Econ 101 Does Not Only Justify Free Market Policies

Donovan Choy

Donovan Choy

MA graduate in PPE. I enjoy satire, spaghetti westerns, Wu-Tang Clan and am an advocate of laughter and liberty.

Econ 101: Every Progressive's Favourite Punching Bag

In a recent Straits Times article, Benjamin Goh and Donald Low warned readers against the use of simplified economic theory in informing public policy. They point out that economic proposals such as free trade benefiting society and the minimum wage reducing employment may in fact simply be expressions of ‘the speaker’s ideology or dogma’, and may hold true only in unrealistic textbook models that have no basis in reality.

This critique is a popular one, often found on left-leaning news outlets such as The Guardian or New York Times. The authors are certainly right to point out that many assumptions undergird popular economic models. Indeed, the nature of economics is that we deal with complex social phenomena that cannot be contained within a laboratory experiment.

The economist Ludwig von Mises taught us that all human action is undertaken within a state of uncertainty and a unique context of time and place, making it hard for to isolate factors and establish causal relationships in the social sciences. Hence the need for simplifying assumptions such as ‘perfect competition’ (where all firms are price-takers and none price-setters), zero transaction costs, where economic agents are perfectly rational, etc.

Making policy with such simplified models is a danger when social reality is different. Given that we live in a world of scarcity, policymakers will need to investigate difficult tradeoffs. A small city-state like Singapore is no different.

 

Neoclassical economics justifies not only neoliberal policies

But it is puzzling that the authors would pin the blame of what they perceive as a dogmatic belief in free trade and free markets on the type of economics that are taught in Econ 101 textbooks.

Yes, pro-market policies have been made from the Econ 101 framework, that much is true. But government interventionism such as tax proposals or market corrections are also commonly justified within the same framework that is built on similar assumptions.

What the authors refer to as ‘Econ 101’ is really popularly known as the neoclassical welfare economics paradigm that has dominated the profession since the early 20th century. In its simplest form, this economic framework is oriented around two main theorems:

  1. The first theorem starts with a set of assumptions about what an ideal market would look like when it is fully competitive and perfectly efficient
  2. The second theorem states that when there is a deviation from the first theorem i.e., market failures, governments should intervene and redistribute income to achieve efficiency

Therefore, by claiming that real world markets are always imperfect, the two theorems together provide an ideological justification for governments to intervene and reach full efficiency in the economy.

What Goh and Low neglect to mention to their readers is that left-leaning economists whom are distrustful of the ‘free market’ are working within the exact same paradigm. In other words, most interventionist policy proposals have been justified based on the same assumptions!

 

Market failure theorists

For instance, the authors mention that the ‘standard economic model’ does not consider the market failure of ‘information asymmetries’. This theory was pioneered by the economist George Akerlof in his famous 1970 paper. Akerlof taught the economics profession that markets are prone to failures because producers possess more information about the products they sold than consumers, putting the latter in a disadvantaged position.

Therefore, by claiming that real world markets are always imperfect, the two theorems together provide an ideological justification for governments to intervene and reach full efficiency in the economy.

What Akerlof did, in effect, is to argue that markets are inefficient because of information asymmetries. Remember the welfare theorems? In other words, he pointed out a deviation from the first welfare theorem to rationalise the second welfare theorem.

Whether or not we may agree with Akerlof’s theory is secondary to my purpose here. The main point is that Akerlof formulated his theory within the same neoclassical economics framework that depended on the previously mentioned theorems and the assumptions underlying them. Only by positing an idealised standard of efficiency could there be any logical sense in recognising a ‘failure’ and therefore a duty for the state (Interested students should check out Mike Munger’s brilliant exposition here).

Akerlof was far from being the only one. A whole tradition of economists from Arthur Pigou (externalities), Paul Samuelson (public goods) and Joseph Stiglitz (network effects, natural monopolies) have all worked within the same framework and tried to justify government interventions to save the market from itself.

The reasoning that all these economists brought forth all adhered to the same normative benchmark, although they have used various different ways to justify the modern regulatory state.

 

What does this mean?

It is highly disingenuous then for Goh and Low to claim that the type of neoclassical economics commonly taught in Econ 101 has somehow given birth to a ‘dogma’ of free trade and free markets. On the contrary, the same research paradigm has been used too, to justify left-leaning policy proposals where there is an onus for government intervention. If we are to jettison these assumptions, then the authors should be consistent about their policy proposals that depend upon the very same assumptions.

There is truth in the authors’ claims that these simplifying assumptions often have little bearing on real world economic analysis. But why then do they continue to maintain that these assumptions of fully rational, utility-maximising agents and perfect competition as useful in providing an ideal benchmark by which we judge an efficient economy?

It is thus wrong in assuming that simplified economic reasoning is the exclusive sin of neoliberal dogmatists. This means that while free trade and an opposition to a minimum wage may reflect simplistic economic reasoning, the preference for tariffs and employment regulations may likewise be guilty of the same error.

Unfortunately, I fear that Goh and Low’s article, well-written as it is, has the dangerous potential to mislead young economic students and public readers rather than informing them. It is fine if the authors support progressive economic policies such as a minimum wage or tariffs. But then their methodological criticisms of Econ 101 are eminently inconsistent with their own policy proposals.

 

Featured image credit from Foundation for Economic Education.

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Donovan Choy

Donovan Choy

MA graduate in PPE. I enjoy satire, spaghetti westerns, Wu-Tang Clan and am an advocate of laughter and liberty.