Nicholas Kaldor wrote a short monograph called Economics Without Equilibrium (Armonk, N.Y., 1985), and it still makes rewarding reading. Now it is true that some of Kaldor’s observations apply more to the full employment era of 1946 to the 1970s (the golden age of capitalism), but there is much that is still highly relevant.
I summarise Kaldor’s arguments below.
I. Prices in the Real World versus Walrasian Equilibrium Theory
For Kaldor, we need empirical investigation of the real world market economies. If our received theories do not fit the facts, the theories need to be abandoned or properly modified.
In many markets in the real world, the “sellers are price-makers and quantity-takers, and not, as Walrasian equilibrium theory supposes, price-takers and quantity-makers” (Kaldor 1985: 31). Many prices are cost-determined, and demand has considerably less influence on prices than neoclassical theory supposes (Kaldor 1985: 31).
Kaldor identifies the major flaw in Walrasian neoclassical theory in relation to prices:
“… since Walras first wrote down his system of equations over 100 years ago, progress has definitely been backwards not forwards in the sense that the present set of axioms are far more restrictive than those of the original Walrasian model. The ship is no nearer to the shore, but considerably farther off, though in a logical, mathematical sense, the present system of derived tautologies is enormously superior to Walras’s original effort.The major flaw in neoclassical theory – and indeed in Austrian theory as well – is the failure to really understand the role of prices in market economies.
Perhaps for that reason general equilibrium theory retains its fascination for teachers and students of economics alike. Indeed, judging by the number of Ph.D. students working on the implications of the rational expectation hypothesis, it is gaining ground, at any rate, in America. One reason is the intuitive belief that the price mechanism is the key to everything, the key instrument in guiding the operation of an undirected, unplanned, free market economy. The Walrasian model and its most up-to-date successor may both be highly artificial abstractions from the real world but the truth that the theory conveys — that prices provide the guide to all economic action — must be fundamentally true, and its main implication that free markets secure the best results must also be true. (This second proposition was indeed demonstrated but under assumptions so restrictive that Professor Hahn turned the argument around and suggested, in his inaugural lecture, that the importance of general equilibrium theory lies precisely in showing how stringent the conditions must be for ‘free markets’ to secure the results in terms of welfare that are naively attributed to them. This may well be true, but if so, it is truth bought at a very high cost.)
But the basic assumption in all this — that prices are very important in the working of a market economy — is rarely, if ever, questioned. Yet it is precisely this over-emphasis on the role of the price system that I regard as the major shortcoming of modern neoclassical economics, particularly the Walrasian version of it.” (Kaldor 1985: 13—15).
In many markets, changes in supply are caused by “quantity signals,” not price signals. A “quantity signal” can be one of the following:
(1) a change in the amount of the stock/inventory* a business carries,What, generally speaking, induces changes in production is a “quantity signal”: changes in demand or in stock. In the latter case, when a producer’s stock falls, he has the incentive to raise production to restore his stock to a normal level (Kaldor 1985: 25), and, if demand changes are expected to be large and permanent, more labour and capital goods will be employed.
(2) a change in demand: changes in the sales volume or orders, or
(3) a combination of (1) and (2). (Kaldor 1985: 23).
* Note that, for many producers, stocks consist of factor inputs and not just output stock.
Kaldor’s conclusion is that in normal times (outside, say, a severe recession) “in actual adjustment of supply and demand, prices play only a very subordinate role, if any [sc. role]” (Kaldor 1985: 25; my emphasis). Moreover, for industries with increasing returns to scale, a large increase in demand can indirectly result in falling prices (Kaldor 1985: 25).
All this means that the fundamental neoclassical ideas must be rejected: the notion of a market economy where prices are entirely or mainly set by the dynamics of supply and demand curves is wrong. Prices are often not adjusted to clear supply by gravitating to some equilibrium, market-clearing level. The main process by which an economy is supposed to have a tendency to a general equilibrium state is thus shown to be a fiction – and this is before we get to theoretical problems with the idea that market-clearing prices exist for all markets, just waiting to be discovered by Walrasian tâtonnement.
II. Supply and Demand
The firm producing a commodity in a fixprice market relies on the carrying of stocks (whether of the finished good or stocks of its factor inputs) and its sales orders (that is, the demand for the firm’s output). Price signals are less important than neoclassical theory assumes.
The normal state of a capitalist economy is unused excess capacity and a certain level of idle resources: therefore production is mostly demand-constrained, not resource constrained (Kaldor 1985: 35). Even at the state Keynesians call “full employment” – which is not zero unemployment but somewhere in the order of less than 1% up to 4% unemployment – capitalist economies are still, generally speaking, demand constrained, not resource constrained. In the case of unemployment, even advanced capitalist economies have “disguised unemployment” in the sense that demand for more labour in manufacturing (or higher paid jobs) tends to pull people from low paid jobs in services, but the loss of employment here does not really result in any significant loss of output and certainly not if workers’ productivity can rise to compensate (Kaldor 1985: 36).
Kaldor does not deny that excessive demand can cause resource constraints in an advanced capitalist economy: it shows up in bottlenecks, delays in delivery and unavailability of certain goods (Kaldor 1985: 37).
But the economies faced with serious resource constraints are more likely to be developing nations, and historically in the 20th century were actually Communist command economies that began as developing nations and that tended to engage in a level of investment beyond their resources.
The source of inflation is mainly higher factor input costs: a higher wage bill or other factor input bill tends to induce higher prices (Kaldor 1985: 53). Changes in demand and in selling volume, on the other hand, are overrated as causes of price fluctuations.
The general stability of mark-up policies of firms in fixprice markets is dubbed “mark-up rigidity” by Kaldor (Kaldor 1985: 41). The profit mark-up in fixprice markets is constrained by the fear that a producer has that his competitors will not raise prices and achieve greater sales at his expense (Kaldor 1985: 40). The mark-up can also be determined by the desire to improve on market share by choosing a low mark-up in relation to other firms.
Many firms need to take care of customer relationships with regular clients, so their pricing behaviour is also constrained by the need to build up and maintain a regular clientele which can rob them of the neoclassical motive of pure profit maximisation (Kaldor 1985: 26, 48).
An important cure for inflation is the use of buffer stocks of important factor inputs that can used to stabilise the price of these commodities when short-term supply side factors influence prices. By this policy measure there will be created the real expectation of long-run price stability (Kaldor 1985: 79). The other solution to inflation is to stop excessive increases in money wages in relation to productivity growth (Kaldor 1985: 79).
Obviously, the need to stop excessive demand during booms is also a factor, but probably the least important one in the arsenal of inflation-controlling policies.
IV. International Trade
Increasing returns to scale are an important characteristic of modern production (Kaldor 1985: 68). The advantages of economies of scale are largely confined to manufacturing (Kaldor 1985: 70).
Walrasian theory is flawed by its assumption of constant returns to scale, and is thus a flawed theory for analysing problems of international development and trade (Kaldor 1985: 75).
Kaldor contends that free trade may damage the growth of industry in some nations, and that free trade is not necessarily beneficial to all parties (Kaldor 1985: 71).
A further interesting observation is that the theory of cost of production pricing (plus profit mark-up) should not be unknown to Austrian economists.
Austrian economics may well contain yet another schism in its theory of prices. On the one hand, we have the strident statements of those Austrians who are in agreement with Walrasians on the nature of prices:
“The characteristic feature of the market price is that it equalizes supply and demand. The size of the demand coincides with the size of supply not only in the imaginary construction of the evenly rotating economy. The notion of the plain state of rest as developed by the elementary theory of prices is a faithful description of what comes to pass in the market at every instant. Any deviation of a market price from the height at which supply and demand are equal is – in the unhampered market – self-liquidating.” (Mises 2008: 756–757).For Mises, the “unhampered market” would produce prices caused by the dynamics of supply and demand curves, and deviations would lead to self-liquidation and market-clearing prices. It is no surprise that Mises also sees real-world markets as having a real tendency towards the equilibrium state he called the “final state of rest,” his version of a Walrasian general equilibrium.
But then we have Ludwig Lachmann, who appears to understand that the Misesian and Walrasian view of prices is false:
“In different markets prices are formed in different ways. Not all pricefixing agents have the same interests. Here historical change plays its part. The decline of the wholesale merchant, whose dominating role Marshall took for granted, for instance in textile markets, and who naturally aimed at setting such prices as would permit him to maximize his turnover (a short-run consideration), reduced the range of markets with flexible prices. The rise of the industrial cost accountant as a pricefixer, with his interest in ‘orderly marketing’ (a long-run consideration) and his aversion to frequent price changes, has made most prices of industrial goods in our world Hicksian fixprices. In all markets dominated by speculation of course prices must be flexible. On the other hand, all bureaucracies, including those concerned with production planning in large industrial enterprises, naturally abhor flexible prices.” (Lachmann 1994: 166).But some understanding of cost of production pricing (apparently) goes right back to the early Austrians Eugen von Böhm-Bawerk and Friedrich von Wieser in these works:
“Those who glibly speak of ‘market clearing prices’ tend to forget that over wide areas of modern markets it is not with this purpose in mind that prices are set. They seem unaware of the important insights into the process of price formation, an Austrian responsibility, of which they deprive themselves by clinging to a level of abstraction so high that on it most of what matters in the real world vanishes from sight.” (Lachmann 1986: 134).
Böhm-Bawerk, Eugen von. 1891. The Positive Theory of Capital (trans. William Smart; vol. 2 of Capital and Interest). Macmillan, London.More recent Austrian discussion can be found in George Reisman, Capitalism: A Treatise on Economics. Jameson Books, Ottawa, Ill. and Chicago.
Wieser, Friedrich, Freiherr von. 1893. Natural Value (trans. Christian A. Malloch). Macmillan and Co., London and New York.
I will reserve full discussion of cost of production pricing theory in Austrian economics for another post.
Kaldor, Nicholas. 1985. Economics Without Equilibrium. M.E. Sharpe, Armonk, N.Y.
Lachmann, L. M. 1986. The Market as an Economic Process. Basil Blackwell. Oxford.
Lachmann, L. M. 1994. Expectations and the Meaning of Institutions: Essays in Economics (ed. Don Lavoie). Routledge, London.
Mises, L. von. 2008. Human Action: A Treatise on Economics. The Scholar's Edition. Mises Institute, Auburn, Ala