Micro Mess

Modern microeconomics  (price theory) comes in two mainstream neoclassical flavors: 1)  The undergraduate textbook Marshallian variant, and 2) general equilibrium Walrasian strain.   The former builds its logic  on the dynamics of a single industry/product, while the latter on the simultaneous interactions of the  entire economy’s various sectors.  Both rely on supply and demand derived price formation.   Here I will focus on the former.

In short, Marshallian price theory draws a conclusion that marginal productivity  equals marginal disutility of wages.   What does that mean in practical terms?  If you’re an economist it means high wages leads to unemployment.  If you’re me (an engineer),  it means about as much as the statement  “unicorns equals fairies.”   In other words, the statement strikes me as a complete fantasy.  Allow me to make the case for this conclusion.

In my essay “Just Measures’ (see tabs), I attempt to restore and correct the 200 year old (and abandoned) classical cost-of-labor theory of value.   Since a labor-based theory of pricing completely rejects demand’s influence on industrial pricing, the relevance of utility (i.e. customer satisfaction), indifference curves, substitution rates,  rational agents, and a few other quickly forgotten concepts become immediately irrelevant.  It makes no difference if the consumer is plain crazy and minimize his/her utility (economist’s worst nightmare); the industrial sector can handle it (simply adjusts the quantity produced; product price remains unaffected).   In other words, if you buy a TV set because you think it is a space portal to another dimension it won’t impact the price of the product.

The more interesting and subtle part of this discussion is the supply side.  Here we are introduced to the strange idea that the output quantity of  single producer is NOT limited by demand, but by the market price that converges to the cost of production resulting from diminishing returns  as output increases.  In other words,  the factory owner stops producing output because a point is reached where cost of production exceeds the revenue generated by increased sales (i.e. he would lose money if sold he more product and does not have the option to raise the price of the product, else he become noncompetitive).

What makes this idea so slippery  is that it is has the appearance of a cost-0f-labor theory of value.  But the implications for wages and resulting demand for labor expose a possible conundrum.  Given a specific wage, the textbook will calculate the specific number of workers that can profitably be hired.   Because this is a model of diminishing returns, a lower  wage for the same calculation, means more workers could be hired without a change in market price of the product in the short run, in addition to producing more product.  This would be quite an amazing result, because output increases on  less buying power given the fixed product price  (recall it has no restraints on demand).   Maybe unicorns do exist after all?

The error in this model lies in the idea that workers are hired based on a relationship of market product price and wages.  This is not correct in my interpretation of reality.  The quantity of labor hired is the result  of the quantity of product demanded.  In more general terms, supply and demand are not independent functions, i.e. you can only demand as much as you supply in terms of labor-cost content.  In terms of causality, the product price is derived from the wage rate.  The wage rate is derived from supply and demand of skill sets.  Two engineers designing the same type of circuits will have the same wage regardless if the circuit is on a $100 cellphone or a million dollar satellite.   In the end, a true cost of production model in a closed economy ensures you can consume what you produce.

Can the Walrasian form of micro saves us from the unicorns?  Unfortunately not. Things only get worse.  General equilibrium theory amounts  to barter, or perhaps more precisely an auction house requiring an invisible auctioneer to call out an near infinite set of prices in order for the entire economy to come to equilibrium (all products prices adjust so they sell).  Admittedly, the auctioneer would need a super computer to solve countless simultaneous equations, but if an invisible auctioneer isn’t the closest thing to fairies, I’m not sure what it is.

As always, critique welcome.

Van Geldstone