Debunking Economics Part 1: Why Demand Curves Aren’t Downward Sloping

This post will mark the beginning of a series on Steve Keen’s book Debunking Economics. My first impression after reading his book was that it was chalk full of great ideas and solid criticisms of “neoclassical” economics as it is currently taught to undergraduate and graduate students. I’m not always fond of Keen’s tone, but isn’t some crank. I’m writing these posts in order to better retain the ideas and concepts expressed in the book, as well as to spark discussion. Other bloggers have also written about and summarized this book, and I will be linking to these posts as well. I’ll say that I don’t really have anything new to add to what has been perviously said, and I am doing this for my benefit.

Keen’s begins his criticism of neoclassical (micro) economics in chapter 3, which centers around the “Law of Demand” , i.e. the idea that market demand curves don’t necessarily slope downwards. This is in direct contrast to what is taught in an “Intro to Microeconomics” course, and subsequent economic courses use the assumption when explaining other concepts.

Market Demand Curves Don’t Slope Downwards

Economists look at demand curves to see how demand for a commodity changes as its price changes, while the consumer’s income remains constant. When you don’t make that assumption, things get complicated quickly. The decrease of price in one good raises the real income of the consumer (the income effect), allowing the consumer to increase the consumption of all goods, not just the good that has become cheaper. So in the case of Giffen Goods, because the rise in price of one good make another good unaffordable, you have a paradox where demand increases as prices rise. Consider necessary, luxury, and normal goods, and you have a very complicated picture and some interesting looking demand curves.

This is why economists make the distinction between the income effect and the substitution effect (if price falls, consumption rises and vice versa). The substitution effect is always negative and it’s what economists use to establish the “Law of Demand”. However, the income effect can be both negative and positive.  So economists neutralize the income effect by using a Hicksian compensated demand function. The consumer is given a level of utility and a set of prices. The consumer then minimizes the amount of money that he/she would need to spend to achieve that given level of utility, thus separating the income effect and the substitution effect.

But once you introduce more than one agent into the economy, things don’t work out so nicely. With two economic agents, one person’s spending is another person’s income. It’s impossible to separate the income effect and the substitution effect, creating loads of complications for the “Law of the Demand”.

Valid Demand Curve

Economists have known this for years. One paper to mention this was written by William Gorman in 1953 (I give Keen a lot of credit for translating this terribly written paper):

We will show that there is just one community indifference curve locus through each point if, and only if, the Engel curves for different individuals at the same prices are parallel straight lines.

Because all utility functions pass through (0,0), this is essentially saying that all consumers have exactly the same preferences. This implies that there is only one consumer in the entire economy, an outright absurd assumption. Because Gorman’s paper was so opague, these results weren’t rediscovered until the 1970s, known as the Sonnenschien-Mantel-Debreu conditions.

But does any of this matter? Keen even admits that “there are some sound reasons why demand might generally be a negative function of price.” Well, it does matter, and there are three reasons why:

1. That contrary to what most lower level economics textbooks will tell you, markets don’t necessarily maximize social welfare.

2. It undermines the idea that “everything happens in equilibrium.” If we have a demand curve like the one above, then the resulting marginal revenue curve (the MR curve is derived from the demand curve) will be even more volatile. The marginal revenue curve will cross the marginal cost curve in multiple places, resulting in multiple points where “everything happens.”

3. The assumption of identical consumers is only valid when when we split society into different classes, which is what the Classical economists were trying to do. However, this approach isn’t used in neoclassical economics. The “one size fit all” treatment clearly has its limitations and macroeconomic theories shouldn’t necessarily be built up from individual behavior.


Links:

  1. Debunking Economics’, Part I: Demand Curves Can Have Any Shape by Unlearning Economics

References:

1. Gorman, W.M. (1953) ‘Community preference fields,’ Econometrica, 21(1): 63-80

2. Keen, Steve. Debunking Economics: The Naked Emperor Dethroned? London: Zed Book, 2011. Print.

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10 Comments

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10 responses to “Debunking Economics Part 1: Why Demand Curves Aren’t Downward Sloping

  1. There is an error in Bentham quote “plain and pleasure” instead of “pain and pleasure”.

  2. Debunking Economics is one of the rare books that made a huge impression on me and really affected my thinking. I had always been skeptical of mainstream neo-classical economics, but I still remember what a shock it was to find that even the very foundations were flawed. When I read this chapter my jaw dropped and I realised that everything had to be questioned and it wasn’t simply a matter of tinkering around the edges.

    Its a brilliant book and its good that you are doing a summary of it (also that you’ve come across Unlearning Economics, one of my favourite bloggeers whose summary of Debunking Economics is how I first came across him).

    • Thanks! Keen’s books has a lot of depth, so I’m finding it a bit difficult to condense his points into blog form. Thankfully I can look at other summaries (e.g. Unlearning Economics) and see what they did to get a better idea of how to structure these posts. Fortunately, I think I got one of the hardest (and longest) chapters out of the way, so it will be a little easier going forward.

  3. Blue Aurora

    Although I can sympathise from where Steve Keen is coming from, I don’t think his criticism of Marshallian microeconomics is completely warranted. Unless of course, Steve Keen makes it clear that Alfred Marshall did stress the qualifications for what is now called “microeconomic theory” in Principles of Economics.

    In the meantime though, the first edition of Debunking Economics has been criticised before. Please see the following review by Dr. Michael Emmett Brady if anyone is interested.

    http://www.amazon.com/review/R7CKDCHY1QR34

    • I don’t think Keen criticizes Marshall himself, but rather the way Marshallian microeconomics is taught in university Intro to Microeconomics courses and some more advanced Microeconomic courses. Knowing Keen, he’s probably read Principles of Economics and is aware of the qualifications that Marshall stressed. In fact, Keen holds Marshall in very high regard.

      This book can be thought of as a critical report card on economics at the beginning of the third millennium. Economic theory, as we know today, was born in the later nineteenth century in the work of Jevon, Walras, Menger (and somewhat later) Marshall. I have a reasonably high regard for these founders of what has become mainstream economics. There were pioneers in a new way of thinking, and yet, in contrast to their modern disciples, they were often aware of possible limitations of the theory they were trying to construct. (pg 34)

      So I think, given this context, his criticisms are completely warranted.

      • Blue Aurora

        I see. Steve Keen has published articles criticising perfect/pure competition however, and although I do see where he’s coming from, I didn’t totally buy in. It seems that Steve Keen possesses a good grasp of the intellectual history of political economy, but you have to keep in mind that he still has his own wants as to how the discipline should go. I’m not sure if I fully agree with his vision. (Nevertheless, I do approve of him citing the econophysics literature.)

        In any case, here are a few pieces by Steve Keen criticising perfect/pure competition.

        http://www.sciencedirect.com/science/article/pii/S0378437106004456

        http://www.tandfonline.com/doi/abs/10.1080/00346760410001684433

        Lastly, I hope that Steve Keen’s brief comments on Alfred Marshall inspire you to getting around to reading Alfred Marshall’s Principles of Economics and other writings by the Cambridge School disciples of Alfred Marshall (the two most notable students of Alfred Marshall are J.M. Keynes and A.C. Pigou, but other members of the Cambridge School included Frederick Lavington, Dennis Robertson, and Ralph Hawtrey)!

      • Don’t get me wrong, I don’t deny that Keen has a particular agenda in mind, mainly to increase the influence of Post Keynesian economics, but his criticisms are still very interesting and relevant.

        As for Alfred Marshall, I definitely plan on reading his Principles of Economics, probably in a few months. I need to kill my book stack quite a bit before I move on to other things.

  4. Pingback: Debunking Economics Part 3: Labour Economics | Irrepressible Thought

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