Neoclassical economics and Government Intervention

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There is often confusion about the economics of government intervention, even among economists themselves it seems. In today’s Age Ross Gittins, normally a very good economics writer, argues that neoclassical economics doesn’t acknowledge the legitimacy of government intervention. This is completely wrong. According to Roy Weintraub in the Concise Enclyclopedia of Economics, neoclassical economics can be defined as follows.  [DDET Read more]

By the middle of the nineteenth century, English-speaking economists generally shared a perspective on value theory and distribution theory. The value of a bushel of corn, for example, was thought to depend on the costs involved in producing that bushel. The output or product of an economy was thought to be divided or distributed among the different social groups in accord with the costs borne by those groups in producing the output. This, roughly, was the “Classical Theory” developed by Adam Smith, David Ricardo, Thomas Robert Malthus, John Stuart Mill, and Karl Marx.

But there were difficulties in this approach. Chief among them was that prices in the market did not necessarily reflect the “value” so defined, for people were often willing to pay more than an object was “worth.” The classical “substance” theories of value, which took value to be a property inherent in an object, gradually gave way to a perspective in which value was associated with the relationship between the object and the person obtaining the object. Several economists in different places at about the same time (the 1870s and 1880s) began to base value on the relationship between costs of production and “subjective elements,” later called “supply” and “demand.” This came to be known as the Marginal Revolution in economics, and the overarching theory that developed from these ideas came to be called neoclassical economics. (The first to use the term “neoclassical economics” seems to have been the American economist Thorstein Veblen.)

In short, neoclassical economics is a theory of value based on preferences, rather than on the costs of production as in classical theory. Neoclassical theory does not imply that prices are optimal. My training in public economics and welfare economics took the theory of value and then examined why markets might fail. Public goods, externalities and common property problems will all cause market solutions to be sub-optimal. In such cases government intervention is usually warranted. The simplest example is pollution externalities caused by producers. The solution to such a problem might involve a tax or quota, or a regulatory solution. Welfare economics is about trying to figure out which solution comes at least societal cost. Only rarely will government intervention is cases of market failure NOT be warranted – this would be the case only if there were no interventions that improved the outcome relative to doing nothing, which in my opinion would almost never be the case.

There are some economists, though in my experience relatively few, who believe that the government is so prone to stuffing things up that government interventions will often make things worse. (These economists tend to be based in the US). Ayn Rand famously argued that governments are always the problem, and unfortunately Alan Greenspan was a follower of Rand (she was invited to his swearing in, something I may have written about here before). But most economists that I know believe that markets do fail, and that a major role of government is to address market failures. In Australia we have had much better policy outcomes than in the United States because policymakers act according to the idea that unregulated markets will sometimes not be optimal – even the RBA and the Treasury believe this to be the case.

Non-neoclassical economic models often tend to give the government a greater role in the economy, but Gittins is wrong to state that neoclassical economics implies no role for government. The belief in  no role for government is an ideological belief that has little basis in economics – even Alan Greenspan has recently admitted that this view is wrong – if you want to watch Greenspan’s swearing in and his recant many years later “The Warning” onPBS is very good.[/DDET]

5 Responses to "Neoclassical economics and Government Intervention"
  1. Just read the Gittins article and thought it was bizarre. I don’t know if Gittins supports the flood levy but there has to be easier way to argue for the levy than attacking the credibility of the ‘neoclassical’ framework (notwithstanding most of the assertions about neoclassical framework are incorrect).
     
    ‘The notion that individuals could choose to confer power on elected governments isn’t contemplated. Nor is the notion that non-market institutions such as governments could create benefits for society that wouldn’t otherwise exist.’ – This was the only part of the article I liked and only because I think the standard undergrad economics curriculum isn’t ecletic enough. There should be more political economy stuff taught in the vein of Microeconomics by Samuel Bowles.

  2. Wasn’t Samuelson the doyen of neoclassical economics?  Didn’t he make a significant contribution to the theory of public goods?  Gittins is getting a bit senile.

  3. Only rarely will government intervention is cases of market failure NOT be warranted – this would be the case only if there were no interventions that improved the outcome relative to doing nothing, which in my opinion would almost never be the case
    Many of us are not extreme Ayn Randers, but still are skeptical of many government interventions.  The question is not whether it is possible for government intervention to improve outcomes, but whether it is likely to.  A government is faced with pressures and incentives which are not always in line with the overall social good.  And even if a government were purely altruistic, as a single, fallible actor it is prone to make bad choices in policies and investments.
    Government intervention too often involves picking winners, such as dealing with climate change with subsidies for developing electric vehicles, and for roof insulation.

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