The Competitiveness of Nations
in a Global Knowledge-Based Economy
H.H. Chartrand
April 2002
Milton Friedman
Essays in Positive Economics
Part I - The Methodology of Positive Economics (c -cont'd)
Web Page 1 Introduction, 3; I. The Relationship between Positive
and Normative Economics, 3;
V. SOME IMPLICATIONS FOR ECONOMIC
ISSUES
The abstract methodological issues we have been
discussing have a direct bearing on the perennial criticism of “orthodox”
economic theory as “unrealistic” as well as on the attempts that have been made
to reformulate theory to meet this charge. Economics is a “dismal” science because
it assumes man to be selfish and money-grubbing, “a lightning calculator of
pleasures and pains, who oscillates like a homogeneous globule of desire of
happiness under the impulse of stimuli that shift him about the area, but leave
him intact”; 20 it rests on
outmoded psychology and must be reconstructed in line with each new development
in psychology; it assumes men, or at least businessmen, to be “in a continuous
state of ‘alert,’ ready to change prices and/or pricing rules whenever their
sensitive intuitions… detect a change in demand and supply conditions”;
21 it
20. Thorstein Veblen, “Why Is Economics Not an
Evolutionary Science?” (1898), reprinted in The Place of Science in Modern
Civilization (New York, 1919), p. 73.
21. Oliver, op. cit., p.
381.
30
assumes markets to be perfect, competition to be pure,
and commodities, labor, and capital to be homogeneous.
As we have seen, criticism of this type is largely
beside the point unless supplemented by evidence that a hypothesis differing in
one or another of these respects from the theory being criticized yields better
predictions for as wide a range of phenomena. Yet most such criticism is not so
supplemented; it is based almost entirely on supposedly directly perceived
discrepancies between the “assumptions” and the “real world.” A particularly clear example is furnished
by the recent criticisms of the maximization-of-returns hypothesis on the
grounds that businessmen do not and indeed cannot behave as the theory “assumes”
they do. The evidence cited to
support this assertion is generally taken either from the answers given by
businessmen to questions about the factors affecting their decisions - a
procedure for testing economic theories that is about on a par with testing
theories of longevity by asking octogenarians how they account for their long
life - or from descriptive studies of the decision-making activities of
individual firms. 22 Little if any evidence is ever cited on the conformity
of businessmen’s actual market behavior - what they do rather than what they say
they do - with the implications of the hypothesis being criticized, on the one
hand, and of an alternative hypothesis, on the other.
22. See H. D. Henderson, “The Significance of the Rate
of Interest,” Oxford Economic Papers, No. 1 (October, 1938), pp. 1-13; J.
E. Meade and P. W. S. Andrews, “Summary of Replies to Questions on Effects of
Interest Rates,” Oxford Economic Papers, No. 1 (October, 1938), pp.
14-31; R. F. Harrod, “Price and Cost in Entrepreneurs’ Policy,” Oxford
Economic Papers, No. 2 (May, 1939), pp. i-li; and R. J. Hall and C. J.
Hitch, “Price Theory and Business Behavior,” Oxford Economic Papers,
No. 2 (May, 1939), pp. 12-45; Lester, “Shortcomings of Marginal
Analysis for Wage-Employment Problems,” op. cit.; Gordon, op. cit.
See Fritz Machlup, “Marginal Analysis and Empirical Research,” op. cit.,
esp. Sec. II, for detailed criticisms of questionnaire
methods.
I do not mean to imply that questionnaire studies of
businessmen’s or others’ motives or beliefs about the forces affecting their
behavior are useless for all purposes in economics. They may be extremely valuable in
suggesting leads to follow in accounting for divergencies between predicted and
observed results; that is, in constructing new hypotheses or revising old ones.
Whatever their suggestive value in
this respect, they seem to me almost entirely useless as a means of testing
the validity of economic hypotheses. See my comment on Albert G. Hart’s paper,
“Liquidity and Uncertainty,” American Economic Review, XXXIX (May, 1949),
198-99.
31
A theory or its “assumptions” cannot possibly be
thoroughly “realistic” in the immediate descriptive sense so often assigned to
this term. A completely “realistic”
theory of the wheat market would have to include not only the conditions
directly underlying the supply and demand for wheat but also the kind of coins
or credit instruments used to make exchanges; the personal characteristics of
wheat-traders such as the color of each trader’s hair and eyes, his antecedents
and education, the number of members of his family, their characteristics,
antecedents, and education, etc.; the kind of soil on which the wheat was grown,
its physical and chemical characteristics, the weather prevailing during the
growing season; the personal characteristics of the farmers growing the wheat
and of the consumers who will ultimately use it; and so on indefinitely. Any attempt to move very far in achieving
this kind of “realism” is certain to render a theory utterly
useless.
Of course, the notion of a completely realistic theory
is in part a straw man. No critic
of a theory would accept this logical extreme as his objective; he would say
that the “assumptions” of the theory being criticized were “too” unrealistic and
that his objective was a set of assumptions that were “more” realistic though
still not completely and slavishly so. But so long as the test of “realism” is
the directly perceived descriptive accuracy of the “assumptions” - for example,
the observation that “businessmen do not appear to be either as avaricious or as
dynamic or as logical as marginal theory portrays them” 23
or that “it would be utterly
impractical under present conditions for the manager of a multi-process plant to
attempt... to work out and equate marginal costs and marginal revenues for each
productive factor” 24 - there is no basis for making such a distinction, that
is, for stopping short of the straw man depicted in the preceding paragraph.
What is the criterion by which to
judge whether a particular departure from realism is or is not acceptable? Why is it more “unrealistic” in analyzing
business behavior to neglect the magnitude of businessmen’s costs than
the
23. Oliver, op. cit., p.
382.
24. Lester, “Shortcomings of Marginal Analysis for
Wage-Employment Problems,” op. cit., p. 75.
32
color of their eyes? The obvious answer is because the first
makes more difference to business behavior than the second; but there is no way
of knowing that this is so simply by observing that businessmen do have costs of
different magnitudes and eyes of different color. Clearly it can only be known by comparing
the effect on the discrepancy between actual and predicted behavior of taking
the one factor or the other into account. Even the most extreme proponents of
realistic assumptions are thus necessarily driven to reject their own criterion
and to accept the test by prediction when they classify alternative assumptions
as more or less realistic. 25
The basic confusion between descriptive accuracy and
analytical relevance that underlies most criticisms of economic theory on the
grounds that its assumptions are unrealistic as well as the plausibility of the
views that lead to this confusion are both strikingly illustrated by a seemingly
innocuous remark in an article on business-cycle theory that “economic phenomena
are varied and complex, so any comprehensive theory of the business cycle that
can apply closely to reality must be very complicated.”
26 A fundamental hypothesis of science is that appearances
are deceptive and that there is a way of looking at or interpreting or
organizing the evidence that will reveal superficially disconnected and diverse
phenomena to be manifestations of a more fundamental and relatively simple
structure. And the test of this
hypothesis, as of any other, is its fruits - a test that science
has
25. E.g., Gordon’s direct examination of the
“assumptions” leads him to formulate the alternative hypothesis generally
favored by the critics of the maximization-of-returns hypothesis as follows:
“There is an irresistible tendency to price on the basis of average total costs
for some ‘normal’ level of output. This is the yardstick, the short-cut,
that businessmen and accountants use, and their aim is more to earn satisfactory
profits and play safe than to maximize profits” (op. cit., p.
275). Yet he essentially
abandons this hypothesis, or converts it into a tautology, and in the process
implicitly accepts the test by prediction when he later remarks: “Full cost and
satisfactory profits may continue to be the objectives even when total costs are
shaded to meet competition or exceeded to take advantage of a sellers’ market”
(ibid., p. 284). Where here
is the “irresistible tendency”? What kind of evidence could contradict
this assertion?
26. Sidney S. Alexander, “Issues of Business Cycle
Theory Raised by Mr. Hicks,” American Economic Review, XLI (December,
1951), 872.
33
so far met with dramatic success. If a class of “economic phenomena”
appears varied and complex, it is, we must suppose, because we have no adequate
theory to explain them. Known facts
cannot be set on one side; a theory to apply “closely to reality,” on the other.
A theory is the way we perceive
“facts,” and we cannot perceive “facts” without a theory. Any assertion that economic phenomena
are varied and complex denies the tentative state of knowledge that alone
makes scientific activity meaningful; it is in a class with John Stuart Mill’s
justly ridiculed statement that “happily, there is nothing in the laws of value
which remains [1848] for the present or any future writer to clear up; the
theory of the subject is complete.” 27
The confusion between descriptive accuracy and
analytical relevance has led not only to criticisms of economic theory on
largely irrelevant grounds but also to misunderstanding of economic theory and
misdirection of efforts to repair supposed defects. “Ideal types” in the abstract model
developed by economic theorists have been regarded as strictly descriptive
categories intended to correspond directly and fully to entities in the real
world independently of the purpose for which the model is being used. The obvious discrepancies have led to
necessarily unsuccessful attempts to construct theories on the basis of
categories intended to be fully descriptive.
This tendency is perhaps most clearly illustrated by the
interpretation given to the concepts of “perfect competition” and “monopoly” and
the development of the theory of “monopolistic” or “imperfect competition.”
Marshall, it is said, assumed
“perfect competition”; perhaps there once was such a thing. But clearly there is no longer, and we
must therefore discard his theories. The reader will search long and hard -
and I predict unsuccessfully - to find in Marshall any explicit assumption about
perfect competition or any assertion that in a descriptive sense the world is
composed of atomistic firms engaged in perfect competition. Rather, he will find Marshall saying: “At
one extreme are world markets in which competition acts directly from all parts
of the globe; and at the other those secluded
27. Principles of Political Economy, (Ashley ed.;
Longman, Green & Co., 1929), p. 436
34
markets in which all direct competition from afar is
shut out, through indirect and transmitted competition may make itself felt even
in these; and about midway between these extremes lie the great majority of the
markets which the economist and the busiman have to study.” 28 Marshall took the world as it is; he sought to construct
an “engine” to analyze it, not a photographic reproduction of
it.
In analyzing the world as it is, Marshall constructed
the hypothesis that, for many problems, firms could be grouped into “industries”
such that the similarities among the firms in each group were more important
than the differences among them. These are problems in which the important
element is that a group of firms is affected alike by some stimulus - a common
change in the demand for their products, say, or in the supply of factors. But this will not do for all problems:
the important element for these may be the differential effect on particular
firms.
The abstract model corresponding to this hypothesis
contains two “ideal” types of firms: atomistically competitive firms, grouped
into industries, and monopolistic firms. A firm is competitive if the demand curve
for its output is infinitely elastic with respect to its own price for some
price and all outputs, given the prices charged by all other firms; it belongs
to an “industry” defined as a group of firms producing a single “product.” A “product” is defined as a collection of
units that are perfect substitutes to purchasers so the elasticity of demand for
the output of one firm with respect to the price of another firm in the same
industry is infinite for some price and some outputs. A firm is monopolistic if the demand
curve for its output is not infinitely elastic at some price for all outputs.
29 If it is a monopolist, the firm is the industry.
30
As always, the hypothesis as a whole consists not only
of this abstract model and its ideal types but also of a set of rules,
mostly
28. Principles, p. 329; see also pp. 35, 100,
341, 347, 375, 546.
29. This ideal type can be divided into two types: the
oligopolistic firm, if the demand curve for its output is infinitely elastic at
some price for some but not all outputs; the monopolistic firm proper, if the
demand curve is nowhere infinitely elastic (except possibly at an output of
zero).
30. For the oligopolist of the preceding note an
industry can be defined as a group of firms producing the same
product.
35
implicit and suggested by example, for identifying
actual firms with one or the other ideal type and for classifying firms into
industries. The ideal types are not
intended to be descriptive; they are designed to isolate the features that are
crucial for a particular problem. Even if we could estimate directly and
accurately the demand curve for a firm’s product, we could not proceed
immediately to classify the firm as perfectly competitive or monopolistic
according as the elasticity of the demand curve is or is not infinite. No observed demand curve will ever be
precisely horizontal, so the estimated elasticity will always be finite. The relevant question always is whether
the elasticity is “sufficiently” large to be regarded as infinite, but this is a
question that cannot be answered, once for all, simply in terms of the numerical
value of the elasticity itself, any more than we can say, once for all, whether
an air pressure of 15 pounds per square inch is “sufficiently” close to zero to
use the formula s = 1/2gt.2 Similarly, we cannot compute
cross-elasticities of demand and then classify firms into industries according
as there is a “substantial gap in the cross-elasticities of demand.” As Marshall says, “The question where the
lines of division between different commodities [i.e., industries] should be
drawn must be settled by convenience of the particular discussion.”
31 Everything
depends on the problem; there is no inconsistency in regarding the same firm as
if it were a perfect competitor for one problem, and a monopolist for another,
just as there is none in regarding the same chalk mark as a Euclidean line for
one problem, a Euclidean surface for a second, and a Euclidean solid for a
third. The size of the elasticity
and cross-elasticity of demand, the number of firms producing physically similar
products, etc., are all relevant because they are or may be among the variables
used to define the correspondence between the ideal and real entities in a
particular problem and to specify the circumstances under which the theory holds
sufficiently well; but they do not provide, once for all, a classification of
firms as competitive or monopolistic.
An example may help to clarify this point. Suppose the problem is to determine the
effect on retail prices of cigarettes of an
31. Principles, p.100.
36
increase, expected to be permanent, in the federal
cigarette tax. I venture to predict
that broadly correct results will be obtained by treating cigarette firms as if
they were producing an identical product and were in perfect competition. Of course, in such a case, “some
convention must be made as to the” number of Chesterfield cigarettes “which are
taken as equivalent” to a Marlborough. 32
On the other hand, the hypothesis that cigarette firms
would behave as if they were perfectly competitive would have been a false guide
to their reactions to price control in World War II, and this would doubtless
have been recognized before the event. Costs of the cigarette firms must have
risen during the war. Under such
circumstances perfect competitors would have reduced the quantity offered for
sale at the previously existing price. But, at that price, the wartime rise in
the income of the public presumably increased the quantity demanded. Under conditions of perfect competition
strict adherence to the legal price would therefore imply not only a “shortage”
in the sense that quantity demanded exceeded quantity supplied but also an
absolute decline in the number of cigarettes produced. The facts contradict this particular
implication: there was reasonably good adherence to maximum cigarette prices,
yet the quantities produced increased substantially. The common force of increased costs
presumably operated less strongly than the disruptive force of the desire by
each firm to keep its share of the market, to maintain the value and prestige of
its brand name, especially when the excess-profits tax shifted a large share of
the costs of this kind of advertising to the government. For this problem the cigarette firms
cannot be treated as if they were perfect
competitors.
Wheat farming is frequently taken to exemplify perfect
competition. Yet, while for some
problems it is appropriate to treat cigarette producers as if they comprised a
perfectly competitive industry, for some it is not appropriate to treat wheat
producers as if they did. For
example, it may not be if the problem is the differential in prices paid by
local elevator operators for wheat.
Marshall’s apparatus turned out to be most useful for
problems in which a group of firms is affected by common
stimuli,
32. Quoted part from ibid.
37
and in which the firms can be treated as if they
were perfect competitors. This is
the source of the misconception that Marshall “assumed” perfect competition in
some descriptive sense. It would be
highly desirable to have a more general theory than Marshall’s, one that would
cover at the same time both those cases in which differentiation of product or
fewness of numbers makes an essential difference and those in which it does not.
Such a theory would enable us to
handle problems we now cannot and, in addition, facilitate determination of the
range of circumstances under which the simpler theory can be regarded as a good
enough approximation. To perform
this function, the more general theory must have content and substance; it must
have implications susceptible to empirical contradiction and of substantive
interest and importance.
The theory of imperfect or monopolistic competition
developed by Chamberlin and Robinson is an attempt to construct such a more
general theory. 33 Unfortunately, it possesses none of the attributes that
would make it a truly useful general theory. Its contribution has been limited largely
to improving the exposition of the economics of the individual firm and thereby
the derivation of implications of the Marshallian model, refining Marshall’s
monopoly analysis, and enriching the vocabulary available for describing
industrial experience.
The deficiencies of the theory are revealed most clearly
in its treatment of, or inability to treat, problems involving groups of firms -
Marshallian “industries.” So long
as it is insisted that differentiation of product is essential - and it is the
distinguishing feature of the theory that it does insist on this point - the
definition of an industry in terms of firms producing an identical product
cannot be used. By that definition
each firm is a separate industry. Definition in terms of “close”
substitutes or a “substantial” gap in cross-elasticities evades the issue,
introduces fuzziness and undefinable terms into the abstract model where they
have no place, and serves only to make the theory analytically meaningless –
“close” and “substantial” are in the same category
33. E. H. Chamberlin, The Theory of Monopolistic
Competition (6th ed.; Cambridge: Harvard University Press, 1950); Joan
Robinson, The Economics of Imperfect Competition (London: Macmillan &
Co., 1933).
38
as a “small” air pressure. 34 In one connection Chamberlin implicitly defines an
industry as a group of firms having identical cost and demand curves.
35 But this, too, is logically meaningless so long as
differentiation of product is, as claimed, essential and not to be put aside.
What does it mean to say that the
cost and demand curves of a firm producing bulldozers are identical with ‘those
of a firm producing hairpins? 36 And if it is meaningless for bulldozers and hairpins, it
is meaningless also for two brands of toothpaste - so long as it is insisted
that the difference between the two brands is fundamentally
important.
The theory of monopolistic competition offers no tools
for the analysis of an industry and so no stopping place between the firm at one
extreme and general equilibrium at the other. 37 It is therefore incompetent to contribute to the
analysis of a host of important problems: the one extreme is too narrow to be of
great interest; the other, too broad to permit meaningful generalizations.
38
VI.
CONCLUSION
Economics as a positive science is a body of tentatively
accepted generalizations about economic phenomena that can be used to predict
the consequences of changes in circumstances.
34. See R. L. Bishop, “Elasticities,
Cross-elasticities, and Market Relationships,” American Economic Review,
XLII (December, 1952), 779-803, for a recent attempt to construct a rigorous
classification of market relationships along these lines. Despite its ingenuity and sophistication,
the result seems to me thoroughly unsatisfactory. It rests basically on certain numbers
being classified as “large” or “small,” yet there is no discussion at all of how
to decide whether a particular number is “large” or “small,” as of course there
cannot be on a purely abstract level.
35. Op. cit., p. 82.
36. There always exists a transformation of quantities
that will make either the cost curves or the demand curves identical; this
transformation need not, however, be linear, in which case it will involve
different-sized units of one product at different levels of output. There does not necessarily exist a
transformation that will make both pairs of curves
identical.
37. See Robert Triffin, Monopolistic Competition and
General Equilibrium Theory (Cambridge: Harvard University Press, 1940), esp.
pp. 188-89.
38. For a detailed critique see George J. Stigler,
“Monopolistic Competition in Retrospect,” in Five Lectures on Economic
Problems (London: Macmillan & Co., 1949), pp.
12-24.
39
Progress in expanding this body of generalizations,
strengthening our confidence in their validity, and improving the accuracy of
the predictions they yield is hindered not only by the limitations of human
ability that impede all search for knowledge but also by obstacles that are
especially important for the social sciences in general and economics in
particular, though by no means peculiar to them. Familiarity with the subject matter of
economics breeds contempt for special knowledge about it. The importance of its subject matter to
everyday life and to major issues of public policy impedes objectivity and
promotes confusion between scientific analysis and normative judgment. The necessity of relying on uncontrolled
experience rather than on controlled experiment makes it difficult to produce
dramatic and clear-cut evidence to justify the acceptance of tentative
hypotheses. Reliance on
uncontrolled experience does not affect the fundamental methodological principle
that a hypothesis can be tested only by the conformity of its implications or
predictions with observable phenomena; but it does render the task of testing
hypotheses more difficult and gives greater scope for confusion about the
methodological principles involved. More than other scientists, social
scientists need to be self-conscious about their
methodology.
One confusion that has been particularly rife and has
done much damage is confusion about the role of “assumptions” in economic
analysis. A meaningful scientific
hypothesis or theory typically asserts that certain forces are, and other forces
are not, important in understanding a particular class of phenomena. It is frequently convenient to present
such a hypothesis by stating that the phenomena it is desired to predict behave
in the world of observation as if they occurred in a hypothetical and
highly simplified world containing only the forces that the hypothesis asserts
to be important. In general, there
is more than one way to formulate such a description - more than one set of
“assumptions” in terms of which the theory can be presented. The choice among such alternative
assumptions is made on the grounds of the resulting economy, clarity, and
precision in presenting the hypothesis; their capacity to bring indirect
evidence to bear on the validity of the hypothesis by
suggesting
40
some of its implications that can be readily checked
with observation or by bringing out its connection with other hypotheses dealing
with related phenomena; and similar considerations.
Such a theory cannot be tested by comparing its
“assumptions” directly with “reality.” Indeed, there is no meaningful way in
which this can be done. Complete
“realism” is clearly unattainable, and the question whether a theory is
realistic “enough” can be settled only by seeing whether it yields predictions
that are good enough for the purpose in hand or that are better than predictions
from alternative theories. Yet the
belief that a theory can be tested by the realism of its assumptions
independently of the accuracy of its predictions is widespread and the source of
much of the perennial criticism of economic theory as unrealistic. Such criticism is largely irrelevant,
and, in consequence, most attempts to reform economic theory that it has
stimulated have been unsuccessful.
The irrelevance of so much criticism of economic theory
does not of course imply that existing economic theory deserves any high degree
of confidence. These criticisms may
miss the target, yet there may be a target for criticism. In a trivial sense, of course, there
obviously is. Any theory is
necessarily provisional and subject to change with the advance of knowledge.
To go beyond this platitude, it is
necessary to be more specific about the content of “existing economic theory”
and to distinguish among its different branches; some parts of economic theory
clearly deserve more confidence than others. A comprehensive evaluation of the present
state of positive economics, summary of the evidence bearing on its validity,
and assessment of the relative confidence that each part deserves is clearly a
task for a treatise or a set of treatises, if it be possible at all, not for a
brief paper on methodology.
About all that is possible here is the cursory
expression of a personal view. Existing relative price theory, which is
designed to explain the allocation of resources among alternative ends and the
division of the product among the co-operating resources and which reached
almost its present form in Marshall’s Principles of Economics, seems to
me both extremely fruitful and deserving of much confidence for the kind of
economic system
41
that characterizes Western nations. Despite the appearance of considerable
controversy, this is true equally of existing static monetary theory, which is
designed to explain the structural or secular level of absolute prices,
aggregate output, and other variables for the economy as a whole and which has
had a form of the quantity theory of money as its basic core in all of its major
variants from David Hume to the Cambridge School to Irving Fisher to John
Maynard Keynes. The weakest and
least satisfactory part of current economic theory seems to me to be in the
field of monetary dynamics, which is concerned with the process of adaptation of
the economy as a whole to changes in conditions and so with short-period
fluctuations in aggregate activity. In this field we do not even have a
theory that can appropriately be called “the” existing theory of monetary
dynamics.
Of course, even in relative price and static monetary
theory there is enormous room for extending the scope and improving the accuracy
of existing theory. In particular,
undue emphasis on the descriptive realism of “assumptions” has contributed to
neglect of the critical problem of determining the limits of validity of the
various hypotheses that together constitute the existing economic theory in
these areas. The abstract models
corresponding to these hypotheses have been elaborated in considerable detail
and greatly improved in rigor and precision. Descriptive material on the
characteristics of our economic system and its operations have been amassed on
an unprecedented scale. This is all
to the good. But, if we are to use
effectively these abstract models and this descriptive material, we must have a
comparable exploration of the criteria for determining what abstract model it is
best to use for particular kinds of problems, what entities in the abstract
model are to be identified with what observable entities, and what features of
the problem or of the circumstances have the greatest effect on the accuracy of
the predictions yielded by a particular model or theory.
Progress in positive economics will require not only the
testing and elaboration of existing hypotheses but also the construction of new
hypotheses. On this problem there
is little to say on a
42
formal level. The construction of hypotheses is a
creative act of inspiration, intuition, invention; its essence is the vision of
something new in familiar material. The process must be discussed in
psychological, not logical, categories; studied in autobiographies and
biographies, not treatises on scientific method; and promoted by maxim and
example, not syllogism or theorem.
43