Knowledge, power & the firm

I'm darkening the pages of the Times again. The thing is, though, the article's not the one I started writing: I got distracted by the markets' reaction to the sub-prime problem.
What I meant to say was that the simpler version of neoclassical economics is entirely wrong. It assumes people are knowledgeable but powerless. This is true in everyday life - hence the success of Harford, Levitt and Landsburg. But it's exactly wrong for many companies. They are powerful but ignorant.
Put it this way. First-year undergraduates are taught that the job of bosses in competitive firms is to solve a production function, subject to prices and wages that are set beyond their control.
But this is hardly ever true. Production functions aren't given. They have to be discovered. This is what entrepreneurship is about; the superiority of Austrian over neoclassical economics lies in seeing this fact. And some bosses are entrpreneurs than others. The upshot is that firms' efficiency varies enormously (pdf) - a fact neoclassical economics thinks can exist only as a disequilibrium.
What's more, bosses have some power to set wages and prices. By recognizing this, we can address problems which simple neoclassical economics cannot.
Why has wage inequality risen in the UK and US? Simple neoclassical economics just wibbles about increased differences in marginal product. But as I point out in that book, it's prodigiously hard to establish this - perhaps because the notion of marginal product is much more unclear than you might think.
Why has the profit share risen since the mid-80s? Only by considering how the balance of class power has changed - a concept neoclassical economics rules out - can we understand this.
Why has equilibrium unemployment fallen so much in the UK since the 1980s? The best answer lies in thinking of the Nairu as determined by a "battle of the mark-ups" - a power struggle between firms to raise profit margins, and workers to raise real wages. The balance of power has moved against workers.
So, it's only by inverting the presumption of neoclassical economics - and seeing that power exists but knowledge is bounded - that we can understand the economy.

Comments

[Peter]

"What I meant to say was that the simpler version of neoclassical economics is entirely wrong. It assumes people are knowledgeable but powerless."
In the context of the sub-prime problem, powerless at one level (to fix the problem) but powerful at another: the market trader in stocks and shares and recycled debt has power to decide the price at which he or she will buy. Not wanting to be saddled with shares and bonds on which they might make a loss, and in some parts of the market forced to buy anything they are offered (which over-rides knowledge that would advise them not to buy), they sharply mark down their buying price. That in turn spooks those holding the shares and bonds to think that they might make a loss, and its therefore essential that central banks inject liquidity.
Your discussion in the blog about companies is in a different universe from the stocks and bonds market - at least that is how it feels for owner-managed businesses.

[Hans]

Why has wage inequality risen in the UK and US?

A good question, but then have lower skilled migrants taken these low wage jobs, and therefore most low wge positions are filled.

Hig wage positions have risen as expected, however the inequality is shown by the divide between the top 10% and the bottom 50%, probably beacuse there is always more room at the bottom.

Bosses only control wages in so far as their product, if the product is desirable and requires knowledge workers, it stands to reason that wages will be high and set by the workers, not the bosses.

The reverse holds true for a mass produced item requiring low skilled workers.

This type of shift is where the IT industry has tried to move ie: Desirable products from Knowledge workers in a 2nd or 3rd world economy, but has never been able to achieve. The reaon being that Religion, caste, politics get in the way of innovation and creative thinking.

Just found you blog, think ill stay for a while as were in interesting times and you have a lot to say, and rather well said too.

[Bob B]

Update:

Do read Martin Wolf's splendid take on recent stockmarket troubles in Wednesday's FT - subscription only, unfortunately.

Basically, the market turmoil is cathartic and a timely punishment upon all those financial institutions which lent money with insufficient diligence to bad-risk borrowers in times when real interest rates were kept artifically low by central banks.

He starts by quoting Bagehot with approval:

“At particular times a great deal of stupid people have a great deal of stupid money. . . At intervals. . . the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, and there is a ‘plethora’; it finds someone, and there is ‘speculation’; it is devoured, and there is ‘panic’.”

Admittedly, it's an intriguing piece of economic analysis these days which is predicated on the supposition that our capital markets are beset by a lot of stupid agents. I wonder if we will have the joy of reading rejoinders on this from our many friends in the city. It harks back to Alan Greespan's comments of c. 1996 about "irrational exuberance".

[Bob B]

"Production functions aren't given. They have to be discovered."

Wasn't that what much of Dorfman, Samuelson and Solow: Linear Programming and Economic Analysis (1958) was all about?

The MS Excel spreadsheet includes a "solver function" - with worked examples - which maximises functions subject to linear constraints.

[Gabriel]

Ranting about "neoclassical economics" and its evils (and how it's wrong *sic*, whatever that means in a scientific context) are a clear sign that the author is either unknowledgeable or fighting strawmen. I'm unhappy to see that this stylized facts also holds in this instance.

[Gabriel]

P.S. ... by which I meant to suggest the "strawmen" case, not the other one... Just so I'm clear.

[Kevin Carson]

It seems to me that the concept of marginal productivity is circular to a large extent. An input's "productivity" amounts, in practice, to what it adds to the retail price. So essentially anything that anybody is in a position to charge for access to, the toll they charge equals the "marginal productivity" they "contribute" by "allowing" the factor to be used. Maurice Dobb's example of toll gates is a good one. If the state allows a privileged class to set up toll gates across highways (without performing any productive function in maintaining them) and pocket the proceeds, then permission to travel on the highway becomes a factor of production. And the amount that the tolls add to the price of the product becomes the "marginal productivity" of the gatekeepers.

Marginal productivity is sterile unless the prior question of justice in distribution of factors is addressed, and a distinction is made between natural and artificial rights of property.

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