9/12/2019

Two Elementary Ideas for Basic Economic Reasoning

"This term I am teaching my History of Price Theory course, a course I enjoy teaching tremendously. But two lessons emerge from both the classical economist and the early neoclassical economists that I think would ensure clear thinking. Ironically, this might actually be exemplified in the writings of Frank Knight on value and price theory, and thus in his price theory. And, those two lessons can be simply stated as: (1) solve for the equilibrium, and (2) always remember we are part of the equilibrium. How do I understand these two lessons? First, if we freeze all the data and we freeze time, work through the logic and let the story go to its completion and determine the optimality conditions. This exercise in logic is essential, and to repeat, it is a huge mistake in economic reasoning to cut the story off too short -- read to the end of the story, so all the equilibrium conditions are fulfilled. As I said, solve for the equilibrium. But the second lesson, which is equally important, is never begin your analysis in the end! This is why the technique of simultaneous equations has serious shortcomings in doing good economics. It has great strengths too -- no doubt -- but by construction it obscures the second lesson evidenced in the practice of the great price theorists from Marshall to Alchian. The equilibrium conditions we worked to solve, emerge from the behavior of actors within the system -- from their weighing of alternatives, from their choices on the margin, from their imaginations of better deals to be struck, from their creative and clever actions. As I said, we are part of the equilibrium. This also true, as my teacher Bob Tollison used to stress, for economists seeking to propose Pareto improving changes in the rules of the game. Change is indeed possible, and in fact, change (as Hayek stressed) is what sets in motion the "problem" that economic theory must address."