurs in at least three mains respects.

1) Monetary theory: dichotomy

• analysis in ‘real’ terms adopting relative prices or also index numbers (Keynes: “conun-

drums”);

• as a result, the classical and neoclassical dichotomy between the “real” and monetary spheres

was restored (with the rate of interest as the transmission between the spheres);

• consequently some version of the Quantity Theory of Money (QTM) was restored;

• Keynes’ view on interest (“the price for parting with liquidity”) is treated as an appendix: it is

seen to be effective only as an additional element in specific situations;

• in this connection the rate of interest is seen as one determinant of savings, thereby restoring

Marshall’s concept of interest, i.e. as the reward for “waiting” (a basic postulate of NCE – see

lecture 4);

• hence, the consumption function C = f(Y; i) in real terms.

The versions of the resulting NCS macroeconomic model is still being used at the bachelor’s

level of economics programmes (the “IS–LM”-model). The main versions of the model are of the

– to current students well known – following shape:

Y = C + I + G + (E-J)

C = f(Y; i)

I = ………

G = ………

etc.

M

M

“real” sphere

MD

=………

MS

= ………

MD = MS

}together some version

of the QTM monetary sphere

2) Equilibrium Theory

Keynes asserts that equilibrium is a special case (hence: The General Theory ...). This idea is

reversed in the NCS: equilibrium at under-capacity (equilibrium without full employment) is a

special case→ government intervention. (It is questionable how this can be called ‘equilibrium’

in the neoclassical own terms.)

3) Fine-tuning With respect to economic policy Keynes focused on an economy in a (prolonged) depression

with price deflation, as well as on the required general-institutional change of the capitalist

system.3 The latter, institutional change, disappears in the NCS. The former policy (i.e.

‘depression’ policy) gets shape in something very different from that, namely a discretionary

policy of levelling off the amplitude of the business cycle with the government budget as an

instrument (fine tuning). (With – in the next figure – something like the dotted development for

GDP as a result over time.)

3 The capitalist system would require a policy giving rise to e.g. the gradual “euthanasia of the rentier” (today the rentier

would include the portfolio investment funds and hedge funds).



4

time

GDP ....... policy effect

Along with it went the development of ‘large’ macro-econometric models – cf. Keynes' criticism

of such models: these cannot account for uncertainty. In his Economics, 10th ed. 1976 Samuelson

writes:

“The business cycle has been tamed, even if not completely made a thing of the past.

Although democratic mixed economies are unlikely to experience old-fashioned, prolonged

depressions once again, recessions and periods of relative stagnation will no doubt stilloccur even though fiscal and monetary policies can moderate their frequency, intensity, and

duration.” (p. 267)

3. Macro and micro theory The NCS leaves the micro-economic edifice of the NCE intact (hence, e.g., the macroeconomic

dichotomy and the eclectic savings function, that is, as including the interest rate). From this

stems the NCS thesis that NCE is adequate, nevertheless in the short run a "Keynesian" (i.e. Neo-

Keynesian) macro-economic government intervention is convenient. Nonetheless, full

employment and equilibrium is also possible without it, namely through:

“a policy of price flexibility; but the length of time that might be necessary for the

adjustment makes the policy impractical” (Patinkin, 1951)

The NCS coincided with the emergence of the separate fields of micro and macroeconomics.

A mathematical formalisation of (orthodox) economics emerged in micro economics, especially

General EquilibriumTheory (GET). Important founders: Hicks [1939, Value and Capital],

Samuelson [1947, Foundations of Economic Analysis] and Arrow & Debreu [1954, Existence of

an Equilibrium for a Competitive Economy, in Econometrica]. On the latter see section C.

4. Growth theory During this period, the NCE micro theory was primarily an allocation theory. Although this was

also a long run theory, there was no growth theory initially. For a long time (in teaching until at

least the early 1980th), the Harrod-Domar ‘knife edge’ model of economic growth (see Lecture 7)

was added as a ‘Fremdkörper ’ (an uneasy fitting addendum) to the NCE macro-theory. (This is

remarkable because – as we will see in Lecture 7 – this model aimed to show that equilibrium

growth is unlikely. Nevertheless, within NCS it was interpreted as an equilibrium theory!)

Around 1960 there emerges (in research) the first ‘true’ Neoclassical macro equilibrium theory of

economic growth (a.o. Solow) with capital–labour substitution. This theory, and the capital

theory behind it, gave rise to a hot debate in the main economics journals between its defenders

and Post-Keynesian inclined researchers, in which the consistency of the Neoclassical concept of

capital was at stake (called the “Cambridge–Cambridge capital controversy”, discussed in the

Appendix).



5

(B) MONETARISM (see the texts of Friedman 1959, 1968 and the critique by Burstein 1963)

The Neoclassical branch called “Monetarism” is a reaction from within Neoclassical economics

against the "Keynesian" (i.e. Neo-Keynesian) elements in the NCS, including its proposed macro-

economic government intervention. It was leveraged by Milton Friedman.4

(See his 1959, wherehe sets out the Monetarist programme.) Friedman reverts back to Marshall and his type of (non-)

macroeconomics, that is mainly that of the Quantity Theory of Money (QTM).

Most briefly the programme (worked out by Friedman and is followers in great detail) runs as

follows:

1. contest of the stability of the NCS consumption function;

2. contest of the possibility of fine-tuning (lags in detection, decision lags, and implementation

lags: by the time e.g. government expansion is effective (after implementation), the economy

is already booming by itself whence the policy works pro-cyclical );

3. on top Monetarists contest a positive macro-economic effect on the economy of an increased

government spending in combination with borrowing by the government: because of their

crowding out of financial means that might otherwise be available for the private sector;4. contest of the adequacy of “large” models;

5. postulate of a stable velocity of circulation of money (V) in QTM; hence

∆ M → ∆ pY

6. proposing “simple” macro-monetary policy: a money growth rule adopted by Central Banks

(∆M in accordance with the structural growth of Y). Cagan [1987]: “a justifiable exception to

laissez faire”.

The points 1, 5 and 6, and perhaps also 3, indeed contest Keynes (see lecture 5) as well as the

NCS. The points 2 and 4 are addressed only against the 'Neo-Keynesians' of the NCS.

Friedman often repeats the slogan “Money matters”. But it was Keynes who really emphasised

that, and applied it far more extensively than did Friedman. The “Neo-Keynesians” of the NCSreduce the role of money.

Initially, the monetarist programme did not catch on. Even so, by 1959 Friedman had, apparently,

gained sufficient status to appear in a hearing before the Joint Economic Committee of the USA

Congress (Friedman 1959 – Reader). Nevertheless by 1969 a then leading monetary economist (a

non-monetarist) could comment on Friedman: “As matters presently stand, the quantity theory of

money is interesting more for doctrinal than for substantive reasons.” (Clower 1969: 65). This

was typical for the general view on Monetarism in those days. However, not more than 10 years

later the scene had changed. The major economic policy changes since 1979 indicate that

Monetarism did at least seep into policy circles (cf. also the constitution of the ECB in the EU

Treaty of 1991 – with Monetarism written in stone).

Chicago School The Monetarists, and together with the NCE branch of the “New Classical Economics” discussed

under E below, are called the “Chicago School”, because many of their leading figures were, and

are, associated with the Chicago University. This also applies to, e.g., Becker (“human capital”

and “economics of the family”).

4 {The term Monetarism came from Brunner 1968.}



6


MarxNeoClassical Eco

Jevons – Walras

Marshall

Keynes

Neo-Keynesians / Neoclassical Synthesis

Samuelson

1870

1940

1960

2000 MonetarismFriedman


Theoretical strands within economic science 1800-1940 and Orthodox strand

The appearance of the Neoclassical Synthesis and of Monetarism

1800



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(C) NEOCLASSICAL MICROECONOMICS: GENERAL EQUILIBRIUM THEORY AND AFTER

1950–1980–2000

1. Introduction Until the 1930s precursors in the field of mathematical methods were neglected by the

mainstream (L&C 391). After 1960 mathematical approaches have become dominant.

Until ±1980 there are two main varieties of Neoclassical Economics:

• Partial Equilibrium Theory (PET), originating from Marshall, now mainly adopted by Monetarism;

• General Equilibrium Theory (GET), originating from Walras, now mainly adopted by the

New-Classicals [see D and E below]

A danger for every theory is to draw premature general conclusions from the theory which take

insufficient account of premises and/or the internal cohesion between concepts.5 From this

perspective Frank Hahn (1981) examines the limitations of Neoclassical General Equilibrium

theory – including its textbook versions. Hahn himself is one of the most renowned Neoclassical

authorities in this area.

2. NCE–GET according to Hahn (1981) Current GET draws on Walras (1874). {For an impression see the separate Appendix B to these

Lecture Notes – that Appendix makes no part of the material for the examination requirements –

the Appendix below, included in these notes, does.} GET was revived in the 1950s by work of

Arrow and Debreu (which also influenced the further mathematisation of NCE).

Hahn stresses that GET is often used falsely: given its very stringent assumptions, the theory

cannot be simply applied (other than by showing that a general equilibrium situation is highly

unprobable in reality).

GET posits two types of “individual” agents: businesses ( firms) and households.

a. Assumed to be given for Firms • book of blue prints (production set);

• prices of all inputs and outputs;

• “state of nature”: complete set of “Arrow-Debreu markets” for all Arrow-Debreu

commodities (in practice this would mean, for example, – as Hahn points out – that today we

would have to have a futures market for, e.g., umbrellas to be delivered in the centre of

Amsterdam on Easter day 2019 in case it rains that day).

→→→→ choice of activities (production & production technique), for every point in time,

place and state;

• absence of “economies of scale”

b. Assumed to be given for Households • endowments (commodities and labour);

• entitlements to shares in the profits of firms;

• prices;

→→→→ choice of consumption goods (and work/leisure time);

• absence of “non-convex preferences”.

a & b →→→→ a Pareto-efficient GE (for each commodity S=D) can possibly exist.

5

This was the basis for the immanent critique by Post-Keynesians of one aspect of NCE–PET (i.e. its capital theory) –see the Appendix.



8

c. General Limitations

• There is no claim that GE also really exists (Hahn p. 125);

• There is no effective indication of how equilibrium prices evolve (p.133);

• There is no claim that GE is socially optimal (Hahn p. 125).

d. Specific Limitations

There are/is:

• no money and monetary matters (p. 130);

• no stock markets (p. 130);

• no uncertainty (p. 130);

• no asymmetric information (p. 130);

• time: “collapsing the future into the present” (p.132);

• no oligopoly and other forms of imperfect competition (p. 130);

• no coalitions (p. 130);

• in general no `power' (p.132);

• applies (with the limitations above) only to large economies (p.130) (there must be `many'enterprises) (p.131);

With regard to the limitations of expectations and “time”, there are two possible solutions:

1) Exogenous expectations→ successions of short-term equilibriums, which are not Pareto-

efficient (p.133);

2) Assuming “Rational Expectations” (RATEX) (i.e. every agent correctly predicts the

equilibrium prices associated with every possible ‘state of nature’). This solution is also not

Pareto-efficient. RATEX theory must also assume that everything that can be learned comes to

be learned (p. 133).

If and when there are no Arrow-Debreu markets, it is unclear exactly what it is that firms do

maximise or should maximise (p.133-34).

3. “Modern” microeconomics: “eclectic formalist modelling”Hahn’s text (1981) appeared in a book with the telling title: The Crisis in Economic Theory. This

illustrates that by this time the GET programme had reached its internal limits. (L&C, page 384,

date this earlier.)

In the mean time much of neoclassical microeconomics is returning to a partial equilibrium

approach, though not necessarily a Marshallian.

Modern microeconomics (research) is an “eclectic formalistic modeling approach” (L&C

405). Even so its approach may – for the time being – best be characterised as one ‘in divergence’

from the neoclassical principles. See L&C’s list on pp. 403-4:

1. The focus on allocation of resources at a point in time is no longer central (there has been

more focus on growth – but this is rather a macro issue).

2. Utility theory is rarely used today.

3. Mathematically calculus is gradually being dropped (though not in undergraduate teaching)

in favour of game theory (this, however, is a matter of technical instruments rather than

content – nevertheless game theory seems to go along with a gradual shift in content).

4. Instead of ‘rationality’, there is a movement towards ‘bounded rationality, norm-based

rationality ... and empirically determined rationality’.

5. Individualism ‘still reigns’ but it is under attack.

6. Even if the (possible) existence of general equilibrium is still a dominant view, the

development of research is rather along the lines of ‘multiple equilibria’.

The list applies especially also to the very recent approach of “behavioural economics”. Withinthis approach fundamental Neoclassical assumptions are (at least experimentally) being dropped



9

and influences from social psychology are being received. It is too soon to judge whether this

approach is an enduring break away from neoclassical economics.

Nevertheless, and in sum, what seemed to be the great force of neoclassical microeconomic

theory, namely its systematic interconnection (even with its shortcomings) is now largely falling

apart:"Since the connection with general equilibrium theory has been eliminated, there is no

theoretical core to limit assumptions. ... If the choice of the model is ad hoc, then the results

are ad hoc." (L&C 402)

(D) NEW-CLASSICAL ECONOMICS: rational expectations (Ratex)

Monetarists are optimistic about the outcome of free markets. The recent branch of the Chicago

School, The New Classical Economics is even more optimistic about that.

Precursors of this approach are (a.o.) Muth {1961} and Lucas {1972; 1981}. From the early

1980s onwards can we discern it as a new branch of neoclassical economics. (A new branch: itmight also be argued that given the falling apart, or even the state of disarray, of NCE, the New

Classicals are the true heirs of NCE.)

Note: Notwithstanding the suggestion by the name “New Classical” the term has – like the

term Neoclassical – few to do with Classical Political Economy.

Key to this branch, in brief, is its movement back to the “macroeconomics” of before Keynes –

just as the Monetarists did – yet for them on the basis of General Equilibrium Theory (not the

Marshallian partial equilibrium theory, which is the basis for the Monetarists).

This movement is based on their idea of a requirement of “microeconomic foundations of macro-

economics”. (Note that for quite some economists this implies the giving up of macroeconomics– which might perhaps be part of the agenda: macroeconomic policy at least is inevitably

associated with state intervention.)

In the NwC view individual behaviour is dependent on the ‘rational expectations’ of individuals;

in particular also on their expectations about economic policy. Individuals adapt their behaviour

to (expected) economic policy. Therefore the predictions on basis of econometric models fail

(these predictions are based on past behaviour).

According to the NwC the economy is continuously in a state of ‘competitive equilibrium’, i.e. all

markets cleare. In as much as the Monetarists they postulate that for the labour market the actual

unemployment is in effect not a disequilibrium unemployment, but rather a ‘natural

unemployment’, an equilibrium unemployment.

This poses of course the problem of how business cycles should be explained. (This has been a

problem for all of the Neoclassical tradition, though perhaps one somewhat less pressing when

equilibrium was conceived to be a “long run” entity.) The NwC indeed undertook this

explanation. “Expectational errors” might perhaps seem to be causative for business cycles. This

was rejected however, because NwC see expectational errors as short lived (whereas cyclical

‘deviations’ are rather enduring for some period). Lucas saw – in line with the Monetarists – the

money supply as the cause of cycles. Instead the NwC developed a so-called “real business

cycle” theory, which conceptualises their cause in exogenous technological shocks.6

6

Interestingly the theme of a technical impetus to the business cycle seems to correspond with that of one branch withinmodern Marxian Political Economy. The important difference is that the latter is no equilibrium theory, and also that for

the latter this technical development is endogenous,



10

We have seen before (Lecture 4) that business cycles had been a terrain researched by heterodox

economists only. In whatever way one might want to assess the NwC business cycle theory, it is

important that now (in 1980) 90 years after the emergence of NCE, the New Classicals finally

undertook research in business cycle theory.

As a final note it may be remarked that whereas the NwC theory of the business cycle is based on

exogenous technological shocks, they developed an “endogenous growth theory” in terms of

endogenous technical development. Further, demand plays no role in this theory: it is a pure

“supply-side economics”.

(E) NEW KEYNESIANS

In terms of research the Neoclassical Synthesis is over. Roughly, however, the so-called “New

Keynesians” (NwK) can be seen as the successors of the NKS (i.e. the Neo-Keynesians).

The term New Keynesian is misleading. As for the Neo-Keynesians these economists havelittle to do with Keynes; they have also little to do with the Post-Keynesians (Lecture 7).

However, relevant for them is the theory of – what was misleadingly called – keynesian

economic policy, that is Neo-Keynesian policy.

• The New Keynesians accept the New Classical idea of rational expectations. However, they

hold that these rational expectations lead to (Neo-)keynesian conclusions, provided that one

does not assume at forehand a unique equilibrium of all markets (as the New Classicals do).

All individuals could take ‘rational’ decisions; the result, however, can be socially ‘irrational’.

• New Keynesians argue for macroeconomic foundations of microeconomics (the reverse of the

New Classicals).

• According to the New Keynesians a “keynesian” policy is theoretically effective, though often politically ineffective (for example because it is often politically difficult to cut back

government expenditure in boom periods – whereas this might be required for making

financial room for expansions in times of recession).

Comment on L&C Chapter 15

L&C 410 : All of the first paragraph after the first sentence is better deleted (Ricardo did analyse

economic growth ; he did present a macroeconomic theory ; on the other hand the problem of

allocation plays a role only with the emergence of the Neoclassicals after 1870).

The following scheme presents the interconnection of the Neoclassical branches presented in

Sections C, D and E.



11

NeoClassical EconomicsJevons – Walras – Menger

Marshall

Keynes


Samuelson

1870

1940

1960

2000

New-Keynesian

Economics

New-Classical

Economics

Gen.Equil.Th.Arrow–Debreu

Hahn

MonetarismFriedman


Keynes and the Orthodox strands 1940-2000

Chigaco School

[Neoclassical] Orthodoxy (broadly)

(F) THE GRADUAL FALLING APART OF NEOCLASSICAL ECONOMICS

I have suggested several times (also in Lecture 4) that neoclassical economics is (being) falling

apart. This is not just so because we have now three or four main branches of within NCE. It is

also the case because within those branches the theoretical problems accumulate.

By using the term “orthodoxy”, instead of neoclassical, I leave somewhat open to what extent

exactly the current ‘mainstream’ is in fact neoclassical. Landreth & Colander argue thatNeoclassical Economics has fallen apart. Perhaps it is too early for a definitive assessment of

this. (Note again the research, teaching and policy distinction – Lecture 4.) The issue depends

also on what exactly one understands by ‘Neoclassical’. The current orthodoxy has the

following main characteristics:

• individualism;

• (bounded) rationality;

• priority of micro over macro (except for the New Keynesians);

• equilibrium (for the disequilibrium approach of the New Keynesians, equilibrium seems

nevertheless the reference point for the disequilibrium);

• some concept of ‘natural unemployment’;

• neutrality of money;• capital as a factor of production: productivity of capital;



12

• production as a black box;

• efficiency of a market economy.

In any case general equilibrium theory is at least a ‘in the back of the mind’ reference point

(also for L&C) – it is central for the New Classicals.

The strict Neoclassical assumptions of their theory of consumer and producer behaviour – as

including the associated ideas of the marginal physical productivity theory – fade. In my view,

however, the (neoclassical) issues that do connect the Orthodoxy still outweigh the issues that

divorces them. Even so the connections are now shaking.

The, once, great force of neoclassical microeconomic theory, namely its systematic

interconnection (even with its shortcomings) is now fading, not only for microeconomic theory

itself but also for macroeconomics. The reasons for it are, in brief:

• internal inconsistencies that have gradually, though increasingly, come to the fore

(‘anomalies’ in Kuhn’s terminology);

• the non-realistic assumptions hamper the application of the theory.

(G) SCHEMATIC INTERCONNECTIONS OF THE STRANDS AND BRANCHES

The scheme on the next page summarizes the interconnections of the strands and branches

thereof as presented in this lecture. (That is except for current Austrian Economics – see L&C

494-496.)



13


MarxNeoClassical Econo

Jevons – Walras –

Marshall

Keynes


Samuelson

1870

1940

1960

2000New-Keynesian

Economics

New-Classical

Economics

Gen.Equil.Th.Arrow–Debreu

Hahn

MonetarismFriedman


Theoretical strands within economic science 1800-1940 and Orthodox

1800

Chigaco School

[Neoclassical] Orthodoxy (broadly)



14

APPENDIX

DEBATES: THE CASE OF THE CAMBRIDGE–CAMBRIDGE CAPITAL CONTROVERSY (CCCC)

Introduction

As indicated in the main text, around 1960 there emerges (in research) the first ‘true’

Neoclassical macro equilibrium theory of economic growth (a.o. Solow) – as it is one with

capital–labour substitution. In fact, the capital theory behind it had for long been a matter of

controversy (see Landreth & Colander 259-270). In 1953 Joan Robinson revived the discussion.

The neoclassical capital theory together with the growth theory gave next rise to a hot debate in

the main economics journals between its defenders and Post-Keynesian inclined researchers, in

which the consistency of the Neoclassical concept of capital was at stake. (The Post-Keynesian

strand will be introduced in Lecture 7.) The debate came to a provisional close with an article by

Samuelson in 1966.

The discussion was led by Neoclassical Cambridge U.S.A. economists on the one side (a.o.

Samuelson, Solow, Arrow) and by Post-Keynesian economists from Cambridge England on the

other side (a.o. Robinson, Pasinetti, Kaldor). Therefore the debate became baptised as the

“Cambridge–Cambridge capital controversy”. Note that the Cambridge England critique is animmanent critique of Neoclassical economics, thus the neoclassical concepts are accepted (that is

to the extent that these are clear and consistent).

This Appendix provides a summary of one of the key points of the controversy.7

A1. The problem of capital aggregation in general: circularity The following figure indicates in simplified terms the problem of the NCE marginal physical

productivity theory (MPP theory). Prices are explained by the MPP of labour and capital. But in

order to make a coherent statement about a physical quantity of labour or capital, one requires

that what is to be explained (prices, including the distribution of income w and r ):

Labour Marg. Phys. Productivity→wage rate [w]

production factors → prices {Capital Marg. Phys. Productivity → interest/profit rate [r]

}

AGGREGATION

It is not meaningfully possible to add up physical capital goods (while labour could possibly be

counted in terms of hours).

A key point of the Cambridge-Cambridge Capital Controversy is that the valuation of `capital'

depends on time as well as on the distribution of income.

A2. Capital and income distribution [the Neoclassical view]

Within neoclassical theory there are at least two concepts of capital.

(a) Capital as a produced means of production (NB: to be valued against historical cost or

replacement value);

(b) Capital as the present value of future returns.

In a state of equilibrium, these two must be equal to each other (Robinson p 51).

7 The main texts (as including Robinson 1953 and Samuelson 1966) can be found in the

collection Harcourt & Laing (eds.) Capital & Growth, 1971.



15

Capital (nr. a) is, of course, the result of some distribution of income (r and w). But according to

the Marginal Productivity Theory that distribution is (in equilibrium) for a given technique of

production determined by the marginal physical productivity of the factors capital and labour.

The value of capital goods is determined by he distribution of income (cf. Robinson 1953: 60;

and Samuelson 1966: 238 – 'Present Discount Value'):K = R1 / (1+i) + R2 / (1+i)

2+ .... Rn / (1+i)

n

R = returns (NB Keynes: uncertainty).

i = current (or expected!) rate of interest/profit

NB: in the Neoclassical Equilibrium Theory, the rate of profit (r) and the rate of interest (i) are

identical.

For the sake of simplicity imagine just 2 periods with R=100; and two different i’s: 5% and 2%

K' = 100 / (1+5%) + 100 / (1+5%)2 = 95 + 90 = 185

K'' = 100 / (1+2%) + 100 / (1+2%)2

= 98 + 96 = 194

So when i↓ the present value of the expected R's increases – so the value of capital goods rises

too. K is thus dependent on the distribution of income.

A3. Distribution of income and changes in technique [Post-Keynesians establish] K 's dependence on the distribution of income has far-reaching consequences for the NCE Growth

Theory (generally the theory of long-run equilibrium) which is based on wage flexibility and

factor-substituting changes of technique. This also affects Neoclassical economic policy tenets.

For instance:

unemployment→ w↓ →more labour-intensive techniques;

conversely, w↑ → unemployment.

A4. The non-perverse case: homogeneity and switching [the NKE view] We have

Y = C + I

Y = W + R

Y = wL + rK

where w is the wage rate, L the amount of labour used, r the rate of profit/interest, K the amount

of capital used.

Implicit in the last equation is a production function – represented by a K/L ratio.

In the neoclassical macro-economic production function we have the production of one (as if)

homogeneous good. The dimensions are physical (not money).

Suppose (for the sake of simplicity) that the capital stock (capital goods) are fully written-off

during the production period.

Y = wL + (1+r)K (1)

where Y is the gross product.8

w = Y/L – (1+r)K/L (2)

w = (Y-K)/L – (rK)L (2a)

Thus the maximum wage rate (at r = 0) is w = (Y–K)/L i.e. the net product per labour hour.

Similarly:

8 In case depreciation would be completely ignored we would have Y = wL + rK.



16

r = {(Y–K)/L – w} * L/K (3)

Thus the maximum profit rate (at w = 0) is r = [(Y–K)/L]*[L/K], i.e. the net product per labour hour,

times the capital stock per labour hour.

A technique is defined by its capital stock to labour ratio:K/L = k

A wage–profit frontier indicates (from equation 1) all possible combinations between r and w for

a given technique.

Figure 1: Wage-profit frontier (for one technique)

Figure 2: Wage-profit frontier for two techniques A and B, [(K/L)B > (K/L)A]

If w↑, from w1 to w2, then we get a switch from technique A to a more capital-intensive

technique B (substitution of capital for labour). To this since at w2 the rate of profit r2 is higher

than r1’ (i.e. the rate that would prevail for the old technique A).This is the ‘normal’ NC case (non perverse).

w

w1

r

r1

w2

B

A

r2

r1’

w

(Y-K) / L

(Y-K)/L * L/K

w1

r

r1



17

Note that because equation (1) is about the macroeconomic production of (supposedly) one

homogeneous good, that equation is proportionally equivalent to the price equation for that good,

i.e.

p = wL + (1+r)pk where pk = K.

A5. The perverse case: heterogeneity and reswitching

[implications of the NCE theory, as shown by Cambr. Eng. (PKE)]Cambridge Eng. introduces a small complication to the framework presented in the previous

section: two types of commodities are produced: capital stock (subscript k) and consumption

commodities (subscript c). We thus have a two-sector macro model. For each sector we have a

different K/L ratio and thus different price equations:9

pk = wLk + pk k k (1+r) (4)

pc = wLc + pk k c(1+r) (5)

pc

= 1 (6)

(pc is the numéraire: the as if “money'”commodity)

define p'k = pk /pc and w' = w/pc

then rewrite (4) and (5) as:

p'k = w'Lk + p'k k k (1+r) (7)

1 = w'Lc + p'k k c(1+r) (8)

Thus:

w = [1–k k (1+r)] / [Lc(Lk k c – Lck k )(1+r) (9)

This relation between w and r indicates the wage-profit frontier for each technique (WPF).

If we now regard the economy as a whole, then the form of the WPF (linear, concave or convex)

depends on the K/L ratios in the sectors (see Figure 3).

Figure 3: Possible forms of the Wage-profit

frontier

9 Remember that K=pk (section 4); now Kk =pk k k .

w

r rr

w w

[a] (K/L)k = (K/L)c [b] (K/L)k > (K/L)c [c] (K/L)k < (K/L)c



18

Now, allowing for more than one available technique, in principle each of the following combina-

tions of techniques is possible – see Figure 4.

Figure 4: Possible combinations of techniques

We have a “reswitching of techniques” when – for the reason indicated below – firms switch

from a technique A to technique B, and then – apparently for a similar reason – switch back to

technique A. This reswitching of techniques (as we will see below) can be ruled out only for the

first combination from Figure 4 [(K/L)k = (K/L)c], the one corresponding with the homogenous

macro-situation of the previous section 4 – Figure 2).

w

r rr

w w

w

r rr

w w



19

Figure 5: Reswitching of techniques

• Let the wage rate be w1. Firms will then choose technique A (yields the highest rate of profit).

• If wages increases to w2, then they will switch to technique B. According to Neoclassical theory this technique B is more capital-intensive than A: we

have substitution of capital for labour.

• If wages increase further to w3, then we have a reswitching to technique A.

According to Neoclassical theory this technique A is more capital-intensive than B: we

have substitution of capital for labour.

• ? ? ? This is of course inconsistent.

One way to explain this inconsistency is that the distribution of income (w, r) affects the

“value” of capital. This would be in line with sections A1 and A2 above. However, this

would also be rather fatal for the Marginal Productivity theory (which is in terms of

physical productivity) – and its explanation of the distribution of income generally.

A6. Result of the debate The result of the debate is that, on closer examination, the earlier general conclusions of the

Neoclassical Marginal Productivity Theory are not tenable.10 Or: the Neoclassical definition of

capital is problematic (which was Robinson's point of departure in 1953). Strangely enough, this

discussion has not permeated through to the Neoclassical textbooks to a significant extent (if at

all).

10. The original fundamental argumentation of the problems, elaborated on by the Cambridge (Eng.) side of the debate, can

be found in Sraffa, Production of Commodities by Means of Commodities; Prelude to a Critique of Economic Theory (1960).

Also refer to Harcourt's summary, `Some Cambridge Controversies in the Theory of Capital', Journal of Economic

Literature, June 1969 (on reswitching especially §4 `A Child's Guide [not exactly that!] to the Double-Switching Debate', pp.386-395). As indicated, the main texts produced in the debate can be found in the collection by Harcourt & Laing (eds.)

Capital & Growth, 1971.

AB

w

r

r1

r2

r3

w1

w2

w3



There is also an economic-political aspect to the discussion. Can we in, general terms, say w↓

→ employment↑ ?? Based on the old Neoclassical ‘parable’ (the term originates from

Samuelson) we can. But as soon as we introduce heterogeneity (or realise what "K" actually is,

and what the full meaning of 'equilibrium' is), it all becomes less simple. We can then no longer

simply draw that economic-political conclusion. In his 1966 summing-up article Samuelson had

to admit the inconsistency of neoclassical theory and concluded:

“If all this causes headaches for those nostalgic for the old time parables of neo-classical

writing, we must remind ourselves that scholars are not born to live an easy existence. We

must respect, and appraise, the facts of life.”

Shortly afterwards Samuelson devoted an Appendix of his textbook Economics to the Cambridge

Capital Controversy. Curiously, in later editions this was later shortened to just a footnote.

Questions

1. State some main characteristics of the Neoclassical Synthesis.

2.

State some main differences between Keynes and the Neoclassical Synthesis.3. Comment on the NKS consumption function of C = f(Y;i).

4. State the main lines of Friedman’s Monetarist programme.

5. What are the three main general limitations of General Equilibrium Theory?

6. State five important limitations/defects of General Equilibrium Theory as set out by Hahn

1981.

7. Why, according to Hahn, is the term “Pareto-optimum” a wrong characterisation of a

competitive equilibrium?

8. State the main characteristics of New Classical Economics.

9. Why were the New Classical economists more or less enforced to develop a business cycle

theory?

10. What are the main characteristics that unite modern neoclassical/orthodox economics?

11. State the most simple form of the circularity of the neoclassical marginal productivity theory

(as expounded by Joan Robinson in 1953).

12. What is the problem of reswitching of techniques for neoclassical marginal productivity

theory?

13. In what constellation can we have no reswitiching of techniques?

6 het 2010 extended lecture notes 6, orthodox ecs

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