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How wrong it is

In almost every chapter of Keen’s book, one of the theoretical models of mainstream economics is taken apart and shown to be invalid, either for theoretical reasons, or because empirical results do not agree with it, or both. The assumption of rising marginal cost is a good example – Keen shows that it may not be valid both for theoretical reasons and because we often observe the opposite in practice. As he does throughout the book – greatly enhancing his credibility – Keen quotes here from the results of a survey by another, and better-known economist, Alan Blinder, who found that “only 11 percent of GDP is produced under conditions of rising marginal cost.” Keen then expounds on the implications of Blinder’s statement. “The neoclassical model of … rising marginal cost is thus wrong in theory and wrong in fact,” Keen writes. “That it is still taught as gospel to students of economics at all levels of instruction, and believed by the vast majority of neoclassical economists, is one of the best pieces of evidence of how truly unscientific economics is.”

Keen also finds plenty wrong with the assumption of a downward-sloping demand curve and particularly with the aggregation of demand curves to get downward-sloping aggregate demand. Demand for a good is supposed to decline as its price rises, but in many cases demand for a good will not slope downward. If you only drink cheap wine and the price of cheap wine falls, you’ll buy less cheap wine, because you’ll have more money available and can substitute a little expensive champagne for some of the cheap wine. Many other examples can be found. Because of the cumulative effect of all these exceptions, Keen argues that the demand curve can take any shape, and equilibrium could be found anywhere. What’s more, he says, neoclassical economists have known this for a long time, but they ignore this inconvenient fact because it would upend their simplistic models.

Keen is on particularly firm ground when he critiques the assumption of upward-sloping individual and aggregate labor supply curves. If a person doesn’t have enough money to engage in leisure, why would they choose more leisure and less work if the wage rate falls? And a higher wage, he says, “means that the same total wage income can be earned by working fewer hours.” Why would you work more hours if the wage was higher? In fairness, Krugman and Wells point out the same thing in their textbook, though there it is explained as a result of the income effect. Keen, in other places, has criticized economic theory’s practice of adding theoretical shims – to explain situations that don’t accord with fundamental theory – as like adding Ptolemaic epicycles, the strange movements of planets that the Greek astronomer Ptolemy had to assume in order to preserve the theory that the sun revolved around the earth.

Keen is especially critical of the development of Dynamic Stochastic General Equilibrium models (a successor to “real business cycle” models) and their assumption of a representative agent – a single hypothetical actor who can stand in for us all. Again he quotes a better-known authority, Nobelist Robert Solow, who has himself complained about how unrealistic the assumptions of these models are. Solow put it this way:

The prototypical real-business-cycle model goes like this: There is a single, immortal household – a representative consumer – that earns wages from supplying labor. It also owns the single price-taking firm, so the household receives the net income of the firm. The household takes the present and future wage rates and present and future dividends as given, and formulates an optimal infinite-horizon consumption-saving (and possibly labor-saving) plan…