Problems Of The Real World

Written by
22 November 2013

This article from the November 2013 edition of the IPA Review is written by Senior Fellow at the IPA, Dr Julie Novak.

Recent generations of economists have been trained under the neoclassical approach to economic thought, providing distinctive perspectives concerning both the principles of economic behaviour and practical implications as to how to view, and indeed, change the world.

The most recognised, and arguably most controversial, feature of neoclassical economics is its paradigmatic conception of human conduct. The quest to allocate scarce resources to fit needs and desires efficiently is easily managed when people are assumed to possess perfect knowledge about given relative prices, cost conditions and resource availabilities, when the transactions people make are costless, and when everybody is depicted as a ‘representative’ agent (say, a household, producer or government).

Expressing the challenge of organising production, distribution and exchange in these reasonably straightforward terms tends to reduce economic problems to something akin to that found in engineering, or a discipline of the physical sciences. In other words, all that representative economic agents have to do to achieve their ends is to maximise their preferences subject to the constraints placed in front of them.

It is not unreasonable to suggest there has long been a sense of disquiet about these principles animating the neoclassical paradigm, from a variety of perspectives. One of the more powerful critiques was provided over many decades by twentieth century classical liberal Friedrich Hayek, who poignantly observed that neoclassical assumptions effectively strip away any rationale for economic conduct, as practically observed.

If humans are truly perfectly knowledgeable, that economic data is a given and transactions are conducted without cost, Hayek asked, then why do we observe real world economic coordinative processes that contradict everything that neoclassical economics holds to be true?

Partly in response to the Hayek question, economists engage in a slight tweaking of the strong neoclassical assumptions, here and there, to supposedly add some semblance of realism to their narrative.

The outcome of these tweaks, more often than not, is an extensive catalogue of scenarios in which decentralised markets supposedly ‘fail’ to arrive at efficient resource allocations. According to this line of thinking, if representative agents interacting in the market fail to dissipate inefficiencies then other representative agents, i.e. politicians and bureaucrats, should step in to assist helpless producers and consumers realise efficiency. While pervasive as an intellectual train of thought within neoclassical economics, the market failure construct has not gone completely unchallenged. In essence, two complementary critical perspectives have emerged.

First, Hayek and Ludwig von Mises pointed to the inability of political actors to allocate resources efficiently, when the freedom to acquire and dispose of private properties has either been extinguished or distorted by policy choices. Second, public choice theorists, such as James Buchanan, referred to the capacity of political actors to conduct policies in ways inimical to the economic interests of the community at large.

In light of the limitations of neoclassical economics, there is a need to move toward economic paradigms characterising economic agents as fallible, yet capable of efficiently allocating resources even through enterprising behaviour, and duly acknowledging the prospective damage rendered by coercive state action to highly functional economic coordination by fallible, yet capable, beings. Australian economist Wolfgang Kasper, together with fellow economists Manfred Streit and Peter Boettke, make serious strides toward a systematic account of economic phenomena, without the neoclassical downsides, in Institutional Economics: Prosperity, Competition, Policies.

Following the path breaking first edition, which sold many thousands of copies internationally including in China, Institutional Economics provides the reader with an insightful exploration of topics, such as property rights, entrepreneurship, dynamic market competition and institutional evolution, not generally covered in mainstream economics textbooks.

The great mystery of economics concerns how it is that billions of strangers can manage to coordinate the production, distribution and exchange of resources. Attaining a solution to this mystery has occupied the thoughts of successive generations of economists, at least from the time of Scottish moral philosopher Adam Smith in the late eighteenth century.

For their part, Kasper, Streit and Boettke offer an integrated account of human action in the economic realm, leading us toward a framework for solving the economic coordination mystery. As the authors explain with a rare sense of clarity, billions of fallible, yet capable, people over the span of the globe manage to successfully coordinate with each other, generating wealth and prosperity in the process, because of a lack of centralised planning of economic arrangements.

How is this so? How is it that people get fed, clothed, housed, transported and entertained, becoming wealthier as a result, without a Central Economic Planning Committee pulling the strings?

As thoroughly explained in Institutional Economics, changes in relative prices and profitability signal to market participants both the availability of resources and the intensity in demand for the resources. Alterations in these signals also spur incentives on the part of producers to justly acquire resources, and transform them in highly specialised ways to create value for consumers.

All of these productive behaviours are crucially guided through a set of informal and formal institutions, ranging from trading customs and norms right through to government economic policies.

As Kasper, Streit and Boettke note, regions of the world characterised by honesty and courtesy in private dealings, protection of property rights, freedom of contract, monetary stability, low taxes, efficient government spending and streamlined regulations tend to be more prosperous than others which do not respect these institutional standards.

High taxation represents a more intensive extinguishment of property rights, reducing the rewards associated with productive economic conduct, whereas prescriptive regulations can artificially direct entrepreneurs towards less productive lines of action. Wasteful expenditures by government, particularly for redistribution, reduce opportunities for private sector agents to direct resources for their own priorities and may encourage people to divert their attentions away from serving others and towards seeking political favouritism.

Friedrich Hayek

There can be no overstatement of the influence of quality institutions underpinning robust economic performance, and the precarious nature of retaining sound institutions. Regrettably, these are painful lessons that ordinary Australians have become accustomed to in recent years.

Readers schooled in the neoclassical tradition of economics might be caught off guard by the interdisciplinary approach of Institutional Economics, which generously delves into aspects of other social sciences, such as history, law, and sociology. For example:

Culture and civilization the values and institutional system, as well its more tangible elements constitute an important part of a society’s capital. It has important consequences for the effectiveness or otherwise of how physical resources of labour, capital and nature are converted to serve peoples’ wants and aspirations.

Such an approach, however, is necessary given the ways in which real economies are affected by non economic perturbations. In any case, this outstanding attribute of Institutional Economics conforms with Hayek’s often overlooked, but essential, observation that one cannot be a good economist by confining oneself to economic studies.

There are numerous intellectual suitors to replace neoclassical economics, some being more persuasive than others. The blend of Austrian economic insights with lessons from public choice, and other aspects of institutional economics, ensures that Institutional Economics is firmly at the forefront of the unfolding development of an economics that places realistic conceptions of human action at the centre of investigation.

The first edition of this book, published in 1999, has deeply influenced my thinking on some of the most complex economic questions of our time, and this revised and updated edition, released late last year, is already proving to be at least as intellectually engaging.

Should economic thought continue its trajectory away from the excessively simplistic foundations of modern neoclassical economics, there will be little doubt that books such as Institutional Economics will be shown to have played a significant role in the revitalisation of economics.

If you've enjoyed reading this article from the Institute of Public Affairs, please consider supporting us by becoming a member or making a donation. It is with your support that we are securing freedom for the future.

Become a Member