Looking forward to economics after CORE

If you have just completed your first course in economics you may be asking: what’s next? If you’re a student, we will explain how The Economy relates to the other approaches you will encounter. If you’re an instructor, and you want to place CORE’s approach to economics in context, this section will also be useful.

The Economy has been an introduction to what we consider is the best of what economists know at this time. Or, perhaps, we should say what we think we know. As has always been the case, economics is constantly changing.

In 1848, John Stuart Mill published Principles of Political Economy, the first great textbook in economics. It was the core text in the English-speaking world until it was displaced by Alfred Marshall’s Principles of Economics 42 years later. Mill’s readers may have been reassured when they read:

Happily, there is nothing in the laws of value [microeconomics] which remains for the present writer or any future writer to clear up; the theory of the subject is complete.

No economics textbook writer today could realistically make the same claim. Our understanding of the economy is constantly in flux. You will have seen an example in Unit 17, in the lessons about the macroeconomy that the Great Depression, the end of the golden age of capitalism, and the financial crisis of 2008 taught us.

Three great thinkers, whose key ideas were formed early in the period covered by Unit 17, transformed how we now understand the economy. (You have encountered all three in the ‘Great economists’ features). In 1936, during the Great Depression, John Maynard Keynes introduced the idea of aggregate demand and its determinants to explain why a capitalist economy might experience persistent high levels of unemployment. Just 12 years later, aggregate demand became a core concept in an introduction to economics written by Paul Samuelson that would in turn displace the certainties of Marshall’s Principles, and would become the standard for what every aspiring economist ought to know.

A second great economist, Friedrich Hayek, introduced the idea of the market as an information-processing system. His most famous article, published in 1945, argued that economic systems and organizations should be evaluated on how well they made use of the economically relevant information that was necessarily available to some, but not to others. Hayek stressed that governments could not access all the information necessary to centrally plan an economy. His main ideas—that information is incomplete and asymmetric—became the foundation of the theories of incomplete contracts in labour and credit markets that you have studied.

A third great contributor to economics of the mid-twentieth century was John Nash, a mathematician. Drawing on ideas of John von Neumann and Oskar Morgenstern, Nash pioneered the development of game theory to model strategic interactions among economic or political actors. His work provided a new lens for the study of economic situations. In many situations, Nash argued, people will take account of the likely responses of others to the actions that they take, rather than interacting with a fixed set of prices (as a price-taker). The Nash equilibrium provides a way of studying outcomes that we find in real economies, because they represent the joint outcome of large numbers of people doing the best they can, given what others are doing.

We have been inspired by, and learned from, these three great thinkers. But, as you have read, we have not swallowed whole the thinking of any of them. You have seen models and evidence that question Keynes’ optimism that a government’s demand-management policies would substantially eliminate involuntary unemployment in the long run. Problems of market failure and economic instability provide reasons to reject Hayek’s argument that governments should limit their activities to enforcing property rights and the other fundamental rules that permit markets to function. Finally, the insights of Nash-inspired modelling of interactions among individuals who are apparently able to calculate the highly complex consequences of their own actions, but who are also incapable of cooperating amongst each other to arrive at solutions to their problems, has been questioned by modern behavioural experiments and research on human cognitive capacities.

Nevertheless, the contributions of Keynes, Hayek, and Nash—aggregate demand, the economics of information, and strategic interactions modelled by game theory—have become foundations of modern economic thinking. Before the end of the twentieth century, all three innovations had become the standard content of postgraduate economic courses. You will see the pervasive influence of all of them in advanced textbooks such as Microeconomic Theory by Andreu Mas-Colell, Michael Whinston, and Jerry Green, or Advanced Macroeconomics by David Romer.

But while aggregate demand was almost immediately introduced as a core topic of introductory economics, asymmetric information and game theory are typically introduced right at the end of the introductory course, if at all. Understandably, students therefore see these approaches simply as extensions of the standard models of Alfred Marshall or Leon Walras (two more of CORE’s ‘Great economists’). This is not the case. These theories challenge two of the found­ational concepts of the standard model—namely price-taking behaviour is the norm in a competitive economy, and complete contracts, which have been made possible by complete information.

Remarkably, most of your fellow students who have used standard introductory textbooks and courses don’t know this fundamentally important piece of information, because they haven’t been told it.

Just as Samuelson popularized the concept of aggregate demand in an introductory text, CORE has taken information economics and strategic social interaction and made these concepts part of the foundation of an economic paradigm that introductory students can learn. (A scientific paradigm is a set of concepts that are basic to how a group of scholars understand the world as embodied in the introductory textbooks that are widely accepted in the field. Previous paradigms are exemplified by the successive contributions of Mill, Marshall and Samuelson.)

We have also integrated more recent developments in the discipline from the fields of behavioural economics, economic dynamics, and institutional economics. In Figure A, we contrast the Samuelsonian paradigm (it is still the basis of most introductory texts) with what you have just studied in this book. We consider the benchmark Walrasian model codified by Samuelson as in the left column to be the standard case that most students are taught, from which ‘deviations’ are studied. The most obvious example of this is the idea that price-taking markets are the standard case, with monopolistic competition being an extension.

Topics Samuelsonian benchmark as taught in introductory economics Contemporary economics and CORE’s benchmark (unit numbers in The Economy)
People are far-sighted and self-interested are also cognitively limited (for example, they have weakness of will) and have motives other than self-interest, such as social norms of fairness and reciprocity (4, 13)
Interactions are among price-takers in competitive markets include price-makers and interest rate and wage-setters, strategic interactions, and non-market interactions (6, 7, 9, 10, 11)
Information is complete is usually incomplete, asymmetric, and non-verifiable (6, 9, 10–12, 21)
Contracts are complete and enforceable at zero cost are incomplete for effort and diligence in labour and credit markets, and for other external effects such as traffic congestion or knowledge (6, 9, 10, 12)
Institutions include markets, private property, and governments also include informal rules (norms), firms, unions, and banks (5–7, 9–11, 22)
History is largely ignored provides data about alternative rules of the game and the process of change (most units)
Differences among people are confined to preference and budget constraint differences among buyers and sellers also include asymmetric positions, for example as employers or employees, and as lenders or borrowers (6, 9, 10, 12)
Power is market power and political power includes also a principal’s power over an agent in labour, credit, and other markets (5, 6, 9, 10, 12)
Economic rents create inefficiencies through ‘rent-seeking’ are also endemic in a well-functioning private economy, creating the incentive to innovate, or to work hard (2, 6–12, 21)
Stability and instability The economy is self-stabilizing. Stability and instability are both characteristics of the economy. (11, 13–15, 17, 20)
Evaluation is confined to the presence of unexploited mutual gains (Pareto-inefficiency) also includes fairness (4, 5, 19, 22)

Figure A Contrasting the Samuelsonian paradigm with CORE’s The Economy.

The right-hand column provides a very different vision of the economy. For example, having studied CORE you may have a different view of competition. Hayek pointed out that assuming a state of equilibrium among price-taking traders effectively shuts down any serious analysis of competition, which he defines, following Samuel Johnson, as ‘the action of endeavouring to gain what another endeavours to gain at the same time.’

He continued as follows:

Now, how many of the devices adopted in ordinary life to that end would still be open to a seller in a market in which so-called ‘perfect competition’ prevails? I believe that the answer is exactly none. Advertising, undercutting, and improving (‘differentiating’) the goods or services produced are all excluded by definition—‘perfect’ competition means indeed the absence of all competitive activities.

To study the process of competition CORE replaced the passive price-taker of perfectly competitive equilibrium with the ‘perfect competitor’. This active competitor exploits available (but incomplete) information to appro­priate any possible rents that may exist when an economy is not in equilibrium. Under some conditions this drives the dynamic process to a Pareto-efficient equilibrium, even when there are impediments to competition.

This is not simply a question of taste. These concepts are essential if we want to try to answer the questions that students all over the world have told us should be the focus of economics.

Figure B The word cloud in the preface made from responses of students at Humboldt University, which is dominated by inequality, is typical. Students globally have also told us they are interested in innovation, environmental problems, unemployment and instability.

The left-hand column of the table in Figure C shows some of the most important problems that students and others tell us that economics should be about; the right-hand column shows some of the concepts essential to understanding these problems.

Problems in the world Essential concepts
Wealth creation, innovation and growth Schumpeterian (innovation) rents, disequilibrium
Environmental sustainability Non-market social interactions, other-regarding preferences
Inequality Rents, bargaining power, institutions, fairness
Unemployment and fluctuations Incomplete contracts in labour and credit markets
Instability Prices as information and the dynamics of price setting

Figure C Important problems that students and others tell us that economics should be about.

This is work in progress. The emerging paradigm that you have studied is not fully developed, and not as simple as the Walrasian benchmark. But to create the Samuelsonian paradigm, economics teaching has made simplifications that we all know are often so much at variance with the real world that the resulting model is inappropriate.

For example, assume that complete information and its corollary complete contracts are usual. Another mid-twentieth century economist, Abba Lerner, explained the success of the Walrasian benchmark:

An economic transaction is a solved political problem … Economics has gained the title Queen of the Social Sciences by choosing solved political problems as its domain.

The conflict of interests that exists in every transaction, he argued, is resolved in a contract that would be enforced by the courts, not by the parties to the transaction. ‘The solution is essentially the transformation of the conflict from a political problem to an economic transaction,’ he wrote.

In a world that ran according to the Walrasian competitive model, based on complete contracts, there would be no role for politics: if the contract was really complete there would be nothing for the exercise of power to be about. If the worker did not work as hard as she had agreed to work, then she simply would not be paid. The employer would have no need to exercise power over the employee, for example by threatening to sack her. The contract would be sufficient in itself to guarantee the outcome needed for the firm to make profits. This aspect of the Walrasian model was what motivated Samuelson’s remark that ‘In a perfectly competitive market, it really doesn’t matter who hires whom, so have labour hire capital.’

The assumption of a complete employment contract also meant that the employer had no need to be con­cerned about the prospective employee’s preferences, for example her work ethic or her desire to send instant messages to her friends while she was working. A result of these and other assumptions of the bench­mark Walrasian model incorporated in the Samuelsonian paradigm was that Lerner’s ‘Queen of the Social Sciences’ could reign alone. Economics could successfully ignore a host of other important insights:

CORE has drawn (and will continue to draw) on these and other insights from the other disciplines in order to understand how prices, wages, and interest rates are determined, how the aggregate economy functions, and other central questions of economics. Instead of seeing all economic activity through the lens of a single model of competitive markets with complete contracts, CORE has invited you to see the economy the way research economists see it, as a diverse combination of institutions and behaviours that is best studied by judiciously choosing among factually tested models.

If you continue to study economics you will discover this paradigm, and continue to see how it differs from the Samuelsonian and other paradigms. You are fortunate, because you will be able to apply the concepts, facts, and capacities that you have already learned. Eventually you will discover how economics continues to change in response to a changing world, and how this understanding of economics creates the policies that can change the world.