Third Fundamental Neoclassical Tenet

This post will be the last to begin the Hunt-Lautzenheiser (2011, p.434) summary of the three fundamental tenets of textbook neoclassical theory: “… the faith that the invisible hand of the competitive market harmonizes all interests through free exchange, creates rational prices, and leads to an efficient allocation of resources; the faith that the free market will automatically create a full-employment equilibrium; and the belief that the wage rate is equal to the value of the marginal product of labor and that the profit rate (or interest rate) is equal to the value of the marginal product of capital – hence, by implication, each social class gets the value created by the factors it happens to own.”

What follows looks at the third tenet, the market capacity to ethically distribute total income. It is easy to reject the practical relevance of the mainstream Wicksell-Wicksteed neoclassical factor-income distribution model. That elegant theory is both incoherent and inconsistent with the available evidence, including chronic labor rents and downward nominal wage rigidity over business cycles. (Chapter 3) Paul Samuelson once called it the “J.B. Clark neoclassical fairy tale”. The GEM Project provides a microfounded, evidence-consistent alternative that does not suppress the existence of scale economies, large bureaucratic firms, meaningful wage rigidity, important nominal-to-real causality, sunk capital, the typically indivisible nature of physical capital, and pure profit. Excluding pure profit in a model of factor-income distribution is especially egregious.

GEM Factor-Income Distribution

In generalized-exchange analysis, the rational payment of wage rent in the large-establishment venue (LEV) is usefully decomposed into its noncyclical and cyclical components:

G_j(t)=W^ń_j(t)/W^m(t)=G^T_j(t)+G^V_j(t),

where W^m denotes market opportunity costs and W^ń_j the jth-workplace reference wage. G^T tracks chronic time-varying labor rent and G^V the cyclical variant associated with downward wage inflexibility. GEM analysis critically features pure profit (Π_j), similarly decomposed into Π^T_j and Π^V_j, that is defined as firm  revenue in excess of total production costs which are associated with labor hours, financial capital, and materials:

Π_j(t)=P_j(t)X_j(t)−G_j(t)W^m(t)H_j(t)−ř^m(t)Ҡ^r_j(t)−P^M(t)M_j(t)=Π_j^T(t)+Π_j^V(t), or

P_j(t)X_j(t)=G_j(t)W^m(t)H_j(t)+ř^m(t)Ҡ^r_j(t)+P^M(t)M_j(t)+Π_j(t),

where ř^m denotes the market price of financial capital, Ҡ^r is the resale value of the establishment’s capital stock, M denotes (homogeneous) material input, and P^M is unit product price.

Total capital Ҡ_j, valued at original cost, equals Ҡ^S_j+Ҡ^r_j; for convenience, sunk capital (Ҡ^S_j) is always equity financed and Ҡ^r is always debt-financed. In this introductory version of generalized-exchange distribution theory, ř^m and P^M are exogenous. Pure profits are claimed by owners of sunk capital (Ҡ^S_j=Ҡ_j−Ҡ^r_j). In the production establishment being assembled, the exhaustion of total product is assured by the residual nature of Π_j. Via G, the distribution equation embodies the rational payment of MWR and therefore the rational causation from fluctuations in nominal demand (PX) to same-direction movement in pure profit.

GEM distribution identifies two interrelated classes of market rents that inform optimizing decisions about production capability and capacity: wage rents (G_j^V,G_j^T) and sunk-capital rents (Π_j^V,Π_j^T), both operating at high- and low-frequencies. If ΔP_j/ΔG_j<1, then ΔΠ_j/ΔG_j<0. Imperfect labor oversight and sunk capital, both characteristic of large-scale production, generate a powerful version of the hold-up problem that plays an essential role in rational investment. Hold-up (H) complications influence ex ante and ex post pure profits resulting from capital-goods acquisition, with implications for investment decisions, equity versus debt financing, market valuations of equity, mergers and acquisitions, bankruptcy incidence, and more. (Chapters 6 and 8)

The residual-rent framework permits the introduction of sunk costs as well as recognizable investment, interest rates, and product pricing into income dynamics. In generalized-exchange modeling, stationary (Π_j^V) and nonstationary (Π_j^T) pure profits are central transmission mechanisms through which demand disturbances influence rational firm choices, including layoffs, job downsizing, labor hiring, and capital investment/liquidation. GEM residual-claims analysis belongs to Michael Jensen’s (2000) insightful class of income-distribution modeling.

Expected real discounted residual rents are:

И_j(0)=E_oj∑(1+ŗ^e(t)+p^e(t))^-tΠ_j(t)),

where E_oj denotes rationally-constructed expectations rooted in cost-effective information available to management at the beginning of the current period (t=0), positing objectively known probability distributions of future outcomes; ŗ^e and p^e are, respectively, the expected discount and general inflation rates; and the series is summed from t=0 to t=η, the expected life of capital investment. Expectations are continually updated over time, and the operator (E) has the standard statistical properties. The residual-rent definitions imply an expected rate of return:

q_j(t)=И_j(t)/Ҡ^S_j(t).

In generalized-exchange modeling, actual and expected residual rents (i.e., pure profits) are crucial capacity signals, informing management production-capability decisions that significantly include involuntary job loss.

Features of GEM Distribution

Hunt-Lautzenheiser describe neoclassical distribution theory as a “settled, unquestioned article of faith among nearly all neoclassical economists”. That is so despite the third tenet having long been a major obstacle in the progress toward micro-coherent, stabilization-relevant macro theory. Replacement by GEM model of factor-income distribution would be a fundamental advance in mainstream thinking.  There is a lot to like in the GEM approach. Most notably, the Jensen-class model is much more consistent with the how highly specialized economies actually behave. Samuelson was right. The famous neoclassical claim of ethical outcomes is indeed a fairy tale.

Other GEM improvements that help clean up neoclassical red herrings embodied in the three fundamental tenets include the following. Pure profits exist and prove a crucial incentive for optimizing behavior. Such profit is not equivalent to interest payments. Bohm-Bawerk’s “average period of production” is not a useful description of capital. Long-lived, indivisible physical capital exists; sunk capital exists. The hold-up phenomenon, simply ignored in neoclassical thinking, is recognized as a central influence on investment spending and rational wage determination. Technical productivity of physical capital is embedded in expectations of future residual rents, along with anticipated product prices, labor prices (featuring hold-up), other input prices, and technological change. What’s not to like.

Blog Type: Wonkish Chicago, Illinois