The Standard Neoclassical View Of The Competitive Process Economics Essay

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Neoclassical, Austrian and Post-Keynesian views represent different Schools of Thought in Economics that explain competitive process in markets and industries. There is also a forth School of Thought, called the Shumpeterian approach, that I won't be looking at in this essay. It will focus on the criticism of Austrian and Post-Keynesian approaches of the neoclassical view. In order to assess the significance of the criticisms I will introduce the theories at first, then I will compare differences and similarities of those which will set the scene for a fair assessment of significance of the criticisms.

So what defines a separate School of Thought? Different historical roots and different basic principles on which the analysis of economic problems are based. Neoclassical theory which, despite widespread and growing awareness of its limitations, continues to serve as an analytical core of mainstream economics(Kirzner, 1997). It was built by Adam Smith and David Ricardo in 18th century and further developed in 19th and 20th centuries by V. Pareto, J.R. Hicks, F. Hayek and A. Marshall. Neoclassical theory (also referred to as Standard Theory) is mainly concerned with Utility Maximization (and Profit Maximization), Recourse Allocation and Marginalism. It is assumed that players are rational and they act independently based on perfect relevant information.

But why is it called Neoclassical theory? Online Business Dictionary splits the explanation into two parts: "neo" and "classical". The "classical" refers to what has just been mentioned above, whilst "neo" differs significantly from its origins by greatly emphasizing mathematical techniques.

Although competition is one of the factors that have its influence, it will be out focus in this essay. Schools have entirely different views on competitive process and whilst Neoclassical theory looks at Perfect Competition as a the key market structure or a benchmark, Austrians and Post-Keynesians strongly believe that relates much more significantly to modern economics. In Perfectly Competitive markets firms set their prices equal to marginal costs and the basic concept is that the competitive market is dominated by firms that do not have any market power and are considered as price-takers. Neoclassical economists also believe that a market equilibrium can also be found. Neoclassical theory can be seen as attempt to link market structure and market conduct along with market performance, thus achieving equilibrium in the market.

The Austrian School, unlike Neoclassical economists is rather concerned with Radical Subjectivism, Fundamental Uncertainty and Entrepreneurship. There are thee economists that main influences on the development of the theory: Menger, that majorly contributed to theory of Subjectivism, Growth and Uncertainty; Von Hayek famous for his contribution Individualism, Knowledge and Market Order; Von Mises who emphasized Entrepreneurship and Market Dynamics. Austrians argue that standard theory's assumptions are unrealistic, and instead of representing reality would simplify them instead. Unlike neoclassical views, Austrians emphasize individuals rather than firms and tend to show disregard to government intervention. Many Austrians argue that the key to understanding the competitive process is entrepreneurship. However, to understand entrepreneurship, at first, players need to understand uncertainty. There are two types of it: Risk and Fundamental Uncertainty. Neoclassical economics operates on the assumption that the world reflects the relationships that that would prevail in such equilibrium models - with the model of competitive equilibrium being the favorite one. While Austrians have not been alone in criticizing this approach to understanding markets, their criticisms have been both pioneering and trenchant.

Whilst competition was considered to be a hostile, according to Kirzner criticism: perfect competition in Standard theory was "the situation in which every market participant does exactly what everyone else is doing, in which it is utterly pointless to try to achieve something in any way better than what is already being done by others, and in which, in fact, it is not necessary to keep one's eyes open to what others are doing at all" (Kirzner, 1973, p.90, [5]). Also, it was almost impossible to identify equilibrium at any point in time, therefore, a solution was found: to ignore the time scale, i.e. to make equilibrium entirely unrelated to time, which, makes absolutely no sense whatsoever, even when taking into consideration the fact that it was entirely theoretical. What I am trying to attract reader's attention to that a use of time frame is essential, is common sense, especially in financial world. Without a time frame, an equilibrium will not be a theory, it is nothing more than a diagram. Austrians argue that in essence the Neoclassical model of perfect competition states that competitive process results in "The absence of all competitive activities" Hayek, 1946,p .96 cited in Wohlgemuth, [8]). It has been further criticised by Kirzner (1997, pp. 64) that it is "a)blatantly false nature of the assumption that market conditions are at all time in equilibrium, and (b) methodological unease with an instrumental mode of theorizing and empirical analysis that finds it useful to presume that equilibrium always prevails, while recognising no obligation to account theoretically for any equilibrative process(from which equilibrium might be explained as emerging)". The above suggests that the whole idea of equilibrium is false, consequently, the Standard theory of competition is false, hence it does not respond to definition of the competitive market. Since the equilibrium is achieved by extracting the best possible outcome derived from mathematical techniques, that according to the Online Business Dictionary, comes from the part "neo", that have been given to them. Which brings me to the point where I state that presents neoclassical economists as machines. Austrians state that entrepreneurial activities are blocked by rational assumptions.

Post-Keynesian School of Thought is rather a young one, first appeared in early 1960's. The key influencers were Kalecki and Davidson, that had particular concerns with with developing key aspects of Keynes' approach(mainly constructed in the 1930s and 1940s). They have further contributed to development of some ideas of Keynes. Keynes was certain that it is impossible, or if possible it is unreliable to understand real life behavior when there is uncertainty, which resulted in a new pricing strategy to be invented. He argued that there is either no or very little relationship between the price of goods/services and demand functions. Kalecki discovered that prices were set using a mark-up rule, i.e. a mark-up on top of the average prime cost. This pricing strategy lies at the heart of Post-Keynesian school of thought. The main assumptions in P-K theory were markup pricing and distribution, unlike Austrians which emphasized entrepreneurship and market dynamics. Post-Keynesians believe that competition in the markets can only be achieved by dominance, hence prices in the market are determined by dominant firms, rather than by markets. Furthermore, unlike clearing process in Neoclassical theory, firms have the ability to adjust prices to their objective. And I would like to emphasize that although it is only a theory(as well Neoclassical approach is a theory too), it can be easily seen in a real life situation the generally companies with larger market shares are the ones that dictate the prices to the rest of the market, hence, firms main objective would be to gain power, meaning that all companies will be aiming for the same objective. Certainly some will reach greater success than other, which brings me to the point that oligopoly will be a normal state across markets, whilst degree of monopoly power will vary between industries. There is no sense in which dominance can be seen as market imperfection. Furthermore, it is believed that markets are keen to reinforce dominance over time. However, we cannot observe the same pattern when referring to Standard theory. The idea of Post-Keynesian School is that there is no universal profit level that can be set, because each firm has its own profit function, which again, can be easily linked to real life situation, unlike Standard Neoclassical theory.

Keynes shares some ideas with Austrian school. However, Austrians split uncertainty into two separate points, "Risk", meaning that agents can allocate a subjective probability distribution over all future outcomes, and "Fundamental uncertainty", meaning that the exact opposite. Whilst Keynes believes that future can be based on historical averages, which averages out Austrian views on uncertainty, meaning that there is no difference between them. This alternate view of uncertainty is partly involved in the approach to pricing, which I mentioned above.

It becomes obvious from what has been mentioned above that agents in P-K theory are non-maximizes, as they do not rely on probabilities and adjust prices to their firms objectives, meaning that unlike neoclassical economists, post-Keynesians are not rational calculators. From this perspective it overlaps with Austrian theory, partly due to the interest of both schools in the work of Shackle.

To conclude, although neoclassical approach lies at the heart of the economics it is very far away from a realistic theory. Kirzner(1997, pp. 60)) states that "despite widespread and growing awareness of its limitation , [neoclassical theory] continues to serve as the analytical core of mainstream economics". Neoclassical theory puts rational decisions on the first place, which blocks all the opportunities for entrepreneurship. Although all players are rational, the model is extremely unrealistic, for two main reasons, which, in fact result into each other: given that equilibrium cannot be observed at a point in time, neoclassical economists excluded the timeframe from it. Along with the timeframe, all the sense and meaning is gone from the model too. Equally, since there is no more time frame, it is assumed that the market is at equilibrium at all times, which is bizarre and according to Kirzner is "blatantly false". Given that market is always at equilibrium, prices are set by market and, thus, firms are price takers.

It is argued by Austrians that neoclassical theory is rather unrealistic and it simplifies reality. Austrians believe that the key is to understand entrepreneurship via uncertainty. It becomes obvious that once Austrians emphasize entrepreneurship, they are not mere calculators like neoclassical economists. However, although Austrians significantly criticize standard theory, they are far from being a realistic theory too.

Although Post-Keynesian School appears to be the youngest out of three, mentioned previously, by far it seems to be the most realistic. Instead of criticizing the theory as a whole, it rather proposes alternative approach. In particular, although they share certain views on uncertainty with Austrian School, it relies on historical averages, which obviously differs to Austrian theory, but partially influences the pricing theory. Post-Keynesians use the concept of mark-up pricing, developed by Kalecki, and also they assume that since they are non-optimizers, and they pursue power and market dominance, firms have the ability to adjust prices to their objectives, hence oligopolistic structure tends to be the most common in markets. Out of three school discussed above, Post-Keynesian school is the most realistic one, because as mentioned above it most closely relates to the real life examples.

Neoclassical theory can certainly be used when looking at abstract cases or situation or to be used to explain theoretical economics, however, it is simply incompetent and unrealistic when looking at less general situations.