Review Of Ken Boulding’s “A Reconstruction Of Economics”

What We Talk About When We Talk About Firms

Introduction

Every era has its ideal object of study. If the long 17th century was a good time to be anything, it was a good time to be a theologian. The field was in turmoil as the traditional foundations slipped away. There were heavy questions with real stakes. The great European powers - Spain & Holland - were embroiled in a forever war to enforce the universal charismatic theological authority of the two Johns: Juan de la Cruz & Jean Calvin.

In reaction, the greatest minds in Europe - Descartes on Juan de la Cruz’s side and Gottfried Leibniz on Jean Calvin’s - sought to create an escape from the endless bloodshed through a new notion: the primacy of reason. The short 18th century became the time to be a philosopher. Similarly, the long 19th century which followed was the time to be a historian.

In the middle of the twentieth century – from the depths of The Depression to the height of the  Trente Glorieuses – the thing to be was an economist. Ken Boulding, our character under consideration today, timed things perfectly. In 1930 Boulding began studying economics and by 1950, as postwar reconstruction hit its stride, he had become one of the guild's greatest exemplars. He was appreciated as an exemplar: in 1949, as he worked on the book under review today, Kenneth Boulding won the second John Bates Clark Medal (Paul Samuelson won the first, Milton Friedman the third).

In 1950, Boulding published A Reconstruction Of Economics. His goal was synthesizing the point of view he had developed over his tumultuous early career. Our goal today is to examine that book and sort out Boulding’s early career and point of view, in order to understand the fruit of the era in which he lived.

A Voice Crying Out In The Wilderness

“Revolutions” in economics are often promised and rarely delivered. “Reconstructions” are often hoped for, but rarely heeded. And so, despite an essentially preservationist mission – a mission of conserving and extending the insights of Keynes & Marshall in the light of further work in economic theory, especially the Paretan revolution of multiobjective programming – Boulding’s book was a dead letter. No one seemed to have an important critique, and yet nobody listened. In his own words, Boulding felt transformed into ‘a voice crying out in the wilderness’. I will now try to draw a map of the wilderness of ideas so that we can find and perhaps even rescue Professor Boulding.

Boulding’s “reconstruction” centers on applying the concepts of multiobjective programming on general quantities of stocks, rather than the traditional economic emphasis on income value flows. It might seem obvious that economic agents have preferences over the stocks they hold in addition to preferences over their income flows, but for many economists it was easier to pretend the label “money illusion” was a kind of analysis. As with most worthwhile advancements in economics, we can trace the origin of Boulding’s approach back to Keynes–specifically chapter 23 of the General Theory.

To give a more charitable interpretation of the traditional flows oriented approach, we can recall Adam Smith’s example of natural (in modern terms, equilibrium) price:

 “It is natural that what is usually the produce of two days' or two hours' labour, should be worth double of what is usually the produce of one day's or one hour's labour.” Adam Smith, Wealth Of Nations, Book I, Chapter 6: ‘On the Component Parts of the Price of Commodities’

Social balance arises from the fact that an unnatural – or nonequillibrium – price would allow an entrepreneur to unfairly divert a flow of income towards himself. 

As is well known, Smith was a theoretical pluralist who used a variety of approaches. In his analysis, income flow itself is a phenomenon which matches personal and social valuations:

“Wealth, as Mr. Hobbes says, is power. … The power which that possession immediately and directly conveys to him, is the power of purchasing; a certain command over all the labour, or over all the produce of labour, which is then in the market. … But though equal quantities of labour are always of equal value to the labourer, yet to the person who employs him they appear sometimes to be of greater and sometimes of smaller value. He purchases them sometimes with a greater and sometimes with a smaller quantity of goods, and to him the price of labour seems to vary like that of all other things.” Adam Smith, Wealth Of Nations, Book I, Chapter 5: ‘On the Real and Nominal Price of Commodities’

The insights which Adam Smith - and his contemporary descendants - produced are undeniable. Boulding’s stock oriented approach is indeed one of those descendents.

The Firm

Boulding’s stock-oriented approach has a clear advantage, in that it allows the firm to play the kind of central role in economic theory as it does in everyday discourse. In the tweets below, none of these references to “firms” are in themselves bad, but they are clearly undisciplined, untethered to any particular theory of how a firm works.

1. Jason Furman on firms

2. Larry Summers on firms

3. Paul Krugman on firms

This isn’t entirely their fault! There is a simple reason even famous economists prefer not to include a theory of the firm in their theorizing: traditional theories of the firm just aren’t very useful. To wit, neither of the above Adam Smith quotes above discuss a firm.

In my opinion, two half-digested but traditional theories of the firm can be disentangled from the mess of theories of the firm: Cournot’s theory of profit maximization and Marshall’s famous runs analysis. Other, even less divested theories (e.g. Coase) can stay in the wilderness.

The idea that “firms maximize profits” seems like an obvious truth with a clear implication: firms operate at a level which equates marginal cost to sales price. The problem is, firms don’t generally use marginal cost as a guide to production decisions. Worse, the theory can’t even be saved by pivoting its claims to behavioral ones: close examination reveals that the principle of profit maximization has no behavioral implications. Even the last line of defense for a theory facing objective meaninglessness - rank subjectivism - offers little succor. As Dennis Robertson argued (section 5), it is possible to interpret “maximum of possible profits” to mean “attainment of subjectively expected profits,” which means something as minimal as “the firm correctly predicting its own capabilities.” Among other problems, why gross profits would be the variable of interest in this interpretation is not clear.

Despite being sometimes unclear, Marshall’s analysis of firm behavior is more workable. The core concept is one of the market as a social location for the convergent evolution of a population of firms which interacts with itself and the world over various “runs” or lengths of time. As brilliantly expounded by Ragnar Frisch, this theory is not as dependent on intrinsically vague optimality conditions or prices matching of marginal cost and marginal price. Rather, Marshall considers two cases: first when prices are low compared with fixed costs, and then when they are comparatively high. If prices are high compared to fixed costs in the short run, firms can price marginally because this covers all costs anyway. If prices are low compared to fixed costs in the short run, then marginal firms (i.e. those with high fixed costs) avoid “cut throat competition” by restricting output. Though the marginal firm is adopting a restrictive production strategy, it cannot restrict production to the extent its supply schedule can be decreasing. If prices remain low compared to fixed costs in the long run, the marginal firms adapt or die. In principle, all firms will eventually approximate a “representative firm” with “normal profits” in the long run, as selective pressures have had a chance to obtain.

In Marshall’s theory the selective process operates on the gap between normal and actual profits determined on the market, rather than subjective expected and actual profits – these have a complex relationship. 

Marshall’s theory is still standard today, and for good reason: in the hands of a master, it can deliver amazing market insights. The parts on firms avoiding “cut throat competition” could be dropped unchanged into the current oil debates. Furman’s tweet however points to a fundamental problem: how can a theory of ‘perfect competition’ allow marginal firms to practice restrictive strategies? This loss of meaning, first pointed out by Italian economist Piero Sraffa, is analogous to the loss of meaning to profit maximization highlighted by Alchain & Robertson (“Marshall’s poetry”) above. 

That these theories can survive such a severe loss of meaning goes a long way to demonstrating how unimportant the working of firms is to standard economic theory. In both, the firm only matters to the extent that there must be something which produces a supply schedule for the market to incorporate. Once that schedule is established, nothing about the firm itself affects prices and quantities.

Two Kinds of Micro

Despite their failure to maintain meaning, the two theories point to two orientations in economics which will be helpful for locating Boulding in the space of ideas: “microeconomics as explanation of the single transaction” and “microeconomics as the theory of markets”. The choice of orientation also determines much about the shape of what one considers “good macro” as well.

“Microeconomics as explanation of the single transaction” asks questions like ‘Why did Bernie Botter buy a bit of bitter butter when better butter makes her batter better?’ (see Boulding’s Economic Analysis). If the student of this school of thought says ‘Maybe she likes the bitter batter better?’ and draws an elaborate Pareto-Edgeworth Box to develop the implications, then she gets a C. If the student of this school of thought says ‘Deadweight loss of the inflation tax’ he gets a B. If the student writes ‘Information.’ and refuses to elaborate then they get an A+ and a referral to the Sveriges Riksbank committee.

Macroeconomics, to these students, is the theory of the sum of all transactions. They can argue whether transactions can or cannot be disentangled into ‘meaningful’ categories. This type of economist - as shown by Alchain or Bowles - tends to emphasize the absolute generality of economics. Profit maximization is a similarly transactions-oriented theory: the only reason firms engage in any individual transaction is to get profit and that’s all there is to it.

If we instead treat “microeconomics as the theory of markets,” we find that a market is a more-or-less formalized social space through which transactions are governed. A market oriented price theory, like Alfred Marshall’s, is comfortable using mode and tempo of market behavior (that, for instance, a dealer on a commodity market can typically buy and sell at the same price if they act rapidly).

Macroeconomics for a market oriented economist is a different beast than for transactions oriented economists. Society is not a sum of markets. In a sense, most economic transactions don’t happen in things understood as markets. Obviously, Bernie Botter cannot typically sell a bit of bitter butter to her retailer at the same price she bought it as Marshall assumes is normal market behavior: retailers don’t pay retail price to buy butter. The role of macroeconomics then is not to sum up, but to outline the boundaries; there are certain aggregate relationships that must obtain for markets to fit together as coherent entities which share a common approach to accounting. 

To tie it all together, market oriented economists with enough vision to view broader society economists – such as Alfred Marshall, John Maynard Keynes, Frank Knight and Frederich Hayek – tend to emphasize the limited nature of economics and its insights. With this map of ideas guiding us, we should be able to pull off an effective search and rescue on Ken Boulding.

A Reconstruction Of Economics