Everything you think you know about Economics is wrong

The American humourist Henry Louis Mencken once wrote of human thought that “Explanations exist; they have existed for all time; there is always a well-known solution to every human problem—neat, plausible, and wrong.”

I can think of no better aphorism for Neoclassical economics. Its solutions are well-known, its models are neat, its explanations are plausible, but its arguments are wrong. But to understand this, you have to go well beyond a textbook-level of knowledge of economics, because economic textbooks present a sanitised version of the theory, shorn of the fallacies which infest it.

Normally, this is because the textbook writers are themselves unaware of the problems with the theory. But on occasions, textbook writers who themselves uncovered fallacies in the theory ignore their own discoveries, and teach the theory as if their own work had never happened.

The most significant instances of this phenomenon—a leading economist finding a flaw in the theory, and then publishing a textbook which ignores both the flaw and his own research into it—concern the two fundamental constructs in economics, the demand curve and the supply curve. The textbook writers in question were prominent and highly influential economists: one, Paul Samuelson, was the main architect of post-WWII mainstream economics; the other, Alan Blinder, was Vice-Chairman of the Federal Reserve, and Vice-President of the American Economic Association.

Together, their findings destroy the iconic foundations of Neoclassical economics, the supply and demand diagram. Explaining why this is so will take us on a substantial diversion from the specific topic of the economics of climate change, and it will take several chapters to show just how unsound Neoclassical economics is. But it is necessary to know this background in order to be able to understand how the laughably bad work of climate change economists came to be published in the first place.

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Paul Samuelson and John Hicks developed the methods by which economists derive an individual’s demand curve {Samuelson, 1938 #291;Samuelson, 1947 #5848;Samuelson, 1948 #6947;Hicks, 1934 #4984;Hicks, 1934 #4985}. Their methods showed that an individual’s demand curve necessarily sloped downwards: that the individual’s demand for a commodity necessarily declined as its price rose. ^[1] In his textbook Economics—now maintained by William Nordhaus—Samuelson told students that the “law of downward-sloping demand” also applied to the market demand curve:

Market Demand
Our discussion of demand has so far referred to “the” demand curve. But whose demand is it? Mine? Yours? Everybody’s? The fundamental building block for demand is individual preferences. However, in this chapter we will always focus on the market demand, which represents the sum total of all individual demands. The market demand is what is observable in the real world.

The market demand curve is found by adding together the quantities demanded by all individuals at each price. Does the market demand curve obey the law of downward-sloping demand? It certainly does. {Samuelson, 2010 #6096`, p. 48}

“Certainly”? Half a century earlier, Samuelson reached a very different result.

In Neoclassical theory, individual demand curves are derived by combining an individual’s tastes—represented by what are called “indifference curves”—with the individual’s income and relative prices. For the market demand curve to have the same properties as an individual demand curve, it must be conceptually possible to represent an entire economy by “social indifference curves”. Samuelson commenced his 1956 paper “Social Indifference Curves” {Samuelson, 1956 #1495} with the concession that this was only possible in extremely limited and clearly unrealistic cases:

What defense do we make when challenged on the use of community indifference curves for a country or group of individuals? I suppose one of the following:

(a) We may claim that our country is inhabited by Robinson Crusoe alone and claim only to show how trade between such single person countries is determined. This is admittedly not very realistic.

(b) In order to give the appearance of being more realistic, we may claim that our country is inhabited by a number of identical individuals with identical tastes; they must also have identical initial endowments of goods if this artifice of examining what happens to the representative individual’s indifference curves is to give us a true description of the resulting market equilibrium. This case, too, is not very realistic, though it may seem a slight improvement over Robinson Crusoe.

(c) We may claim to be depicting trade of a totalitarian nation. One dictator determines demand within his country and his consistent indifference curves provide us with the community indifference curves for that country. Some might regard this as Robinson Crusoe brought painfully up to date.

(d) None of the previous explanations meets the case of two (or more) dissimilar individuals within each country. {Samuelson, 1956 #1495`, p. 3. Emphasis added}

He then proved that community indifference curves were impossible, with the sole exception being “where tastes are identical, not only for all men, but also for all men when they are rich or poor” {Samuelson, 1956 #1495`, p. 5}. This proof showed that a market demand curve derived by adding up multiple individual downward-sloping demand curves could have any shape at all—it did not have to slope down.^[2] As later rediscoverers of this conundrum concluded, “The utility hypothesis tells us nothing about market demand” {Shafer, 1993 #349}.^[3]

This should have been “a Pythagorean moment” for economics. Pythagoras believed that all numbers could be expressed as the ratio of two integers: we call such numbers “rational” today. But one of his followers discovered that there were “irrational numbers”: numbers that were not the ratio of two integers. This follower was purportedly drowned for his troubles,^[4] but the result was ultimately accepted. The dogma that all numbers were rational was abandoned, and mathematics advanced dramatically as a result.

This has not happened with economics, because the economists who proved this result {Gorman, 1953 #1491;Samuelson, 1956 #1495;Sonnenschein, 1972 #1484;Sonnenschein, 1973 #1483;Sonnenschein, 1973 #1486;Sonnenschein, 1974 #1482;Kihlstrom, 1976 #1485;Shafer, 1982 #6082;Shafer, 1993 #349} were too wedded to their dogma—the teleological belief that a free market economy maximizes social welfare—to accept this conundrum that they had discovered.

This led to behaviour by these economists which, in a purely psychological sense, can be characterised as insane. The desire to show that a free-market system maximizes social welfare was so strong that they devised “solutions” to this conundrum which literally contradicted the foundations of Neoclassical thought.

Samuelson’s solution was to invoke altruism.

Classical scholars will remember Virgil’s famous warning in The Aeneid to “Be wary of Greeks bearing gifts”.^[5] The same warning applies to Neoclassical economists wielding the concept of “altruism”. A theory based entirely on the concept of maximizing self-interest appealing to altruism to overcome a logical conundrum, is as trustworthy as a Wooden Horse at the gates of Troy.