Neoclassicism in Action: Hayek on the Ricardo Effect

Commenting on my post earlier this week in which I called Hayek a neoclassical economist, Paul Krugman provided this informal description of what it means to be a neoclassical economist. I wouldn’t say that his description is exactly right, but in the spirit of neoclassicism that Krugman himself deploys in his description, I would say that, for my purposes, Krugman’s description is good enough. Here’s what Krugman said:

So, what is neoclassical economics? There’s a historical definition, having to do with the “marginal revolution” of the late 19th century and all that, but what I think we mean in practice is economics based on maximization-with-equilibrium. We imagine an economy consisting of rational, self-interested players, and suppose that economic outcomes reflect a situation in which each player is doing the best he, she, or it can given the actions of all the other players. If nobody has market power, this comes down to the textbook picture of perfectly competitive markets with all the marginal whatevers equal.

Some economists really really believe that life is like this — and they have a significant impact on our discourse. But the rest of us are well aware that this is nothing but a metaphor; nonetheless, most of what I and many others do is sorta-kinda neoclassical because it takes the maximization-and-equilibrium world as a starting point or baseline, which is then modified — but not too much — in the direction of realism.

That description struck a nerve, because in writing my previous post, I had looked up a couple of passages where I recalled that Hayek had deployed very neoclassical kinds of arguments. One passage was in the perhaps the last article that Hayek ever published in a top-rank economics journal, a 1969 paper entitled “Three Elucidations of the Ricardo Effect,” published in the Journal of Political Economy. In the introduction to the paper, Hayek explains:

[A]s the general thesis of what I have called the “Ricardo Effect” may not now be familiar to all readers, I shall first restate it in a which, though not wholly unobjectionable, I have often found to more readily intelligible than the more precise statement I have given on earlier occasions.

Hayek then continues in the next paragraph with following description of the structure of his model:

The theorem called the Ricardo Effect asserts that in conditions of full employment an increase in the demand for consumer goods will produce a decrease of investment, and vice versa. The manner in which this result is produced can be conveniently represented in a diagram corresponding to the familiar representations of the production function. In this diagram, however, the total stock (fixed and circulating) of capital is measure, on the abscissa; and the total stream [aka flow] of input, including all that is required to maintain the stock of capital at the level most profitable in the circumstances, is measured on the ordinate. We shall assume for the present purposes that this production function is linear and homogeneous. Since the magnitudes represented along the two co-ordinates both consist of variable combinations of heterogeneous goods and services, these can of course be represented in value terms. This would be strictly legitimate only if we could assume that the prices of the various goods and services involved remain constant. In fact, however, the changes which we will consider necessarily involve some changes in the relation between these prices. Hence the slightly unsatisfactory nature of the technique, to which I have referred before, derives. It seems to me, however, that this defect does not seriously detract from the validity of the conclusions which can be derived in a comparatively simply manner by these methods. Readers who wish to see a more exact demonstration will have to refer to my 1942 article. But for the present purposes, I trust that this simplified exposition will suffice. I have long found it effective in teaching, but because of this defect, have refrained from putting it into print.

Sounds an awful lot like Krugman’s description of neoclassicism to me. (If you want to see Hayek’s diagram, you need to follow the JSTOR link to the JPE article, or get a hold of Hayek’s New Studies in Philosophy, Politics, Economics, and the History of Ideas (p. 167)

For another example of Hayek’s neoclassicism see volume 2 of Law Legislation and Liberty, pp. 117-19. It would be tedious to reproduce the whole passage here. But it is worth reading just to see how Hayek deployed standard neoclassical production theory in an elegant and compact exposition of the theory of general equilibrium and Pareto-optimality.

6 Responses to “Neoclassicism in Action: Hayek on the Ricardo Effect”

  1. 1 greghill1000 August 30, 2012 at 7:49 pm


    Interesting post as usual. But it seems discordant in two respects. First, Krugman defines neoclassical economics as an approach that starts with constrained maximization plus equilibrium before adding various imperfections. I don’t see anything in your post that suggests Hayek proceeded in this fashion. And, given Hayek’s emphasis on local knowledge, it’s easy to see why Hayek wouldn’t affirm a representative agent model, no matter how many different “representative agents” inhabited it. After all, how could you possibly describe all the different sources of information, different for each actor, on the basis of which the model’s participants are presumed to “maximize.”

    That said, the passage from Hayek you cite above betrays a curious willingness to aggregate heterogeneous capital goods into a “production function” of all things. Now, this may indeed be a neoclassical exercise, but it seems out of sync with virtually everything else Hayek stresses in his work.

    Nevertheless, I’m a big fan of your blog. Keep it up.

  2. 2 andrew lainton August 30, 2012 at 9:20 pm

    In the above quote Hayek is expressing
    1) Humes theory of forced savings
    2) The classical theory of growth where all growth must be preceded by prior savings

    Both are key postulates of classical rather than neoclassical thinking (where there is no monetary circuit and money is just a veil),

  3. 3 Greg Ransom August 30, 2012 at 11:04 pm

    David, you are mistaking themuse of common formal logic & math constructs for common explanatory strategies.

    The key to understanding Hayek is to understand his rival explanatory strategy.

    You don’t seem to get this, or even to be aware of this difference in explanatory strategy, which is a fundamental failure to understand what Hayek is doing.

    In Hayek learning in the context of local knowledge and changing relative prices is the explanatory cause / mechanism.

    Hayek is explicit in saying that the tautological formal logic/math is NOT explanatory.

    Read the first 4 or 5 chapters of Hayek’s The Pure Theory of Capital along with Hayek’s famous 1937 and 1945 and 1946 papers to see Hayek laying out this explanatory strategy.

  4. 4 David Glasner September 2, 2012 at 1:32 pm

    Greg Hill, Hayek’s diagram which I didn’t reproduce involves finding a point of tangency between an isoquant and isocost curve, that is a form of maximization (either constrained or unconstrained depending on how one sets up the problem). Who said anything about a representative-agent model? Such models may be useful in certain circumstances, but I hardly think that they are an essential part of anyone’s conception of what neoclassical economics is all about. Actually Hayek did engage in a fair amount of aggregation which is perhaps what you have in mind when speaking about representative agents. Some aggregation is inevitably necessary when working with any theoretical model. The question is at what point does aggregation cease to be a simplifying assumption that allows a model to be tractable and a model that abstracts from essential features of the reality that needs to be explained. There’s no hard and fast rule. It depends on the problem and it’s up to the intuition of a good theorist to know where to draw the line. Certainly reducing the entire economy to a single representative agent is almost always going too far.

    Thanks for the encouragement. As long as some people keep writing stuff for me to disagree with, I will be keep trying.

    Andrew, I think of neoclassical theory as a certain approach to solving economic problems involving optimization by households and firms and an equilibrium in which everyone is optimizing given what everyone else is doing. Hayek seems to be doing that in the quotation. He arrives at certain result which you consider to be classical rather than neoclassical, but to me the important thing is not the specific result but the type of reasoning Hayek employed to get to that result.

    Greg Ransom, Why don’t you summarize for me what you think Hayek’s explanatory strategy is and explain to me how it fits into the discussion that I quoted from his paper on the Ricardo Effect? Your comment, as it stands, is way too abstract for me to comprehend in the context of this discussion

  1. 1 Hayek on the Unsustainability of Inflation-Fed Booms « Uneasy Money Trackback on August 30, 2012 at 7:57 pm
  2. 2 Hayek outside equilibrium « Increasing Marginal Utility Trackback on August 30, 2012 at 10:32 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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