Economics for Heretics:
denuding the myths of orthodox economics

-by Dante A. Urbina-

translated by D. Ohmans
© copyright 2018

Text imprint Lima Peru, ©2015

Economics for Heretics TOC
PREFACE - Economy in crisis and economic theory in crisis: The necessity of an alternative Chap.1 - THE MYTH OF THE RATIONALITY OF THE CONSUMER o The orthodox theory of the rationality of the consumer o A useless function: the utility function o Inconsistent consistency: "rational fools" o Economic individualism: a universal phenomenon? o Are we egotists by nature: a critique of the anthropological assumptions of economic orthodoxy o Egoistic altruism? Ockam's razor and mother Teresa against economic orthodoxy o Reasons of the heart: the ethical factor in economic decisions o An avalanche of anomalies: homo economicus visits the psychologist o Now homo economicus goes to the laboratory: experimental economics o Do not forget the right hemisphere! Performing an encephalogram on the consumer o We are not omniscient! The problem of limited rationality o We are not cold calculators! The problem of uncertainty o Conclusion Chap.2 - THE MYTH OF THE PRODUCTION FUNCTION o The orthodox theory of the production function o The "Holy War" of capital: the controversy of the two Cambridges o Things become viscous: "molasses" and the aggregation of capital o Murdered with its own sword: mathematics against the economic orthodoxy o The production function castrated: the sterility of the orthodox theory to explain the technological process o With what shall we produce? Critique from the ecological perspective of the production function o A supposition it is necessary to substitute: the assumption of substitutability o The final blow: the sophistry of empirical validation of the production function o Conclusion Chap.3 - THE MYTH OF THE THEORY OF DISTRIBUTION o The orthodox theory of distribution o An unproductive concept: the sophistry of "marginal productivity" o A theoretical anomaly quite normal in practice: the Leontief function and marginal productivity o A theory that through sloth does not change: leisure and the work offer o Is the notion of free and competitive labor markets pertinent? The institutionalist critique o To each according to her contribution? The multi-product case o Is the labor factor merely a cost? A critique from Keynesian and neo-Keynesian economics o The final blow: Sraffa's devastating critique of the orthodox theory of distribution o Conclusion Chap.4 - THE MYTH OF PROFIT MAXIMIZATION o The orthodox theory of profit maximization o No to the "mechanical optimizer"! The Schumpeterian conception of the entrepreneur o "Animal spirits": the problem of uncertainty o Maximize profits or minimize losses? The problem of risk o The behavioral economy returns to the fore: the problem of perspective o The broken plates of a divorce: the problem of agency o Consequences of technological change: the power of the technostructure o A true inconvenience: the possibility of seeking other goals o IMg = CMg: and where is the evidence? o Conclusion Chap.5 - THE MYTH OF COMPETITIVE MARKETS o The orthodox theory of competitive markets o The fallacy of free and competitive markets: the planning system o Everyone against everyone? The law of duality o Market and power: the social structures of the economy o Disappearance of the invisible hand: the birth of strategic thinking o Some scissors that should be cut: the supply and demand curves o Extreme unrealism and contradictions: analysis of the assumptions of the perfect competition model o A terribly imperfect theory: logical inconsistencies of the perfect competition model o Failed recursion: the "false Messiah" of successive approximations o Conclusion Chap.6 - THE MYTH OF MARKET EFFICIENCY o The orthodox theory of market efficiency o The markets are not omnipotent! The problem of market failure o Efficiency for what? The uncomfortable question of content and goals o A not at all optimal criterion: Pareto optimality o Efficiency for whom? Market and exclusion o Fair injustice? The fallacy of "prior votes" and the "meritocratic scale" o Destroying a dogma: the fallacy of consumer sovereignty o Competition leads to efficiency? John Nash vs. Adam Smith o An uninformed argument: the market as socializer of information o Endogenous explanation of the crisis: Minsky's hypothesis of financial instability o Conclusion Chap.7 - THE MYTH OF GENERAL EQUILIBRIUM o The orthodox theory of the general equilibrium o A castle in the clouds: the exaggerated abstractionism of the theory of general equilibrium o Impertinent commentaries: analyzing the pertinence of the assumptions of general equilibrium theory o The mirage of relative prices: the non-existence of general equilibrium o An unprofitable theoretical transaction: the surplus costs of uniqueness o Destabilizing stability: the Sonnenschein-Mantel-Debreu theorem o Stability and sterility: the absolute uselessness of general equilibrium o Is the DSGE model salvation? Confessions of an orthodox economist o Conclusion Chap.8 - THE MYTH OF NON-INTERVENTION OF THE STATE o The orthodox theory of non-intervention of the State o Good for nothing? The fallacy of the intrinsic inefficiency of the State o Saved by the State: the industrialization of Germany, Russia, Japan, and China o What is corrupt in the corruption argument: critique of Friedman and the public choice school o More assistance to those who cooperate? The role of the State in the promotion of economic efficiency o Seeking "the optimum" is not always optimal: the Lipsey-Lancaster theorem o In defense of political economy: critique of monetarism and the theory of rational expectations o Against the sword and the wall: totalitarianism of the State or totalitarianism of the market o Liberal hypocrisy: liberalism, dictatorship and other demons o Conclusion Chap.9 - THE MYTH OF FREE TRADE o The orthodox theory of free trade o Welfare for all? The critique of Singer and Prebisch of the theory of comparative advantages o Porter's critique: competitive advantages and comparative advantages o Why do factor prices not equalize? Critique of the Heckscher-Ohlin model o Liberal hypocrisy once again: the kick down the stairs o The development of underdevelopment: the problem of circular causality with cumulative effects o The law of the jungle and globalization: international Darwinism o The great fraud: United States and the Free Trade Treaties o Refuting Henry Martyn: fallacies of the analogy of free trade and technological progress o Conclusion Chap.10 - THE MYTH OF DEVELOPMENT o The orthodox theory of development o What can be measured and what cannot be measured: the fetishism of the PIB o The obsession with development: the error of the absence of choice o I'm rich! Yet why am I not more happy? The "paradox of happiness" o Persons or merchandise? The personalist critique of the orthodox theory of development o Is the road to heaven paved with bad intentions? Concerning the good, the beautiful, the dirty, and the useful o Development for all? The fallacy of universal prosperity o Only a question of time? "Schumpeterian underdevelopment" and dependency theory o Predestined enemies: orthodox theory and underdeveloped nations o Conclusion EPILOGUE - "What is to be done? Towards a new economic theory"


     Crisis in the economy, crisis in economic theory: that is the context in which we 
live. Nobody knows for certain if we can emerge gracefully from the present world 
economic crisis or exactly how or when we shall do so. It is even possible that the 
crisis originated by the private financial bubble is being "solved" generating a new 
bubble of indebtedness of the States by the massive introduction of fictitious money in 
the bank rescues. Be that as it may, one of the things which the crisis has made clear is 
that we cannot as we are with the same scheme of economic theory.
     But what is this scheme? It so happens that in economics there is a focus that is 
clearly dominant: the Neo-classical theory. This focus, which supposedly "renews" the 
classical economists, practically monopolizes the teaching of what strictly has been 
called "economic theory" in almost all the economics faculties of the world. One can speak
of other focuses, it is clear, in courses "without importance" such as those of the 
"History of Economic Thought, Economic History" or "Economic Sociology"; yet the "pure and
hard" courses in economic theory (Macroeconomics and Microeconomics) have to be centered 
and based almost exclusively upon the conventional scheme.
     It is not that the other focuses have not developed analyses and consistent theories 
upon the same field as macroeconomics and microeconomics, yet what happens is they all 
tend to be minimized or ignored as "peripheral" (curiously, the same attitude that the 
"developed" nations have with respect to the underdeveloped) or, in any case, if it is 
incorporated into the teaching, it has to be fitting the corset of the dominant 
epistemological scheme. What better example of this than the case of the considerably 
broad and complex Keynesian theory that is taught almost exclusively in terms of 
formulation of the Neo-classical Keynesian synthesis, that is to say, only after 
having passed through the filter of that which is consistent with the dominant theory. 
Thus, most of the time, the student will be acquiring her comprehension of the economy on 
the basis of such ideas as the competitive market, the rational consumer, the supply and 
demand model, the production function, general equilibrium, market efficiency, free trade,
rational expectations, economic growth as the primordial objective, etc.
     Perhaps with this one could think that the material treated here has only a 
"theoretical" interest without greater relevance in the "practical" world. Nothing more 
false. The economy is a field where the "good" and "bad" theories can have very great 
effects in reality, which range from the most marvelous to the most devastating. If a 
doctor has a bad theory and applies it, she can end up killling one person; if an 
economist has a bad theory and applies it, they can end by killing thousands of 
persons. Curiously, whereas the doctor goes to jail for negligence, the economist who best
know how to apply savage policies can obtain a good post at the IMF, the World Bank, the 
committee of economic consultants of a "developed" nation or some powerful multinational.
What is important is that the savagery be applied in a very calculated and intelligent 
fashion and in consonance with the interests of those who hold the economic power; or 
that is, thus something like an "economic hitman." Examples in this regard can be clearly 
seen in the application of the neo-liberal policies of the so-called Washington Consensus 
in the poor countries of Africa and Latin America.
     Yet something bad is not necessarily required to cause these negative effects. 
Precisely there resides the great venom of a bad theory: that it can cause good men to do 
ill or lose the opportunity of doing good. Thus then, those students who receive 
unilateral formation in economic theory go into the real world and become businessmen , 
ministers, consultants, and even presidents. And they can be applying even with good 
intentions, erroneous economic policies that generate negative effects on society, upon 
culture, institutionality and/ or the environment. Yet to the conventional economist it 
will be difficult to perceive all that in its true dimensions for she has been repeatedly 
taught in the university that all these are important variable but, in the final analysis,
are "exogenous" variables for the economist, which is to say they fall outside of her 
realm of study. To be occupied with those problems, therefore, is principally the labor of
politicians, psychologists, sociologists, and ecologists. Even this same economist can 
complain of all these problems upon reading the newspaper in her house on Sundays, yet in 
the daily calendar of Monday to Friday will not have them as a central preoccupation since
"they are concerned with exogenous aspects.
     And not only that. A deficient economic theory can leave the economist very badly 
situated when the phenomena of reality occur. This is something now almost classical in 
the history of contemporary capitalism; after epochs of optimism concerning the prosperity
of the economy and the "solidity" of the economic theory, the great crises arrive and 
leave the economists perplexed. That was seen en the Great Depression of 1929, the 
petroleum crisis of 1973 and our current "Great Recession" beginning with the financial 
crisis of 2008. In this regard, an economist as recognized as Paul Krugman (Nobel prize 
2008) wrote, in September of 2009, in his column in the New York Times titled "How 
did economists get it so wrong?" proposing that a large part of the epistemological 
failure of the economists before the crisis is that they preferred "beauty to truth," 
that is, they were too complacent with the "mathematical consistency" of their theories 
and they forgot the hard and complex reality. And in large part this is how the 
theoretical scheme of Neo-classical economics functions: constructing mathematically 
adorned myths that function as bridges between the undeniable contrary evidence and the 
faith which they wish to preserve. The problem is that those theoretical myths create 
real monsters.
     What is it that is required, then? Heresy. We need to strongly question that 
"orthodoxy" of economic thought, that which John Kenneth Galbraith would call "the 
conventional wisdom." A heretic is one who does not believe in the orthodoxy. So 
then, this is an heretical book, heretical with respect to that economic theory 
which includes amny lies and fallacies wrapped in apparently scientific language. This 
orthodox theory, the Neo-classical, has been proclaimed "the king" of the paradigms of the
economy and circulates very happily through the university halls. But someone has to tell 
the "king" that he is naked, somebody has to denude the myths of orthodox
economic theory.
     Now, when someone wants to say that "the king is naked," they will not say it to the 
consultants or courtesans of the king, going there first being foolish. Much better one 
is going to say it to the public. The prestige and even the life of the courtesans depend 
upon their obedience to and reverence for the king: if this is denuded, they will follow 
him saying he is wearing a handsome outfit. Thus, they are the persons least disposed to 
objectively analyze embarassing questions about the king. The people, on the other hand, 
are more open to listen and, what is more important, it is what they need to hear. 
In consequence, this book is not primarily directed to orthodox ultra-specialized 
academics but instead to all those educated and socially committed who might be interested
in the relevant question. Likewise, the book also can be of much interest and utility to 
all those professionals or students of Economics and the like who have "doubts of faith" 
or who are disposed to rationally question the "faith" they profess and/ or that has been 
inculcated in them.
     The foregoing, evidently, has implications for the form of printing this book. One 
seeks to realize a serious critique yet, at the same time, that it not be academicist nor 
ultra-specialized. And indeed this book seeks to be fruitful while with academicism and
ultra-specialization there is, in reality, much sterility given that, with an esoteric 
language that the man in the street will never understand, one begins to submerge herself 
in a type of study where one begins to know ever more and more about ever less and less, 
until one ends knowing almost everything about almost nothing. This book instead tries to 
have a general character concerning the critique of economic orthodoxy and about the 
topics of heterodoxy. Obviously the orthodox economists will take advantage of that the 
criticize diverse parts of the work saying that it has insufficient academic depth (read 
"extension") and that such and such a theory has not been analyzed with such and such 
sophistication that was published in such and such a "paper." It is a price worth paying 
so that the book can reach more persons to whom the questions it treats are very relevant.
To create an academic treatise, apart from that it should have more than two thousand 
pages to represent a minimally "satisfactory" approach in accord with the standards of 
"scientific papers," would result in the book being read, optimistically with luck, by 
little more than a dozen persons.
     Nevertheless, not being "ultra-specialized" does not imply that the book has 
insufficient academic rigor. Even though the language can be considerably sarcastic and 
even amusing, we have sought to realize an approach of pertinent epistemological level and
an abundance of academic literature in books and specialized articles are cited. 
Accordingly, whoever wants to further deepen some topic can refer to the indicated 
reference in that regard and read those sources.
     On another side, is is also possible that the book be criticized for being "too 
radical." With regard to that, three replies might be given. In the first place, to 
welcome the compliment: radical means, in rigorous terms, "that it goes to the 
root" and precisely here we wish to arrive at the bottom of the equivocations of economic
orthodoxy. In the second place, if one wants to use the word in the sense of "extremist" 
one must say that in a certain way it also becomes necessary that there be such a type of 
ideas for in the current context a change is required and the "lukewarm" ideas do not tend
consistently to that but instead, in general, are simply "absorbed" and easily neutralized
by the dominant scheme. Finally, one must say that if it is radical it is not only one's 
fault but instead the orthodox economic theory has its "little share of blame." And 
indeed, this being the established theory, everything that questions it will seem a bit 
presumptuous and even aggressive. Equally, a man who shelters in an old doorway under bad 
conditions and it falls on him could obtain fame as a victim for that. Notwithstanding, 
the poor condition of the door also contributes its part of the blame.
     Yet beyond the foregoing, there will still be those indignant that such a 
"dignified" and "ancient" portal has fallen. They will say, who are you to refute two 
hundred years of economic theory? Well, to tell the truth, two hundred years is not long. 
Economics deals with a "science" still "in diapers" and in an evolutionary process. In 
fact, there have been in physics ideas of greater antiquity and prestige that also have 
been put seriously into question. The emotional attitude of wanting to conserve the 
"intellectual capital" in which we were raised, questioning, when faced with consistent 
criticism, the person who make it (falacia ad homnem) and not the critique itself,
leaves few possibilities for a genuine (and necessary) advance in knowledge.
     In any case, we are dealing with a struggle. And there a "heretic" needs a great 
heart sustained by the confidence that reason is on her side and that she will obtain 
recompense in the "other life." And the recompense in the "other life" of this book will 
be that there can be an economic theory authentically more open to other paradigms, which 
interacts more with other social disciplines and which has a more solid philosophical 
basis. That day, economic theory will be able to do greater and better things for the 
world. And, if there is a struggle that in the final analysis matters, it is the struggle 
for a better world. Let us begin, then, our intellectual contribution to this fight.

                        Chapter 1

                                        "Human action is always rational."
                                            Ludwig von Mises, Austrian economist
The orthodox theory of the rationality of the consumer

     The postulate of rationality is the fundamental postulate of orthodox 
economics. In essence it tells us that economic agents act rationally, which is, 
that they always administer their resources (time, effort or money) in such a way as to 
maximize their level of welfare or utility incurring the least costs possible.
     "The economic model for the conduct of the consumer is very simple: it affirms that 
people try to choose the best patterns of consumption that they can afford ," professor 
Varian tells us concisely in his famous manual of microeconomics. Thus, then, modeling of
the consumer behavior becomes rather simple for the orthodox economist. First she 
constructs a utility function of the general form U = f(x, y) which
captures the level of well-being (measured by U) that an individual experiences as 
a consequence of the consumption of determinate quantities of the goods x and 
y. Following this she finds the function of budget restriction of the 
consumer in question, or to say, the combinations (baskets) of the goods x and 
y that can be bought with the given level of income which is available. This budget
restriction has the form I = Pxx + Pyy, where I 
represents the level of the individual's disposable income and Pxx and 
Pyy are the respective prices of the goods x and y. 
Finally, she applies optimization determining the respective quantities that the 
individual should consume of the goods x and y to maximize her utility. That
is achieved by means of the intensive application of the differential calculus to consumer
conduct modeled by means of the two functions mentioned (utility and budgetary 
     Yet do not think that the majority of orthodox economists consider this model of 
rational choice only as a mere speculative representation of the conduct of 
individuals when they consume. Completely to the contrary. With reason some have spoken of
an "imperialism of the economists" in the sense that they seek to explain whatever 
dimension of human behavior by means of the Neo-classical theoretical apparatus of 
rational choice. Thereby, it becomes valid to consider that the soldiers, the kamikaze 
pilots, the heroin addicts, and even the suicides are mere maximizers of utility. A good 
example of that is the economist Gary Becker, Nobel prize in 1992, who has become famous 
by extending the Neo-classical method of analysis to fields that previously were immune to
economic thought such as marriage, robbery, drugs, and prostitution. He himself writes: 
"The economic focus is not restricted to goods and material needs nor to markets 
with monetary transactions, and conceptually does not distinguish between greater 
or lesser decisions nor between 'emotional' decisions and those of another type. 
Strictly...the economic focus provides an applicable measure to all human behavior: to 
all classes of decisions and to persons in all conditions.
     Thus, then, we see that in the writings of the current orthodox economists they make 
manifest a very particular vision of human nature: that of homo economicus. It 
imagines the individual essentially as a "rational calculator" who seeks to maximize her 
utility in a constant balancing process of costs and benefits.
     However, this vision regarding human nature is not new. Already in the 19th century 
the classical economist John Stuart Mill maintained that economics studied man "only as a 
being who desires to possess wealth, and who is capable of comparing the efficacy of the 
means towards obtaining that end...and as a being who, inevitably, does that with which 
she can obtain the greatest quantity of necessary things, commodities and luxuries, with 
the least amount of work and physical abnegation." Elsewhere, in his famous work of 1776, 
The Wealth of Nations, Adam Smith, the so-called "father of Economics," describes 
man as an essentially egotistical being from whom "it is not from the benevolence of the 
butcher, the brewer, or the baker that we expect our dinner, but from their regard to 
their own interest.
     It is understood that it is important to also indicate, for its operationalization, 
that the Neo-classical model of rational choice requires that certain assumptions be 
fulfilled, which are basically three:
1) Completeness: Before any gamut of options whatsoever, the individual always is 
capable of determining which she prefers.
2) Transitivity: If one prefers A to B and B to C, then she necessarily prefers A 
to C.
3) Monotonicity: The consumer is essentially acquisitive, always preferring having 
more to having less.
     Finally, it is necessary to specify that the concept of rationality which orthodox 
economics postulates is not teleological nor intrinsic, but instead more 
instrumental. In other words, it has to do more with the efficient administration 
of the means than with the rationality and/ or pertinence of the ends or the
constitution of the preferences themselves (for the orthodox economist these are 
"exogenous" and so remain outside the model of analysis). The Austrian economist
Ludwig von Mises agrees with the orthodox focus in this respect: "Praxiology (the science 
of human action) and economics...are concerned neither with the motives that lead 
one to act, nor with the ultimate ends of the action, but instead with the 
means which man must employ to reach the proposed objectives. However fathomless
may be the abyss from which the instincts and the impulses emerge, the means one invokes 
in order to satisfy them are the fruit of rational considerations which consider the 
cost, on one hand, and the result reached, on the other."

A useless function: the utility function

     As we have just seen, the totality of Neo-classical analysis rests upon the notion 
of a utility function, that is to say, that which captures the level of well-being 
that an individual obtains through the consumption of determinate goods. The objective 
will be to maximize that function given the restriction of income. This being so, the 
orthodox economists see it as very useful since by virtue of that, it is possible for them 
to construct sophisticated mathematical models about the conduct of the consumer. However,
we maintain that it deals with a useless and even pernicious notion inasmuch
as it does not permit approaching in a coherent way the dynamic of consumer choice.
     We begin by analyzing the problem of measurement. Utility, in being 
constituted as a mathematical function, must necessarily relate quantities. Yet in 
terms of what quantities can we measure happiness? We have units of measurement for 
weight, altitude, velocity...yet we do not have units in terms of which to measure 
happiness! To tell the truth, considered on its face, such a notion itself seems absurd 
for giving a coherent explanation of the consumer. One does not go around thinking: "I 
shall buy a blue pen instead of a red one because the first gives me 8 units of happiness 
and the second only 3." No, we do not make that type of cardinal evaluation in 
terms of exact quantities but instead we more perform an ordinal comparison in 
terms of which good is qualitatively more suitable to satisfy a concrete need ("I 
buy the blue pen because it is the color I normally use to sign documents").
     Surely the orthodox theorists will reply here, together with Samuelson, that 
"Generally the economists of today reject the concept of cardinal (or measurable) 
utility... Or what counts for the modern theory of demand is ordinal utility. With this 
focus, the consumers need only to determine their order of preferences among the baskets 
of goods." A very lovely reply. The problem is that it is not consistent with an 
essential principle for the orthodox theory of the consumer: the equi-
marginal principle! In accordance with this principle--which Samuelson curiously
expounds on the same page (!) as his previous sentence--the consumer should "adjust her
consumption such that the last dollar spent on each good provides the same marginal 
utility." The mathematical expression corresponding to this, considering the case of 
consumption of n goods is the following:

     UMg1/P1 = UMgn/Pn

Very well, to reach this expression it is necessary, in the first place, to apply 
derivatives to the utility function in order to obtain the marginal utility 
(UMg) with respect to each good and, in the second place, to
divide such results between the corresponding prices. Yet both processes 
necessarily imply a utility function in quantitative terms! Thereby the same Neo-
classical economists have placed the noose around their neck. If they want they can 
perform conceptual juggling arguing that "the utility function only uses numbers to 
summarize ordinal ranges." However one would have to respond, paraphrasing the Austrian
economist Murray Rothbard, that "the scales of valuation for each individual are purely 
ordinal and qualitative, and there is no coherent way to measure the distance between such
a type of ranges; in consequence, any concept involving such a distance is nothing more 
than a fallacy."
     We shall now analyze one of the constitutive notions of the utility curve: the
basket of goods. As we have seen at the beginning of the chapter, the analysis of 
the orthodox economists do not start with a function of the type U = f(x) but 
instead one of the form U = f(x, y) in which quantities of the goods x and
y are considered. Now, we all have the experience of entering a store to buy 
certain goods: we basically think about what we want to buy and decide how many units to 
take of each good. At times we go for a single good (a pastry that we craved, let us say) 
and other times we go for various (10 of bread and two cans of milk, for example). The 
decision process is clearly given in terms of how many units of each good 
we consider buying, and that is natural. Nonetheless Neo-classical economics rejects this
evident fact and depicts us as choosing not between different goods but instead between 
different baskets of goods. That is to say, for the Neo-classical economists we do 
not ask how much bread and how many cans of milk we want to take but instead that we 
perform a joint analysis comparing "baskets" of combinations or bread and cans of 
milk (eight of bread and two cans of milk vs. five of bread and three cans of milk, for 
example). But, why adopt a complication so counter-intuitive and absurd?
For a very simple reason: because the baskets can be topologically equivalent and thus 
assure artificially by force that the representative utility function will be 
mathematically well-defined. As is seen, the orthodox economists have no embarassment 
whatever in sacrificing clarity and realism to the functioning of their mathematical 
     Finally, we have the question of continuity. The orthodox economists assume 
that utility functions are continuous, namely, that they can consider utility values even 
for decimal or fractional quantities of the goods in question. That condition is 
absolutely necessary to the Neo-classical analysis because if it is not fulfilled 
it is not possible to apply the differential calculus and, in consequence, the 
optimization of the consumer cannot be operationalized. Yet, is this a coherent 
assumption? In no way. A good is defined as an object with the capacity of satisfying some
human need. Now, what concrete need is satisfied with 0.186 computers or 5.17 pens? That 
simply and plainly is not conceivable by the human mind and thus is not relevant to any 
choice in the real world. We human beings do not make decisions on the basis of infinitely
small steps. Ergo, the evidently extensive discretion within good and prices is made 
simply irrelevant to the Neo-classical theory (or how many of us daily confront decisions 
such as how to buy 0.4875 packets of crackers for, let us say, 1.28479 dollars).
     It is evident, then, that the notion of a utility function, in the context in 
which orthodoxy use it, not only generates no utility for economic theory but, on the 
contrary, constitutes an authentic hindrance to the objective comprehension of consumer 
behavior and therefore should be discarded and replaced because, as the saying well says, 
"that which does not help, hinders."

Inconsistent consistency: "rational fools"

     Independently of the above the Neo-classical economists were in any event conscious 
that to sustain their entire theory of the consumer in an unobservable mathematical 
entelechy was exceedingly problematical with respect to the empirical hallmarks. We see 
persons making consumer choices but we do not see the (supposedly) underlying utility
curves. It was necessary, then, to leave the notion of utility without sacrificing all 
the assumptions, axioms and constructs around the postulate of rationality. And it is 
there where Paul Samuelson comes to the rescue with the concept of revealed 
     Following professor Varian, "we would formulate the principle of revealed preference 
saying: 'If one selects the basket (combination of quantities of goods) X instead of Y 
(when it is possible to select that as well) one must prefer X to Y.' In this formulation,
it is evident that the model of conduct permits us to utilize the observed choices to make
some deductions concerning the underlying preferences." In other words, if under the 
theory of rational choice one deduces what a consumer would select starting from 
her preferences (modeled in a utility function), with the focus of revealed 
preferences he deduces the preferences of the consumer starting from her observed 
     Now, this focus on revealed preferences is evidently tied to the assumption of 
consistency. The individual interests are revealed in each act of selection. If it 
observed that some individual chooses a set of goods in place of another, then we say that
that individual has a revealed preference for the first set. Beneath this conception 
individual interests, choice and utility are essentially the same. In consequence, "with 
this body of definitions, the individual cannot help but maximize her own utility, 
except through the effect of inconsistency." Thus, the behavior of an individual is 
considered rational if it can be explained in terms of some preference relation consistent
with the theory of revealed preference.
     The problem with this definition of rationality as consistency is that it can 
lead to many inconsistencies. For instance, if an individual were to act contrary 
to what she really wants yet does so in a consistent fashion an orthodox economist would 
say that is a rational individual. Furthermore, he would say that, given she chose an 
option she did not want in place of one that (supposedly) she did want, she is 
revealing that in reality she preferred the first to the second, which would lead 
us to the logical (?) conclusion that in reality, she wanted what she did not want!
     And do not think that this is an absurd or exagerrated case. As we shall see below, 
behavioral economics and neuro-economics have repeatedly demonstrated that on many 
occasions we choose things which we would not choose if in reality we were to slowly 
consider our decisions. It is thus that Amartya Sen speaks to us of "rational fools," that
is, subjects who are capable of selecting--very "rationally" and "consistently"--things
they really do not want. And so internal consistency is not a sufficient condition for 
guaranteeing a person's rationality. It is still necessary to evaluate whether they 
act in consonance with their own interests or motivations and on the basis of externally
conditioned impulses. However, the impossibility of distinguishing between inconsistencies
and changes in taste puts such a possibility in doubt. Orthodox economics remains trapped 
in a dead end alley.

Economic individualism: a universal phenomenon?

     Anyone who possesses a basic knowledge of anthropology or sociology will have 
already noticed that one of the principal problems of the model of rationality which 
economic orthodoxy proposes is that it postulates as humanly intrinsic and historically
universal something that in reality is very conditioned and particular: 
individualism, a product of the capitalist spirit of modernity and English 
utilitarian philosophy of the 18th century.
     Perhaps many think that this represents an exagerration and say: "Yes, indeed we 
truly are individualists!" Nevertheless, that is due in large part to our societies (above
all in the West) having been modeled on the capitalist-liberal project of modernity and 
that type of behavior and attitutude towards life becoming common. In this manner, one's
tendency to improve one's own chances, which Adam Smith discusses so much, though in our 
day might seem indisputable, in reality depends upon the type of society. If it is of the
communitarian type (like the Andean society), or rests upon an organicist 
conception (like millennial Chinese society) or is hierarchically structured in 
terms of castes or estates (like the Indian society) vertical mobility will be very 
limited and the individual in general will live in conformity with the security that his 
material lot, except for catastrophes or exceptional events, will be the same for all the 
days of his life. If, additionally, the society in question does not believe in 
progress (an idea belonging to the rationalist philosophy of the Enlightenment) 
there will be no collective endeavor to improve economic welfare and, in consequence, the
individual's greatest preoccupation will  be in following and preserving the tradition of 
his forebears (think for example of feudal Europe).
     In fact, it is squarely in this line of reasoning that, pursuing economic 
anthropology, various critiques of the postulate of rationality have been realized. 
Thus, scholars such as Marshall Sahlins, Karl Polanyi and Maurice Godelier have 
independently demonstrated that in traditional societies the selections that people make 
in matters of production and exchange continue to follow the reciprocity which differs so 
much from what the orthodox model postulates that they have rather tended to call those 
systems "gift economies" instead of "market economies." An example of that is the famous
potlatch ceremony of the North american indians in which they gave away (and even
destroyed) all sorts of goods establishing a kind of duel of gifts where the emerging 
winner would be the one who might give the most valuable gifts to the others. As against 
this, the Neo-classical idea of the egotistical individual, perpetually dissatisfied and 
adverse to working became useless, since the happiest one was he who worked the hardest 
during the year in order to be the one who could give the best and greatest gifts to the 
village. And, in fact, they keep giving today, for example in "stewardship" of religious 
festivals that take place commonly among the Andean peoples whose migrants and/
or descendents, being those who have "invaded" and massively populated cities like Lima 
(more than 10 million inhabitants) in Perú, comprise the true economic motor of the 
country above all as emerging and even informal entrepreneurs.
     In line with the foregoing, another demonstration of economics based upon reciprocity
we find in the interesting phenomenon of "Andean rationality." It concerns a model of 
socio-economic interaction that has been developing since before the Christian era among 
the Andean population of South America and which is principally based on the logic or 
cooperation and reciprocity, as well as on communal property and joint work. So 
structured, the model of Andean rationality differs radically from that of the modern 
West: while in this latter one individually seeks to maximize benefits minimizing the 
risk, in the former the peasant seeks to collectively minimize his risk in order to 
rationalize his endowment of resources. Here one is dealing not so much with 
exploiting the soil to extract as much product as one can, but instead more with 
administering it in harmony with nature and the community.
     It would seem, then, that the orthodox economists, seduced by the entelechy (or the 
fetish?) of the market, must have forgotten that the economy is always and necessarily 
given in a specific socio-cultural environment and it cannot be understood outside of 
it. Thus, when they explain their models they begin by enumerating the assumptions 
upon which they are based yet they always forget to make the most important assumption 
explicit: that they operate in a capitalist market economy. It may seem a tremendous 
truism, yet in reality is not. There are many zones of the world where the socio-cultural 
environment does not entirely correspond with capitalism yet which even so function 
perfectly. Then, when an orthodox economist arrives at one of those she does not 
understand yet even so, on the basis of her pre-determined mental schemes, proposes 
politics of "development" that end by being socially destructive (although, it is 
clear, they will never take account of that because the "social" variables are 
"exogenous"). Furthermore, the incoherence of orthodox "developmentalism" goes to extremes
which, on one hand "reward" ecological and organic production via prices while on the 
other introduces massively anti-ecological trans-genetic cultivation creating "green 
     It is absolutely necessary, therefore, that we economists reflect profoundly upon the
following words of Polanyi, Arensberg and Pearson: "The majority of us have been 
accustomed to thinking that the touchstone of the economy is the market... What to do, 
then, when we come across economies that operate upon a totally different basis, without 
any market feature or gain obtained through buying or selling? It is then that we should 
revise our conception of economics."

Are we egotists by nature: a critique of the anthropological assumptions of
economic orthodoxy

     Orthodox economics sees man as an essentially egotistical being who seeks to 
satisfy his own necessities motivated only by personal interests. So important is the 
notion of egotist man for the orthodox theory that it is already taught in the first 
classes to students of economists throughout the world. Perhaps many of them consider 
egoistical motivation as something undesirable yet end by accepting it as the correct 
basis for construction of the economic theory (and reality) for, at the end of the day, 
they see it as an inevitable feature of human nature. Nevertheless, this uncritically
assumed belief should be critically analyzed.
     Perhaps it is due to the myth of egoistical man (above all in Western culture) only 
it was not until the decade of the Seventies that the scientists began to seriously 
examine their assumptions. One of the things that most surprised them was to find that 
qualities previously considered marginal in human behavior like empathy (to be able to 
feel what another feels), altruism (to help someone without expecting recompense) and 
other pro-social behaviors (sharing, helping, consoling, cooperating, et cetera) were much
more frequent than what had previously been believed. How can we explain the reputed 
Argentine philosopher Mario Bunge that "for man to be competitive over cooperative is 
simply false. We are all at once cooperative and competitive, and the majority of us more 
the first than the second. As the contrary we would not be capable of functioning as 
components of social systems, from the family to the transnational firm. To exaggerate 
competition at the expense of cooperation in the manner of the dialectical philosophers, 
the social Darwinists and liberal economists makes comprehending the very existence of 
social systems impossible."
     In particular, the most interesting findings have occurred in the study of babies 
(who have not yet reached school age and, hence, are still not continually compelled by 
their parents and professors to compete with their companions and outmatch them). The 
recently born does not distinguish clearly between herself and others, but cries more 
intensely when they hear the bawl of another baby, evidencing by that an innate tendency 
to respond to the needs of others as if one's own. At one year, they display worry when 
somebody is hurt or shows sadness. At a year and a half, the infant can already 
distinguish between "I" and the "other," but continues assuming that the feelings of the 
other are similar to her own. Already at two years of age, she distinguishes between her 
own feelings and those of others, yet even so seeks to console whoever displays signs of 
pain or sadness, and their empathic emotions are more developed. Thus also at three or 
four years of age it is common to observe all sorts of pro-social behaviors.
     The conclusion of these studies is that the tendency to be concerned for others is as
peculiar to human nature as is preoccupation with oneself. This does not mean that the 
human being is not capable of egotistical and even anti-social attitudes. Yet it does 
demonstrate that persons give evidence of an entire gamut of behaviors from the meanest 
to the most altruistic. Consequently, it becomes clear that the anthropological conception 
of orthodox economics sins from being excessively biased and simplistic.

Egoistic altruism? Ockam's razor and mother Teresa against economic orthodoxy

     As we just saw, a very evident fact exists that puts the myth of egotistical man 
directly in check: the fact that often we are willing to make sacrifices of our own well-
being for the well-being of others. Upon observing that one person is willing to sacrifice
themself for others the most reasonable is to think that he does it for love. However, 
orthodox economics has invented a more "intelligent" explanation: if a person is willing 
to sacrifice themself for another she does it through egoism. For example, 
economics Ph.D. Sean Masaki Flynn of Vassar College tells us: "The economists take as 
given that people make choices in life to maximize their personal happiness. This 
viewpoint invariably provokes objections, because people frequently are disposed to 
support great personal suffering to help others. Nevertheless, the the point of view of an
economist, you may consider this desire to help others as a personal preference. The 
mother who does not eat so as to give the little food she has to her baby may be pursuing 
a goal (helping her child) which maximizes her own happiness. The same can be said of the 
people who make donations to charity institutions. The majority of people consider such 
generosity 'disinterested,' yet it is also possible to suppose that the persons perform 
certain actions in order to make themselves happy. If people make donations because that 
makes them feel good, their disinterested action is motivated by an egotistical 
     This type of explanations of altruistic acts has two problems: one epistemological, 
the other empirical. The epistemological problem is that they violate a basic 
principle of science knows as Ockham's razor by which a simpler theory in 
explanation of a determined phenomenon should be preferred over another that is more 
convoluted. And indeed with the goal of maintaining intact the traditional version of the 
egoistical economic agent the orthodox economists have elaborated an entire series of 
complicated theories (like the already mentioned "egotistical altruism") to explain those 
facts which put it in peril. In consequence, a simple and direct explanation
has been relegated in favor of another complicated and indirect one.
     Obviously intervening there are the prejudices of the various members (in the 
majority English and North Americans) of the "scientific" community who construct (and
have constructed) the economic theory. The popularity of the egoistical interpretation of 
altruistic acts is not due, therefore, to scientific motives, but instead to the fact that
admitting the existence of love does not accord with the standard mental models of the 
human being manipulated and promoted in the West.
     Regarding the empirical problems of the egotistical altruism theory we have, 
in the first place, that a large part of the "evidence" in its favor already begin from 
the assumption that we are egoists (fallacy of petitio principii) or do not refer 
to authentically altruistic acts. Thus, the "evidence" that we have about various persons 
(including ourselves) who give alms solely to "feel good with their conscience" (which is 
evidently egoist) is not so because in reality there is no form of altruism or sacrifice 
for in reality the concept of "alms," at least in the subjectivity of this type of donors,
logically implies that it involves no sort of real sacrifice: our extra money is donated.
     On the other side, there exists strong and important evidence against the hypothesis 
of egotistical altruism. We take as reference one of the most representative cases: that 
of mother Teresa of Calcutta. According to economic orthodoxy mother Teresa performed all
her acts of sacrifice for the poor solely out of egoism. But note, they will tell us, not 
a mean egotism but instead more of an "inclusive egotism" by which mother Teresa would 
maximize her welfare maximizing the welfare of others. In this mode, its utility function 
will be of the form:

               UMT = f(dUP) such that:
               dUMT / dUP > 0
Where UMT measures mother Teresa's level of well-being, 
UP measures the level of well-being of the others (especially the poor 
of Calcutta) and the condition dUMT / dUP > 0 expresses that 
the higher the level of welfare of the others, the higher will be mother Teresa's welfare 
level (in other words, her utility function is a direct function of the utility of the 
     Now then, according to the Indian economist Amartya Sen, Nobel prize in 1998 and also 
known as "the mother Teresa of economics," our preoccupation for others can be based upon 
two types of attitudes: solidarity (I concern myself with others because it affects
my well-being) or commitment (I concern myself with others independently of how it 
affects my well-being). Following this classification most correct would be to say that 
mother Teresa's attitude toward the poor basically was commitment.
     For those who really know their history this becomes evident. And indeed during 
mother Teresa's beatification process various unknown aspects of her inner life kept 
coming to light which demonstrate her authentic commitment to God and to the poor beyond 
her individual "utility function." The most surprising of them is the experience of the 
"dark night of the soul" that characterized 50 years of her existence. She, who had given 
everything for love of God and the poor and being a great symbol of happiness and hope, 
had the constant experience of being abandoned, of not being loved. Her personal 
experience cannot be explained by the paradigm of home economicus nor by the thesis
of "egotistical altruism." Mother Teresa, evidently, does not pertain to economic 

Reasons of the heart: the ethical factor in economic decisions

     An essential postulate of the epistemology that drives orthodox economics is to 
separate aspects of the human reality into spheres or domains which even if 
"somehow" related do not deserve to be studied conjointly. Thus, constitutive aspects of 
social reality such as politics, history, culture, law, and ethics are designated as 
simply "exogenous" and, consequently, are not taken into account at the time of 
constructing the economic theory. As Shackle put it well: "It has been assumed that the 
field of economic events is enclosed within itself and is self-sufficient, separated from 
the rest of the matters of humanity by a wall of rationality."
     Going specifically to the theme of the rationality of the consumer and taking into 
account the aspect of ethics (the same is valid for the other realms: politics, law, et 
cetera) we find that if orthodox economics does not actually approach the consumer as 
immoral it posits them as essentially amoral: "For a homo economicus,
all that counts are the consequences of his behavior for his interests and desires in a 
concrete case. He is flexible and adaptable, and accomodates to each new situation with 
its specific restrictions... He does not voluntarily subordinate his personal 
interests to the interests of others or to the norms of morality and the law."
     However, as Sen has astutely observed, it is evident that just a motivation as simple
as egotism makes it impossible to untangle the economy from ethics. For rationality is not
something merely empty or instrumental as the orthodox theory purports, but instead it 
always has a content. The conceptions of rationality can be seen to be influenced 
by the motivations and values which are held. The economy does not originate in a self-
sufficient laboratory different from that of ethics. Values guide the behavior of 
individuals and they are institutionally conditioned, through example and education, by 
     In this manner, the individuals' selections can have ethical motivations and not 
thereby be irrational. Ethics has a very clear practical connotation in the inter-
relations between individuals and the prosecution of social welfare. It follows that the 
North American economist Kenneth Joseph Arrow, Nobel prize in 1972, in proposing his 
famous impossibility theorem warns that one should keep values in mind and not only
preferences as variable in the social welfare function and also that in order to achieve 
agreement between individual choice and social choice it is necessary for empathy and 
sacrifice to exist in the subjectivity of the individuals.
     If these considerations have not been incorporated into the orthodox economic 
analysis it is principally because the multi-dimensional complexity of the motivations of 
the individuals disrupts the ruling stability of the traditional economic models. Put 
otherwise, keeping in mind ethical considerations within the economic theory would imply
violating the characteristics of egoistical behavior and introduce new concepts relating 
to motivation (sympathy, compromise, norm of conduct, et cetera) which evidently would 
become very uncomfortable for the economic orthodoxy. Nonetheless, as Pascal said it well,
"the heart has its reasons, of which reason knows nothing."

An avalanche of anomalies: homo economicus visits the psychologist

     In the year 2002 a very curious event happened: the Nobel prize in economics was 
awarded to a non-economist, the Israeli psychologist Daniel Kahneman who, according to his
own declarations, never had taken an economics course. The approach of this psychologist 
was to put to test various of the assumptions of Neo-classical economics with respect to 
the rationality of the consumer by means of "heuristic methods" starting from which he 
determined that on various occasions a large portion of us do not behave in a "rational" 
manner. All this made space for a new focus in economics: behavioral economics. The
themes which behavioral economics has studied are various. One of the most interesting is 
that referred to as cognitive bias. In accord with this we are not self-centered 
subjects who objectively contemplate the available options but instead we allow ourselves 
to be influenced by the mere form in which they are presented (it has been found, for 
example, that people tend to choose a certain medical treatment is they are told it give 
them a 20 percent chance of survival yet tend to reject the same treatment when 
they are told they have an 80 percent chance of dying) and on occasion we are not even 
capable of identifying them correctly.
     Likewise it was found that we are much more likely to be controlled by habits 
than by calculated deliberations. In this mode, if we have a good experience with 
an initial product we tend to continually select it even when there are better 
options. So strong is the evidence in favor of this that starting from it Al Ries and 
Jack Trout have formulated their first immutable law of marketing: "it is better to
be the first than to be the best." They write: "Many believe that the fundamental question
in marketing is to convince the consumers that you have the best product or service. It 
is not so... The fundamental question in marketing is to create a category in which one 
can be first. It is the law of leadership: it is preferable to be the first than to be 
the best. It is much easier to enter the mind first than to convince someone that you have
a better product than the one which arrived first." Obviously they could not say this were
we rational consumers who always select, much in accord with the already mentioned theory 
of rational choice, the best option independently of how the options are presented.
     Following this Ries and Trout provide a very suggestive series of examples to prove 
their thesis: "One reason that the first brand tends to maintain its leadership is that 
the name often becomes generic. Xerox the first photocopier, became the name for 
photocopies. The people stand before a Ricoh, Sharp or Kodak photocopier, and say: 'Where 
is a Xerox?' They will request Kleenex when the box clearly says Scott; they will offer 
you a coke when all that they have is Pepsi-Cola. How many ask for self-sticking tape 
instead of Scotch tape? Not many. The majority use names of brands when they become 
generic. Gillette, Fiberglass, Formica, Gore-Tex, Jello, Krazy Glue, Q-Tips, Saran Wrap, 
Valcro; to name a few.
     In turn, the behavioral economists have studied the problem of the consistency
of preferences associated with the assumption of transitivity, and have found various 
incompatibilities. In effect, individuals often prefer A to B, B to C but not necessarily 
A to C. That can seem a  bit counter-intuitive at the logical level for we view it like a 
uniform comparison of numbers with a greater or lesser value, yet if we carefully analyze 
the empirical world we shall observe that such shifts actually exist. Or perhaps if we 
prefer an apple to a banana and a banana to an orange we will always and 
necessarily prefer an apple to an orange? No, it is not that simple. In any event, if 
one is not convinced, they can reflect more carefully about the strange decisions we make 
on the amorous plane. That suffices to give justification to behavioral economics.

Now homo economicus goes to the laboratory: experimental economics

     In the year 2002 the Nobel prize in economics was obtained not only by the 
psychologist Daniel Kahneman but also by an economist: Vernon Smith. Why? Basically, "for 
having established laboratory experiements as a tool in empirical economic analysis." 
With that there emerges, then, the paradigm of experimental economics.
     One of the most interesting topics in experimental economics is that referring to 
testing for possible rational conduct of agents in specific contexts of incentives, 
institutions, strategic interactions, and/ or artificially modeled market mechanisms. 
Thus, for example, they have found that in games of complementary strategy a small group 
of individuals with "pro-social" tendencies can significantly change the behavior of 
egoistical individuals. In this fashion, it turns out that egotism is not an 
unequivocally "given" condition in the interaction of agents but instead that their
survival, decline or development depend upon the praxeological context in which they are 
     Similarly, experiments relative to the "ultimatum game" have demonstrated repeatedly
that people are in general more disposed to sacrifice monetary recompense if it is small, 
which openly contradicts not only the notion of the individual as a marginal 
calculator but also the monotonic assumption according to which we are 
acquisitive beings who always prefer having more to having less.
     On another front, experimental economics has developed a very relevant innovation in 
pedagogy: the experiments with students. Basically it concerns economics professors who 
organize controlled dynamics with their university alumni in order to test certain 
postulates of economic theory. This type of experiment has become so important that 
prestigious scientific journals such as the Journal of Economic Literature include 
sections dedicated exclusively to experiments of this sort.
     A particularly interesting experiment in this respect was that organized by the 
German economist Reinhard Sippel at the end of the Nineties to test the hypothesis of 
consumer rationality. He presented a series of prices to his students which they could use
to "buy" diverse goods, with options established to test how rational the students were 
with regard to the benchmark of Neo-classical economics. The great majority of his 
students turned out to be "irrational" according to this standard because they violated 
some or all of the axioms covering preferences. They preferred A to B and later B to A, or
given a choice between A and B, chose A, later between B and C chose C, and between A and 
C, chose C.
     Yet do not think that experimental economics is charged with demonstrating that 
people are irrational without further discussion. As Camerer has said "the objective is 
not simply to create a list of anomalies, but the anomalies are used to inspire and 
structure formal alternatives to the theory of rational choice." What happens, then, is 
that the standards of "rationality" of the orthodox economists are so unrealistic and 
restrictive that the experiments have no option but to evidence their 
irrationality. For instance, in Sippel's experiment one sees clearly that the 
problem with the Neo-classical standard is that it does not take into account in a 
coherent manner the problem of temporality so that, as Veblen keenly observes, "the
marginal utility theory is of a totally static character. It offers no explanation 
whatsoever of any types of change because it is only concerned with adjusting values in a 
given situation." However, when one deals with real individuals (the pupils in 
the experiment in this case) one learns that the making of decisions is not an atemporal 
act but instead it is more that the human beings constantly confront the passage of
time and the conditionings intrinsic to it. In this way, life more resembles a continuous 
movie with many changing elements than a mere set of photos and, in consequence, the 
method of comparative statics of orthodox economics results in sterility.
     Thus, then, perhaps the orthodox economists should imitate the intellectual honesty 
of professor Sippel who, even when he had organized the experiment precisely with the goal
of demonstrating to his students that the orthodox theory indeed worked, felt obliged to 
admit that "the evidence in favor of maximization of utility is, in the best of cases, 
confused... Therefore, we should pay more attention to the limits of this theory as a 
description of how persons actually behave, that is to say, as a positive theory of 
consumer behavior.

Do not forget the right hemisphere! Performing an encephalogram on the consumer

     The advance of neuroscience or sciences of the brain has not been foreign to the 
economy. In fact it is thanks to them that they have been able to inquire into the 
physical bases of various of the discoveries of behavioral ecoomics, in this way giving 
birth to another new branch in economic studies: neuro-economics.
     As with behavioral and experimental economics, various studies have been performed 
with this new focus and very interesting results and conclusions. The goal is basically to
open the "black box of cerebral activity." We have there, for example, the famous study by
Sanfrey and others, who applied the "ultimatum game" to 30 persons connected to equipment 
to register neurological activity, with the objective of verifying the existence of 
significant differences in individuals before the different stimuli generated by distinct
offers. It suffices to say that the selected subjects participated in various rounds of 
the game, having human beings as opponents in 50 percent of the cases and a computer in 
the other 50 percent.
     The results were extremely interesting. They showed that certain regions of the brain
activated in a disproportionate manner when the subjects received "unfair" offers from 
human beings in comparison with what happened with "fair" offers from humans and with all
offers--fair and unfair--stemming from the computer. That evidently demonstrates that a 
physical basis exists in economic decisions and that these are not exempt from elements of
an emotional nature.
     A very important sub-branch of neuro-economics which is highly related to the theme 
of consumer rationality is that of neuro-marketing. This can be defined as an 
advanced discipline that researches and studies the cerebral processes which influence the
conduct and the decision-making of persons in the fields of action of traditional 
marketing: design of products and services, prices, positioning, publicity, channels, and 
     The contributions of neuro-marketing were crucial. As Néstor Braidot explains in his 
interesting book Neuromarketing: why your clients go elsewhere though they say they 
like you? this new discipline "allowed combining a set of affirmations from 
traditional marketing, like the efficacy of emotional publicity in brand loyalty or the
fallacy of attributing rational behavior to the consumer." Similarly it was discovered
that "the so-called buy button seems to be located in the middle pre-frontal 
cortex. If this area is activated, the client is not deliberating, she has decided to 
acquire or possess the product." Evidently this is very different from the consumer 
orthodox economics assumes, who very rationally deliberates over which will be the best 
option given her restrictions and preferences.
     And not only that. As Braidot well reports, neuro-economics, "on analyzing the 
topic of price, discovered that the maximization of utility based upon rational thought 
is not the principal motivation which weighs in decision-making given that, in most
instances, the triggering factors for the purchases were emotions, values and everything 
that activates the brain's system of rewards."
     Yet perhaps the most interesting part of neuro-economics might be the study of the 
particularities of each of the brain's hemispheres and how they influence our economic 
decisions, principally those of purchasing.
     As is known the human brain consists of two hemispheres: the left and the right. The 
left hemisphere is above all logical and analytic, being what we use when we 
verbalize a speech that we have prepared or resolve mathematical exercises or process the 
information in a sequential fashion, and is related to linear thinking. The right 
hemisphere, on the other hand, is above all creative and synthetic, being what we utilize 
when we accomplish a work of art or fall in love, or process information in a holistic 
form, and is related to creative thinking.
     Very well, it is evident that the left side of our brain corresponds much more to the
calculating and analytic activity belonging to homo economicus. Nevertheless the 
role that said hemisphere plays in our economic decisions is ever less for publicity and 
other forms of influence designed, developed and perfected for marketing are directed 
above all towards the right part of our brain causing our buying and consumption decisions
to be ever more emotional and impulsive. In this manner, directly "attacking" the right 
hemisphere manages to avoid that the rational and critical attitude of the left exceeds 
the first level, and thus a set of habits and preferences for irrational consumption are 
generated in the individual.

We are not omniscient! The problem of limited rationality

     One of the essential assumptions so that the orthodox postulate of consumer 
rationality can function is the assumption of complete information: consumers--and 
in general all economic agents--always consider all relevant information in order to make 
the best decisions.
     However, this assumption has been strongly questioned through the concept of 
limited rationality proposed by the United States economist Herbert Simon. In 
essence what Simon tells us is that we are not omniscient at the moment of making economic
decisions. In the real world we all have limited resources and information and, in 
the end, find ourselves necessarily obliged to make decisions based upon 
incomplete information and/ or analyses. The search for maximum utility 
involves too much time and effort; therefore, we settle for "reasonably good" decisions 
over "optimal" decisions.
     Evidently with this the sacrosanct mechanism of optimization so much used by 
orthodox economics in their mathematical models falls to the ground. Now it is not 
necessary nor even reasonable to think that individuals optimize. It is sufficient to know
that, in given contexts, they follow as best they can the norms established by the 
different sub-groups of society. Expectations do not have to be of the rational Neo-
classical type. People not always (or better put, almost never) have in mind all the 
variable, nor even the relevant ones. Often they try out decisions. Conventions dominate. 
It is necessary to rely on the behavior of the group, because of strength in numbers 
(think, for example, of the decisions referring to clothing, food or movies).
     We have, then, that limited rationality is compatible with sociological 
organicism because, as a consequence of these real-life deficiencies in the logistics 
of choice, individuals should follow procedures and rules based on experience and social 
practice. The Neo-classical theory, however, continues to cling to the deficient focus of 
sociological individualism.
     And this brings us clearly to the point of difference in the operationalization of 
these two visions concerning the economic agent. While for the Neo-classical paradigm the 
decision of the consumer is basically a mechanical and individual process, 
for focus on limited rationality we deal with an interactive and sequential 
process. And in effect: in real life the majority of times we do not make our buying 
decisions in an isolated fashion and only upon the basis of already given parameters such 
as the price but instead we already have in mind the actions and reactions of the other 
agents and we orient ourselves in relation to them. Thus, for example, we very much take 
into account the reactions and experiences of other consumers around us when we attempt to 
obtain technological innovations (software, cellular programs), recreational goods (trips, 
vacations) or fashion products (clothing, footwear).
     Meanwhile, limited rationality leads us to delimit our range of deliberation. 
We are simply not capable of thinking about all the possible options nor do we have a 
structure of preferences configured for all of them. Or how many of us have, for instance,
established preferences for a Boeing 747 or specific computer microparts? Yet it concerns
not only this type of examples. A decision as simple as choosing among different 
merchandise can already imply an immeasurable complexity in combinatorial terms. How many 
shopping carts could be filled with different combinations from among ten products? 
Several thousand! Thus, if the Neo-classical model of rationality were true, upon entering
a supermarket one would have to confront a decision comparable to having to select a 
shopping cart from among thousands hypothetically available in the parking lot each one 
full of different combinations of goods. But evidently it does not happen in this way. 
More likely what people reasonably do is to ignore all those possible combinations 
utilizing groupings of goods ("buy fruit" instead of "buy apples or oranges or pears or 
bananas, et cetera), habits ("I should always get canned soup"), charges ("my mother told 
me I should buy a box of cereal"), or other forms of practical simplification. It is in 
this way that in reality we act in our purchases. Ergo, the model of limited 
rationality is much more plausible than than of Neo-classical rational choice.

We are not cold calculators! The problem of uncertainty

     In his well-known (and critical) characterization of homo economicus the 
economist Thorstein Veblen, father of the North American institutionalist school, tells us
that "the hedonistic conception of mankind is that of an instantaneous calculator of 
pleasures and pains, which oscillates like a homogeneous globule of desire for happiness 
under the influence of stimuli that move him around the area, yet leave him intact." In 
other words, what Veblen is telling us is that for the orthodox  conception the consumer 
is above all a "cold calculator" guided only by that which causes her pleasure.
     Yet is this truly so? We definitely believe it is not. Human beings are exceedingly 
complex entities. We do not reduce to mere "instantaneous calculators" of pleasures and 
pains. We are, preferably, curious, active and erratic. We seek new ways of doing things, 
we probe, we equivocate, learn, do things out of habit, etc. We are, in summary, a 
substantial and diverse framework of social, cultural, historical, political, and 
psychological complexities; not mere optimizers.
     And all this complexity brings us to the problem of uncertainty. This derives 
from the previous paragraph: given that the agents never deal with complete 
information, they always confront the possibility that their actions do not furnish 
the desired result. The agent can make mistakes. Therefore, because of her
uncertainty, she always makes decisions under risk.
     Yet do not think that this is a condition merely external to the deciding agent. 
It is incorporated in her very subjectivity. Yet the Neo-classical theory has not 
wanted to comprehend this and at most arrives at formulating one model or another of 
"decision under risk" in which the uncertainty is treated by means of 
deterministic probability functions! This is an evidently inadequate treatment for 
it implies completely leaving aside the psychological process constitutive of all 
decision-making. And indeed, the orthodox Neo-classicals like it or not, here psychology 
is eminently endogenous, not exogenous.
     So then, the orthodox economists should be more humble and recognize the 
structural limits of their theory attending to the contributions of economic 
anthropology, behavioral economics, experimental economics, neuro-economics, the focus of 
limited rationality, and institutionalism and also learn from the scientific attitude of 
Carl Menger, founder of the Austrian school, who "with his attention fixed on reality, 
could not abstract, and did not abstract from, the difficulties which the subjects 
confronted" being always conscious that man "far from being an 'instantaneous calculator,'
is a creature who runs in circles, who makes mistakes, is poorly informed, tormented by 
uncertainty, perennially floating between attractive hopes and obsessive fears, and 
congenitally incapable of making decisions fixedly calibrated on the search for 
satisfactions." This seems a more exact description of the actual post-modern consumer,
whether the orthodox economists like it or not.


     The goal of this chapter has been to critically examine the orthodox theory of the 
rationality of the consumer. Basically we have seen that:
     1) The so-called utility function is not only useless but even pernicious to 
economic analysis insofar as it necessarily depends upon implausible and incoherent 
conditions like those of cardinality and continuity and unnecessarily complicates the 
analysis with the concept of "basket."
     2) To attempt to correct the foregoing adding on the theory of revealed 
preferences does not truly resolve the problem since the formal condition of 
consistency implied under this focus can lead to inconsistencies of content and generating
"rational fools."
     3) Strong evidence exists beginning with studies of agricultural economists that 
individualism is not a univeral phenomenon but instead is socially and culturally 
     4) On the basis of psychological studies it has been determined that the pro-
social tendencies (empathy, altruism, solidarity, cooperation, et cetera) are much 
more present in human behavior than had been thought and, therefore, the egotistical 
motivation model errs as unilateral and simplistic.
     5) The thesis of egoistical altruism is a mere ad hoc hypothesis of the Neo-
classicals that not only violates the epistemological principle of Ockham's razor but also
supplies important empirical evidence en contra (principle of the primacy of reality).
     6) Ethical motivations can influence (and in fact do influence) economic decisions 
above all in a sense which contravenes that postulated by orthodox economics yet without 
becoming "irrational" behavior inasmuch as ethics has a very practical connotation for 
social life.
     7) Behavioral economics has demonstrated that the greater number of us do not 
behave in the "rational" manner predicted by the Neo-classical theory given that our 
behavior and decisional process are found to be systematically affected by an entire 
series of psychological factors related principally to cognitive bias and inconsistencies.
     8) Experimental economics has validated the above finding furthermore that 
"pro-social" agents can have an effect on the behavior of the egotists in certain 
environments, that we do not necessarily take the marginal benefits into account and that 
on repeated occasions the assumptions upon which orthodox economics is built are not 
     9) Neuro-economics, by having demonstrated the great importance of the right 
hemisphere of the brain in decision-making for buying casts to the ground the idea of the 
centered and rational consumer who chooses automatically.
     10) The focus on limited rationality establishes that, given our limitations 
in acquiring, understanding and processing information, what is most reasonable is to make
decisions with bounded schemes and with simple rules and not acting "rationally" by means 
of calculation and detailed analysis of all the possibilities.
     11) The problem of uncertainty is not a mere external restriction that we can 
evade by means of probability calculations but instead endogenously affects our decision 
process, such that we are not "cold calculators."
     All this constitutes a powerful cumulative case en contra to the Neo-classical
postulate of consumer rationality. Therefore, the orthodox theory of consumer rationality 
is nothing more than a myth. May it rest in peace.

                        Chapter 2

                               "The laws and the conditions of production have
                                    the character of material truths. They contain
                                    nothing arbitrary."
                                            John Stuart Mill, classical economist
The orthodox theory of the rationality of the production function

     The production function may be the most important relation for technical 
analysis--as much microeconomic as macroeconomic--of orthodox economics. It may be the 
importance of this notion and the faith placed in it which caused professor Paul 
Samuelson himself, 1970 Nobel prize, to come to say: "As long as they do not revoke the 
laws of thermodynamics I shall continue relating inputs and outputs: that is, 
believing in production functions. While factors obtain their remunerations through
the offers made in quasi-competitive markets, we shall adhere to the Neo-classical
approximations in which the offers relative to the factors are important in the 
explanation of their market remunerations."
     Yet what is a production function? According to professor Nicholson's explanation in
his popular microeconomics text, "the production function depicts what the enterprise 
knows with regard to how to mix different factors in order to produce a product" in terms 
of a "mathematical function that records the relationship between a firm's inputs and its 
outputs. If output is a function of capital and labor only, this would be denoted by:

               "Q = f(K, L)"

...where Q represents the quantity of production of a concrete good over a period, 
K represents the machinery (that is to say, the capital) used during a said period 
and L represents the hours of work inverted.
     Then we learn that the great importance of the production function in orthodox 
economic analysis lies in that it might permit the businessman to know the quantities of 
capital and workforce he will need to use to reach a certain level of production. In this 
approach, the problem of the firm will be above all a technical problem. On 
this point it is very important to indicate as essential assumption for the 
construction of the production function: the assumption that one operates with a 
given technology. In other words, technology remains constant. This 
assumption is absolutely necessary for orthodox theoretization because were it not 
followed one would always be changing the functional relation between capital and the 
workforce and, ultimately, that would be simply impossible to express in determinate 
mathematical terms.
     Later, given the previous assumption, the orthodox economists advance to modeling 
production functions by means of the famous isoquants. But what is an isoquant? 
Well, nothing more and nothing less than a curve that shows the different combinations of 
capital and labor which would generate the same quantity of production. Graphically an 
isoquant would be as follows:
     A very important characteristic of isoquant curves is the degree of 
substitutability they present, or to say, "the facility with which we can substitute 
capital for labor or, in more general terms, how we can substitute one factor by another."
Why is this property so important? Because it permits the businessperson to fire workers 
replacing them with more capital or save on capital by contracting more workers 
maintaining the same production level as in the initial situation.
     And that takes us directly to the subject of the so-called typical production 
functions. In particular, the economists' favorite typical function is the famous 
Cobb-Douglas production function. The enchantment of this function resides in that,
given that the mathematical conditions of continuity and convexity are 
fulfilled, it permits "continuous substitution of factors" and, in the end, the intensive 
application of differential calculus to derive economic theorems. Its general form is:
Q = AKaLb.
     Another typical type of function is the Leontief production function, 
developed by the Russian economist and Nobel prize of 1973 Wassily Leontief and according 
to which the factors of production must be utilized in already determined fixed 
proportions to manufacture the product, such that there is no possibility whatsoever of 
substitution. The general form of this function is: Q = min (aK, bL).

The "Holy War" of capital: the controversy of the two Cambridges

     In the middle of the past century there occurred one of the most titanic intellectual
wars ever witnessed in the history of economics: the famous controversy of the two 
Cambridges around the definition of "capital" in the current orthodoxy. This "war" 
involved an effective army whose barracks commander was found in Cambridge, Massachusetts,
more specifically at the prestigious M.I.T. (Massachusetts Institute of Technology) and a 
fearsome army whose home general was to be found at Cambridge University in England. The 
ranks of the first army were comprised of the most prestigious economists of the era such 
as Paul Samuelson, Robert Solow and Franco Modigliani, among others. With regard to the 
ranks of the second army, these were composed of heretical economists (principally post-
Keynesians and neo-Ricardians) as fearsome as Joan Robinson, Luigi Pasinetti, Pierangelo 
Garegnani, and Nicholas Kaldor, among others.
     The first shot of this war came from Robinson in 1953 when she published a very 
heretical article entitled "The Production Function and the Theory of Capital." Her 
questioning was prophetic. She attacked the heart of orthodox economics placing under 
judgment the notion itself of a production function. She writes: "The production
function has been a powerful instrument of bad education. The student of economic 
theory is taught to write O = f(L, C) where L is an amount of work, C a quantity of 
capital and O a production level of goods. It asks you to assume that all workers are 
equal, and that L is measured in man-hours of labor; mentions to you something about the 
problem of index numbers involved in the selection of a unit of the product, and then 
quickly passes to the next question, in the hope that it does not occur to one to ask 
in what units is C measured. Before she stops to ask, she will already have become 
a professor, and thus the clumsy thought habits are transmitted from one generation to the
     Robinson goes on to ask: "Should capital be valued according to its irrevocable 
past costs or its unknown future profits?" That put the orthodox economists into grave 
straits. If they answered the second they fell inevitably into a fallacy of circular 
reasoning since in order to know the future earning potential of capital it is 
necessary to actualize its yields, that requires knowing the interest rate level, which in
turn is determined as a price in the capital market where, as much for supply as with 
demand for capital, it is necessary to already know measured and valued 
capital itself! Thus, what one sought to explain entered into the explanation and turned 
out to be a dead end (somewhat as if we were to ask someone "What is your telephone 
number?" and they were to respond "Call me and I'll give it to you").
     Yet the second option is also problematic. If the orthodox Neo-classical economists 
responded that capital should be valued as a function of its past costs they fell into the
serious, undesirable and dangerous extreme of endorsing the Marxist theory of 
capitalist exploitation. In effect, to price capital in terms of its past costs they 
would have had to do so in terms of the social labor quantity necessary to produce it and,
consequently, the production function Q = f (K, L) would have become the function
Q = f(L) where the only actually productive factor would be the labor and that 
would make it highly difficult to justify capitalist profit understood as reward to mere 
capital (think of the profits of the stockholders who possess yet do not work) for the 
entirety of the value would be produced by the labor, yet this would not receive 
all of the reward. In this manner, if they advocated for the second solution, the Neo-
classical economists culminated giving a great gift to the Marxists since they thus 
corroborate what Marx said, that  "capital is not solely the possibility of utilizing 
labor, as Adam Smith says. It is, in essence, the possibility of utilizing unpaid 
     Thus, more than 20 years of controversies elapsed. Hundreds of academic articles 
published about this debate. Many brilliant minds working on the problem. Much rivalry 
between the two sides... Yet nobody could consistently resolve Robinson's critique.
The orthodox side in Cambridge Massachusetts was defeated. Eloquent in this respect is the
testimony of Ferguson, the great martyr of orthodox economics: "The problem we confront is
not that of knowing whether the Cambridge critique has theoretical validity. It 
has. It is more of dealing with an empirical or econometric problem: does the system 
possess sufficient substitutability to establish Neo-classical results... Until the 
econometricians give us a solution, to confide in the validity of Neo-classical 
economic theory is a question of faith." What a man of faith! The heretics, on the 
other hand, we doubt...
     Another eloquent testimony is that of the orthodox economist Robert Solow who even 
came to admit that he had taught his theory of economic growth--intensively based on the 
aggregate production function--to the students at M.I.T. "for more years than one 
would like to remember." He also admitted that what he constructed was nothing more than 
an entirely simplified scheme, a "parabola" as Samuelson called it: "My dictionary defines
'parabola' as a 'fictitious narration or allegory through which moral or spiritual 
relationships are typically expounded.' If moral or spiritual relations, why not economic?
A parabola does not ask to be true to the letter, but instead to be well-
formed. Even a well-formed parabola has a limited applicability. There are always 
tacit or explicit assumptions serving as the basis for a simplified story. It may 
not matter for the point being discussed to explain the parabola; that is what parabolas 
make possible. When it does matter, the parabola can be deceptive. In a simplified 
model, there are always aspects of economic life that remain external. Consequently, 
there will be some problems upon which it sheds no light; but even so, there may 
be problems upon which it seems to shed light, but which in fact are propagating an 
error. Sometimes it becomes difficult to distinguish between both types of situation. The 
only thing that can be done is to honorably try to circumscribe the use of the parabola 
to the domain where in fact it is not deceptive, and that cannot always be known in 
     Yet it so happens that simply and plainly there is no domain where the "parabola" of 
the production function would not be deceptive. In effect, if the capital cannot be 
measured, it becomes absurd to construct a mathematical function (that is, with 
quantitative terms) on the basis of itself. Therefore, the "parabola" is empty of 
content. A logically inconsistent theory cannot ever be called scientifically 
valid concerning empirical reality, as Hahn had well recognized when he confessed 
that "when the aggregate version of the Neo-classical theory is used, simplicity is 
obtained at the cost of logical coherence and, in general, these theories deliver 
erroneous answers... The opinion that, despite everything, 'it can work in practice' 
sounds a little fraudulent, and in any event the responsibility to provide proofs falls 
upon those who hold this." Furthermore, when Solow says that "there will be some problems 
upon which it sheds no light; there will be some problems upon which it sheds no 
light; yet even so, there may be problems upon which it seems to shed light, but which 
in fact are propagating an error but even so, there may be problems upon which it seems 
to shed light, but which in fact are propagating an error" it clearly brings to mind that 
drunken man who sought the keys to his house far from where they had actually fallen, 
adducing that in the site where he was looking there was more light. Sincerely laughable 
(if not to make us cry).
     With all this, the Neo-classical production function continues to be taught. In 
economics departments around the world the professors keep training (and besotting)
their "university children" with humorous stories of "Neo-classical parabolas," thus 
transmitting, from generation to generation, those "clumsy thought habits" of which 
Robinson spoke (yes, though you may not believe it all this continues being taught in 
economic theory courses...and the uncritical pupils keep becoming 
     The orthodox position in this respect has already been thoroughly refuted, yet none 
of this has been incorporated in a clear fashion into standard economic theory. The 
strategy of silence rules. Practically no professor or academic talks about these 
problems. Or if they speak, they ignore or "neutralize" them. And the same occurs with 
"over-curious" students. If anyone dares to mention the Cambridge critique in class, she 
will be told it is off the subject or that that will be explained afterwards but 
first they must strive to understand the Neo-classical theory (with this achievement the 
student forgets the question in the short term, subjects her mind to the corset of Neo-
classical theory in the medium term and now will never ask uncomfortable questions in the 
long term).
     To conclude, a very significant datum. Paul Samuelson received the Nobel prize in 
1970 for his "contributions to the betterment of analysis in economic science," Franco 
Modigliani received it in 1985 for his "pioneering analysis of savings and the financial 
market growth," and Robert Solow in 1987 for his theory of growth, entirely based upon the
production function. No participant from Cambridge in England--not even Robinson (?!)
received this distinction.

Things become viscous: "molasses" and the aggregation of capital

     Following the above line, we now analyze the aggregation problem, which is to 
say, that referring to how the different elements can be grouped that enter into 
production of variables K, L and Q to be able to coherently construct the 
     With respect to the aggregation of the product (Q) there is no great problem. 
While the good is homogeneous it will always maintain commensurability: apples plus apples
will give us apples and chairs plus chairs will give us chairs. With regard to the 
aggregation of labor (L) the thing is a little more complicated because in a 
business there are different types of work and workers and not all are homogeneous (an 
hour of work by the engineer is not the same as an hour of work by the accountant or the 
laborer). Nevertheless, even though "we take a wide view" and consider the labor factor as
if it were a more or less homogeneous element summing it in terms of man-hours. However, 
in the case of the aggregation of capital (K) the thing becomes practically 
impossible. Capital is neither homogeneous nor divisible. There is in it an 
irreducible element of incommensurability and, in consequence, it cannot be 
simply aggregated. Therefore, once again the question arises regarding the very 
existence of the production function such as it is approached.
     However, the first Neo-classical authors were already conscious of this problem and 
to solve it postulated the existence of a sort of magical substance that provided capital 
with incredible plastic and malleability capacity: "molasses." Thanks to this "substance" 
capital not only became a multi-purpose and homogeneous good, but also it could be treated
as a flow and, at the same time, as a stock. In this manner, the blessed "molasses" 
functioned like a "philosphers' stone" for orthodox economics: it converted into gold its 
unusable and used up theories and promised to give eternal life to the production 
function. However, Joan Robinson arrived to ruin the party. After her lapidary article 
nobody could allege lack of knowledge of the difficulties that encumbered this type of 
magical resource used to "simplify" reality.
     Yet let us return to the aggregation problem. We had seen that if indeed the labor 
factor could be apparently homogenized into "man-hours" the same could not be done 
with capital given that a basic term of commensurability for it did not even exist. Let us
illustrate by way of example. Suppose that we are in a bakery in which there is a 
computer and an oven. In this case the computer as much as the oven forms part of the 
capital of the enterprise yet they are not the same thing nor have the same price. 
Thereupon, if we assume (as the orthodox economists do) that there is a generic price "r" 
for the computer and the oven by the fact that they form part of the "capital" we are 
tacitly asserting that this capital is some type of homogeneous substance which can be 
added, subtracted and divided, when the fact is that, given their heterogeneity, 
this is not so: an oven divided into two is not an oven, nor even a capital good; half an 
oven plus half a computer is not a new machine.
     But there remains another option: to price in money each one of the elements that 
comprise the capital and later sum the quantities of money. "Eureka, we have found a 
method to homogenize and, therefore, to aggregate capital!" the orthodox economists will 
say. Yes, congratulations. The bad news is that this method of aggregating capital does 
not work being incorporated into a production function! In a production function one must 
include physical units or K and L, not sums of money. Furthermore,
this method of aggregation of capital can result in leading to many absurdities and 
contradictions. Let us imagine, for example, two identical enterprises with the same 
physical endowments of capital and labor, yet which are differentiated by the fact that 
one of them has paid a higher price than the other for the same machinery 
(capital). The stock of capital measured in money is greater in one than in the other: is 
it therefore more productive? Does that allow increasing the quantity of the product 
fabricated per hour? No. Ergo, monetary valorization alone does not allow solving the 
aggregation problem.
     Nevertheless, current microeconomic and macroeconomic texts keep speaking about 
capital as if treating a homogeneous and malleable substance; to capital can be added more
capital, a part can be removed and another added, and it keeps being capital. That deals 
with a lie. A lie upon which basis have been constructed very beautiful and sophisticated 
macroeconomic models (Solow's model, Ramsey's model, Diamond's model, Romer's model, et 
cetera). Yet a lie in the final account.

Murdered with its own sword: mathematics against the economic orthodoxy

     One of the things that the orthodox economists most treasure is the logical rigor of 
their theories, which they achieve, according to them, by means of the mathematization of 
all the economic analysis. "One must always use mathematics to be rigorous, one 
need never fall into discourse," they say.
     However, it is precisely in this respect that it becomes quite ironic the the Neo-
classical economist, who so insist on the use of mathematics to avoid logical fallacies, 
systematically evade the critiques which are made of the very logico-mathematical 
fundamentals of their theories. In order to see that, we return to the traditional 
Cambridge critique concerning the Neo-classical theory of capital. As we have seen, this 
critique was not limited to indicating that the Neo-classical assumptions were forcing 
reality but also--or better, above all--demonstrated that the orthodox theory of 
capital had internal inconsistencies. Nonetheless, the years have passed and, 
despite the vainglorious orthodoxy of "theoretic rigor," the question persists without 
     Next, given that in the Cambridge controversies we have an example of how mathematics
can be used to make logical fallacies evident, we shall present a simple demonstration of 
how the Neo-classical conception of capital is incoherent. In other words, we will kill 
the orthodox school with their own sword.
     With y the output per worker, k the capital per worker; r the 
interest rate for rental of capital; w the wages; and y = f(k) the per 
capita labor production function, we have:

               y = rk + w

Very well, taking the derivative, we have:

               dy = + k.dr + dw

And given that, in theory, "r" is equal to the marginal productivity of capital:

               r = dy / dk

From which, simplifying, we will have capital being defined as:

               k = - dw / dr.............................(1)

However, additionally, we know that:

               r.k = y - w

Therefore, simplifying, we have another definition of capital:

               k = (y - w) / r...........................(2)

     Thus we have two definitions of "k" given by (1) and (2) and they will only be 
coherent if they coincide. Lamentably for orthodox economics, that only happens--as 
Samuelson demonstrated--in the case where all the compositions of capital in all the 
sectors of the economy are equal, which evidently never happens under capitalism (would
anyone be disposed to postulate that the composition of capital in agriculture is exactly 
the same as in mining or industry?) The orthodox theory only works for an absurd 
and non-existent case. Yet let us not be ill-mannered, and so excuse ourselves as 
Robinson excused herself: "I am sorry if I give the impression that it does not bother me 
that two exactly equal pieces of equipment can represent different quantities of 
accumulation of capital."

The production function castrated: the sterility of the orthodox theory to explain the 
technological process

     We had seen that one of the essential assumptions for the construction of the 
production function was that the relation between capital and labor remained constant. The
consequence of that? That the orthodox theory remains irremediably "castrated" during the 
moment of explaining the most important and crucial element of production: 
technology. Let us see why.
     By technology orthodox economics understands the given sets of information and
knowledge that can be applied to the production of goods and services, i.e. the 
knowledge held by the firm about the different production possibilities, 
which in turn are determined by the engineers.
     By now one can posit various critiques of this vision of technology. In the first 
place it is inconvenient because it treats (even if it be only "methodologically") as 
static and exogenous something that is essentially dynamic and endogenous. In 
effect: technology is more a process than a result. Even further: it deals with a 
continuous process that develops at each moment within the same enterprise, 
as the evolutionist school of technological change maintains as well as a Neo-
Schumpeterian focus on innovation according to which, as an inevitable 
consequence of the evolution of capitalism, innovation comes to be a systematic 
activity of the large firms with the capacity to invest in R+D (research and development).
     Yet do not think that the endogeneity of the technological factor is only 
something pertaining to large enterprises (if indeed a more conscious, systematic and 
organized mode is found in them). It is valid for all types of businesses. That becomes 
evident, for example, if we begin to see the workers as "human capital" with freedom and 
capabilities instead of seeing them simply as "factors of production" almost comparable 
with raw materials. The workers form a continuous, inevitable and 
constitutive part of the enterprise's technological progress to the extent that 
they keep learning special abilities for executing their work and, therefore, for them 
technology cannot be considered as given (and still less in our times of 
professional ultra-specialization).
     Now, returning to the critique of the orthodox conception of technology we find that,
by defining it as a given stock of information which does not need to be explained,
this paradigm is limited only to describing its impact upon the production function and 
the equilibrium conditions leaving aside that which would be more important to 
know: the origin and the causes of technological change. Thus it is that
Pepall, Richards and Norman tell us that: "The Neo-classical focus does not lack 
weaknesses. Although it indicates the way in which the firm's production plan 
changes in response to changes in inputs and the price of production, in reality it 
tells us little about the way this plan is designed. In other words, it reveals 
little about what happens inside the business, and more specifically the way in which 
the different competitive interests of the administration, the workers and the 
stockholders are reconciled in the design and execution of a production plan."
     Clearly shown in the above is the fact that despite practically all orthodox 
economists recognizing that changes in technology progressively and 
radically alter production they are not interested in developing a consistent 
theory which explains their dynamic and center more upon explaining by means of the 
blessed production function how the utilization of factors is optimized with a 
given technology. An example of that is the already variously cited professor 
Samuelson when in the part referring to the production function in his famous economics 
manual begins by explaining to us that the level of production that can be obtained from a
determinate set of factors "depends on the state of technology" whereby it follows, 
returning to the minutia explicable in class, to say: "yet at any moment there will be a 
quantity of product obtainable starting from given quantities of the introduced 
factors." We see, then, the essence of the strategy (fraud) of orthodox economics: 
to recognize the importance of the important so as later to commence theorizing over 
things without importance.
     Meanwhile, with regard to the orthodox conception of technology it also must be said 
that it becomes inconvenient because it distorts and hides the true nature of business 
technology selection and also abstracts from the intrinsically uncertain, random and 
probabilistic nature of technological change. In effect, the enterprise has no 
certainty regarding its choice, as the Neo-classical theory pretends with its dynamic 
of optimization, yet instead randomly scrutinizes the technology, even within itself, 
developing R&D projects on the basis of its own knowledge and technological learning 
in order to later decide on a basis of satisficing over and above that of 
optimizing. Given this context, even the "advanced" Neo-classical models for 
explaining the dynamic of technological change, like Romer's model, become irrelevant. 
And, it is clear, this drama of sterility is even more evident in Solow's famous model, 
taught as the basis of macroeconomic growth theory in practically all the economics 
departments of the world, now that the conclusion for this model is, paradoxically, that 
the model does not work, so should be the dynamic for the unexplained 
variable A (that includes technology) which will explain growth (do the orthodox 
economists have to commit so much mathematical juggling to arrive at the obvious, that 
technological progress is the funamental factor for growth?)
     Now then, the assertions of the evolutionary school of technological change 
seem more relevant in this regard than the most sophisticated Neo-classical models. And 
indeed, even though one must always take care with unjustified extrapolated notions from 
the natural sciences to the social sciences, the basic schema of the "theory of evolution"
through random mutation and natural selection, constitutes a schema with great heuristic 
capacity to analyze the way that firms perform their "technological search" in a 
changing, uncertain and competitive environment where they must survive and progress.
In this context, as we have already said, the firm acts more on the basis of 
"satisficing" than of "optimizing." In fact, as the evolutionary economist Sidney Winter 
has shown, the Neo-classical theories of endogenous technological progress on the basis of
businessmen  who optimize the stock of information for production are logically 
inconsistent because they end by implying an ad infinitum regression: "It can be 
said that a determined maximizer of profits will adopt the form of organization which 
requires observation of those things it is beneficial to observe at the moments when it 
is beneficial to observe them: the simple reply is that that choice of an informative 
structure which maximizes profits requires information and it is not evident how the 
aspiring maximizer of profits is to acquire such information. Or which guarantees that she
does not pay an excessive price for this information"; so, at the end of the day one must 
seek "satisficing" and not necessarily "optimizing" conduct since there "should be limits 
for the spectrum of analyzed possibilities, and such limits should be arbitrary in the 
sense that whoever makes the decisions cannot know that they are optimal." It would not 
seem, then, that technological change occurs in the manner suggested by even the most 
sophisticated orthodox models of "endogenous growth."
     Also, from the Marxist viewpoint, with its wider and more pertinent concept of 
"development of the productive forces," the reductionism of the Neo-classical scheme has 
been criticized by simply discussing this as something purely technical without taking 
into account the intrinsically implied historico-social aspect. Arrizabalo writes: "One 
thing is the formulation of a productive workforce, strictly associated with their 
technical production capacity, in an asocial mode and, thus, exclusively related to 
productivity. Another thing, very different, is the economic and thus social category of 
productive forces, a category that goes far beyond a purely technical consideration. 
Certainly the productive forces are based upon the productive capacity, which depends in 
turn on the combinations that can be established between living work and the available 
means of production. Yet in no case are these combinations divorced from the social 
'rules of the game' (the relations of production) that determine which of those 
combinations is actually carried out." It is clear, therefore, that the Neo-classical 
conception of technology is absolutely impoverished and sterile.

With what  shall we produce? Critique from the ecological perspective of
the production function

     Let us imagine for a moment that the production function that orthodox economics 
presents is valid. And then, let us imagine that, in fact, we have to carry out a 
real production process upon its basis. Let us think, for example, of the 
production of a cake. What do we need for it? In accordance with the Neo-classical 
production function--of the general form Q = f(K, L)--we would need the elements 
capital and labor. We gather, then, all the elements of capital (defined as 
the set of instruments utilized for production): pitchers, bowls, vats, pallets, 
oven, molds, knives, etc. Now we gather the elements of the labor factor: basically it 
would be our own workforce (or that of a pastry chef contracted for the term) with all 
the abilities incorporated for making cakes. Then, given a technological configuration, 
that is to say, a relation established between the productive factors (Q = f(.)) 
re-uniting the elements of capital (K) and labor (L) that we have 
enumerated, we should be able to obtain the product, or that is a cake. But we do not 
obtain anything! It is not possible... There must be an explanation...
     We try an intensive incrementing of productive factors: we obtain much bigger vats 
and contract with various pastry chefs whom we instruct to mix more rapidly...yet not even 
thus do we obtain a single cake! "Why?" we ask disconcerted.
     The answer is very simple: nothing is produced because there are no raw materials 
with which to produce! It does not matter how many vats we get nor how many cooks we 
hire nor how rapidly they stir-if there is no batter to mix! And in effect: basing 
ourselves upon the Neo-classical production function, we have gathered together all the 
elements of capital and labor yet have not taken raw materials into account at all.
We have enumerated various things, surely. Yet at no time have we mentioned flour, sugar, 
eggs, etc. Thus, basing ourselves upon the Neo-classical production function, we have 
attempted to be God: we have wanted to create something from nothingness! However, it 
becomes evidently absurd in this context and in any relating to a real productive 
process: one cannot make a cake without cake batter. One cannot produce without raw 
     So then, it is precisely on this basis that the great economist Nicholas Georgescu-
Roegen, father of an ecological focus, presents his critique of the production function 
and of orthodox economics (which he rightly calls "pencil and paper economics"). He starts
by analyzing the physical bases of the productive process and from there jumps to 
viewing the implications of the First Law of Thermodynamics (whereby "Matter is neither 
created nor destroyed, only transformed"): one cannot produce without a material 
basis. Consequently, the Neo-classical production function becomes inconsistent
and absurd for not taking the factor nature into account.
     And it was expected. In the 19th century, the era when the Neo-classical school was 
born, they still believed in the so-called "theory of indefinite progress" and the 
modernists asserted that the resources of nature were endless such that there never
could be a limit to human prosperity. The orthodox theorists assumed this belief and on
its basis constructed the economic theory. Thus, the most essential and 
limiting factor of the economic process was left totally aside: the ecological
factor. Nevertheless, as Max Neef put it well: "There is no economy that would be 
possible exclusive of the services offered by the ecosystem. This is so absolutely 
evident and obvious that is is truly an epistemological scandal that in no 
economics textbook, if one goes to the final word index, can they find the words 
'ecosystem,' 'nature' or 'thermodynamic.' They do not exist! They simply do not 
exist. Why? Because the economics which is taught is conceived as a system closed upon 
itself having no relation with any other system...when obviously it is inserted in a 
larger system that is called the biosphere and around which come all the services 
offered by the elements of that biosphere. Where will the economist be is photosynthesis 
ceases? There would be no economists! What would happen to the economy if suddenly all the
world's bees were to die? There would be no pollenization... Yet no economist presumes 
that he must know this... That entire part is presented as a gigantic sea of ignorance on 
the part of the economy." In other words, there cannot be economics without ecology
and orthodox economists have not even acknowledged this.
     "But the problem is easy to solve!" the orthodox economists will say. "We add the 
factor R (natural resources) to the production function, and it's ready!" What 
ignorance! An ignorance only comparable with that also shown by such economists when they 
pretend to have comprehended the process of technological change only because they have 
incorporated a variable A in the production function.
     Let us see. It will be a "Solow-Stiglitz" variant of the production function (what 
they call the artifice with which they have pretended to solve the problem) in a Cobb-
Douglas format which is:

               Q = Ka Lb Rc

               such that: a + b + c = 1

     How a Cobb-Douglas function is treated implies complete substitutability of 
factors, which is to say that one can replace one of the factors with another (or 
others) maintaining the same level of production. But it is precisely there where 
the inconsistency resides.
     Mathematically, if R (natural resources) tends to zero, such a 
diminution can be compensated with increases in K or L maintaining the
same production level. The multiplicative structure of the function permits that. 
However, this becomes inconsistent on the factual plane because if R tends 
toward zero, K and L must necessarily do so sometime. In the first 
place, because they depend on R: the capital goods are products of a previous 
process that already presupposes the natural factor and, in turn, the workforce requires 
natural resources to sustain itself (can anyone imagine what would happen to our 
productivity if we only imbibed the equivalent of one glass of water per day?)
In the second place, because the amount of the product that capital and labor can generate
always and necessarily depends upon the flow of inputs to be transformed (it
does not matter how rapidly the pastry chef stirs or how big the available vat is, for 
without having ingredients for the dough she will be unable to make a single cake).
     So then, the Georgescu-Roegen critique of the production function shows us clearly 
that the economy has ecological limits. And that brings us to a central concept for
analysis: entropy (growing and irreversible decay or disorder) which implies that 
in a closed system (dimensionally bounded) and assuming matter as a packet of condensed 
energy (read ordered or organized, as it is in practice) and every time it is transformed 
(for example, burning wood to ashes and smoke but obtaining light and heat) what we are 
doing at root is disordering it and that is irreversible. And also, and with this the 
explanation is complete, if the scientists of the future succeed in obtaining wood 
starting from smoke and ashes, that which is certain is that the quantity of energy they 
would have to use for that would be greater than that generated by burning it (they, 
knowing that by the law of entropy there is no perfect reversibility, would 
not undertake such an absurd project). Ergo, the benefit from the qualities of natural 
resources has an objective limit and capital and labor cannot forever exploit nature 
because it too is subject to the law of diminishing returns.
     And that is not to mention the problem of the residues and ecological contamination 
that all productive processes imply. In effect, given that--due to the law of 
entropy--it is impossible to arrive at 100 percent efficiency, to produce something 
always and necessarily generates a residue or waste which must be treated. It is to say, 
after making a cake it is needful to clean the kitchen and wash the utensils. And the 
same applies for the planet earth as a whole which, imprudently, we are not doing.
     Nevertheless, orthodox economics has systematically left all this to one side. For 
them the ecological factor is purely exogenous. Now then, etymologically 
economics means "administration of the household." And our house in the last 
analysis is the planet earth. Yet orthodox economics has proved itself--evidently--as a 
poor administrator of it because, by leaving the ecological factor out of the analysis, it
necessarily carries a large part of the blame for the current problem of global warming
which advances uncontrollably operating against our very survival.

A supposition it is necessary to substitute: the assumption of substitutability

     As we have seen, one of the essential concepts of orthodox production theory is that 
of substitution, which is that referring to the possibility of substituting one 
factor for another without changing the level of production. Thus, under this assumption, 
the economic problem was reduced to finding that combination of factors (capital and 
labor) that enables reaching the highest isoquant curve (that is, the greatest production 
possible) given the isocost restriction (that is, the budget utilized by the enterprise 
to contract for the distinct factors of production). In turn, in reference to the theme of
"degree of substitutability," we recall that there were two typical forms of the 
production function: the Cobb-Douglas and that of Leontief. And it is upon those that we 
shall center our analysis.
     Let us see. Between these two types of typical functions orthodox economic theory 
strictly prefers Cobb-Douglas to that of Leontief. Why? Because the former--once 
complying with the mathematical conditions of continuity and convexity--
allows for "continuous substitution of factors" and the intensive application of 
differential calculus, while the second display a zero degree of substitutability and, to 
top the evils, is not derivable - remember that its general form is Q = min(aK, bL)
In other words, the Cobb-Douglas function is a "well-behaved" function--according to the 
same Neo-classical economists--whereas Leontief's function of fixed coefficients would be
a "spoiled" function.
     Yet beyond how the orthodox economists feel with regard to the Leontief function, we 
have to ask ourselves in the interest of scientific realism which is the type of 
production function more consistent with reality. So then, for anyone who has some 
real experience with the phenomenon of production and who has not remained simply 
and fully with what the microeconomics manuals say, it will be evident that reality has a 
"strict preference" for the Leontief production functions. Why? Because, as common 
sense well advises us, the most reasonable is to think that the relationship between 
labor and capital is, in practically the totality of production methods, one of 
complementarity over that of substitutability. A form of production is 
almost never found where one can simply replace capital with labor (or vice versa) 
maintaining the same level of production (we leave it as an exercise for the reader to try
to think of one). Every machine will be in general complemented by a fixed quantity of 
workers that cannot be varied or which can be varied very little. Thus, for example, once 
we have decided how "modern" or technified our bakery should be, the engineers will tell 
us that to use the installations over a period of time t it will be necessary to 
apply an average workforce flow in order to remain within that parameter. In this manner, 
if we attend to the real world, the most probable is that we will not obtain "well-
behaved" isoquants so needed by the orthodox economist to display her preparation in the 
calculus of derivatives.
     Some might object to this point saying that indeed there are some microeconomics 
manuals, such as that of professor Nicholson, which speak of the great importance and 
realism of the Leontief production function. Nonetheless, whoever holds that must also 
concede that in those same manuals, even though they accept the existence of various types
of production functions besides the Cobb-Douglas, they conclude developing practically 
all argumentation on its basis. One repeats, then, in this instance the ingenious 
sophistical gimmick that orthodox economics applies to technological change: to recognize 
the importance of the important so as, nevertheless, to later advocate unimportant 
     It is evident, then, that the orthodox manuals sacrifice the realism of the theory 
in favor of mathematical elegance. And indeed, as Martin Shubik well stated in his very 
heretical article "A Curmudgeon's Guide to Microeconomics": "probably one of the most 
important technical considerations that led economists to adopt the concept of continuous 
substitutability among input factors would be that continuous isoquants (like those of the
Cobb-Douglas type) are easier to form than the discontinuous (like those of the Leontief 
type) since "if one wants to present the theory utilizing calculus it is convenient to 
have curves like a pair of derivatives defined at every point."

The final blow: the sophistry of empirical validation of the production function

     At this point the reader should have lost all faith in the theoretic validity of the 
so-called production function. Nevertheless, it must be said still that various orthodox 
economists hide under the viewpoint according to which the validity of the Neo-classical
theory is an empirical and not a logical question. In particular, what they argue is that 
the cited Cambridge critique is correct in a formal sense but that it has no consequence 
in the real world. "It is true, the theory is inconsistent... Yet it continues being valid
because it still functions," they maintain.
     The empirical proof that normally is used to back up this position is comprised of 
the numerous regressions performed with different Neo-classical production functions in 
which the awaited coefficients have been produced.
     Sato's declaration is eloquent in this respect: "While we live in this world, we 
need not abandon the Neo-classical postulate. In order to reject it, it is necessary to 
demonstrate that this world is imaginary. This demonstration has not been attempted by the
literature... My argument is that the state of the question at this moment tends to 
establish the world in which the Neo-classical postulate dominates... Furthermore, the 
same Neo-classical postulate is the empirically proveable principle in the form of 
estimation of the "CES" production function and other varieties. This can cause us to go 
beyond the purely theoretical speculations upon this theme."
     In fact, the confidence which the orthodox economists place in the empirical validity
of the production function is such that it even has infected Mario Bunge himself, who 
maintaining that economics is not a science, even refers, contradictorily, to the Cobb-
Douglas function as "an empirical law."
     Very well, it is precisely here that we wish to exploit to inflict the final blow 
upon the orthodox theory of production. We shall begin with the sacrosanct Cobb-Douglas 
     Let it be a dynamic Cobb-Douglas function (which is, that takes time into account) 
and with constant returns to scale (which means, assuming a form such that if the factor
endowment is multiplied by "n" the production too will be multiplied by "n"):

               q1 = eut KaL1-a.... (1)

Where: Q is the production level, eut is the updating factor 
(t and u are the indices of time and technical progress respectively), 
K the capital, and L the labor. Now, if we assume that, as the Neo-classical
theory postulates, the participation levels of capital and labor in the product are equal 
to their marginal physical products, the coefficient a will be equal to its share 
of the profits and the coefficient (1-a) will be equal to labor's share in the 
national product.
     "But this is precisely what is seen in the great majority of national estimations of 
national production by means of the Cobb-Douglas! The calculated coefficient a is 
equal to the share of profits in the aggregate accounts! The orthodox theory has triumphed
once more and has defeated the Cambridge critique on the grounds of empirical reality!" 
the orthodox economists exclaim. Not so fast... As the distinguished Marxist economist 
Anwar Shaikh has shown in 1974 this result does not need to worry us at all. Let us see 
     If we re-write the Cobb-Douglas production function as output per unit of work, we 

               y1 = eut Ka.................... (2)
Where y and k are the output per capita and the capital per capita. If we 
take the logarithmic derivative of (2) we obtain the standard formula with which dynamic 
Cobb-Douglas production functions are estimated empirically, with △y and 
△k being the rates of growth of the output per capita and the capital
per capita:

               dy = du + (3)

     Curiously a very similar result can be obtained by means of the identities of 
aggregate accounting. If w is real wages and r the profit rate, national 
income is:

               Y = wL + rK..................................................... (4)

Then the output per capita is:

               y = w + rK...................................................... (5)

     Later, if we take the derivative of equation (5) with respect to the returns over 

               dy / dt = w.(dw / dt) / w + kr. (dr / dt) / r + rk. (dk / dt) / k

Now we divide this whole expression by y. If we remember that (dy/dt)y is 
the production growth rate per capita, and the symbol "d" the indicator of the growth 
rate of a variable, we arrive at the following equation:

               dy = (w / y) dw + (rk / y) / dr + (rk / y) / dk................. (6)

This can be rewritten as:

               dy = T + B / dk................................................. (7)

Setting the real share of profits equal to:

               B = rk / y

Such that:

                T = (1 - B) / w + B. dr

     In this manner, the equations (3) and (7) are similar, with both parameters a 
and B representing the percentage of profits. However, the first equation is 
derived from the typical Cobb-Douglas production function and its restrictive assumptions,
while the second is nothing more than a dynamic expansion of the national accounts. 
Consequently, it is no surprise that, when shares in the income are approximately
constant over time and among sectors, the Cobb-Douglas represents a good approach, because
it can be derived from the identities in the national accounts!
     And do not think that this is something exclusive to the Cobb-Douglas. As Simon has 
well demonstrated, the same observations are valid for the much beloved by orthodox 
economists CES (constant elasticity of substitution) production function.
     In consequence, we can conclude that estimations by the Cobb-Douglas and other 
production functions have in no way proved the empirical validity of the orthodox 
postulate. On the contrary, it has been limited to only verifying countable identities 
that are fulfilled in a necessary mode independently of the Neo-classical theory. 
It remains then in the dust, the attempted empirical defense of the production function.


     The objective of this chapter has been to critically examine the orthodox theory of 
the production function. Basically we have seen that:
     1) Starting from the controversy of the two Cambridges the very existence of 
the production function has remained seriously in question since no coherent form of 
measuring capital has been found and thus, it becomes unviable to include it as a 
quantitative variable in the former.
     2) To attempt to resolve the above clinging, as the first Classical economists did, 
to a magical substance called "molasses" which would make capital malleable and 
homogeneous is simply improper because, as we have already demonstrated, there always are 
elements of irreducible heterogeneity that prevent us from aggregating different 
capital goods as if they were commensurable and divisible.
     3) The Neo-classical approaches can lead to inconsistent mathematical 
formulations regarding capital that only match in the absurd and non-existent case 
where the compositions of capital in all sectors of the economy are equal.
     4) By assuming technology as "given," the Neo-classical orthodox focus becomes 
absolutely sterile for explaining technological change, which is perhaps the most 
important element in production.
     5) By not considering the ecological limits and the non-existence of perfect 
reversability that the law of entropy implies, the production function becomes 
unviable for our own survival. In turn, the pretended Solow-Stiglitz solution simply is 
not workable because its mathematical properties are openly counter-factual.
     6) The Cobb-Douglas production function, on which the orthodox analysis is 
intensively based, is in open contradiction with the greater part of reality where the 
relationship of productive factors is not so much of substitutability but instead of 
complementarity as seen in the Leontief production function which, however, becomes
very problematic with regard to the properties desired by orthodox economics, since it 
offers a zero degree of substitution and does not permit applying differential calculus.
     7) A large part of the attempted empirical proofs of Neo-classical production 
functions like the Cobb-Douglas or the CES are in reality spurious because their 
correspondence with the observed data are provided simply by a casual coincidence
of the identities in the national accounts when those are involved and the factor shares 
are relatively constant over time, which is common.
     All this constitutes a powerful cumulative case against the Neo-classically 
postulated production function. Thus, the orthodox theory of production is nothing more 
than a myth. May it rest in peace.

                        Chapter 3

                            "The main problem for Political Economy is to 
                                   determine the laws that regulate distribution."
                                                David Ricardo, Classical economist
The orthodox theory of distribution

     As we have seen in the previous chapter, in accordance with the concept of the 
production function, to generate a certain quantity of product two factors 
intervene: capital and labor. This product generates, in turn, in the market, an income 
for the enterprise. And it is there where the fundamental problem of distribution 
emerges, to wit: how do we perform sharing of that income among the factors that generate
     For orthodox economics the reply to this (in truth complicated) question is very 
simple: each factor will be compensated according to the value of its contributions to 
production. And how do we measure such contributions? Easy: by means of their 
marginal productivity. We shall explain this.
     In the first place, we should define the concept of productivity. By 
"productivity of a factor" is understood the quantity of product that a unit of it can 
generate. Thus, we can speak of the productivity per worker, per machine, per hour of 
work, etc.
     What, then, is marginal productivity? It is the quantity of additional product
that is obtained by incorporating one more unit of a certain factor, keeping all 
the other factors constant. Mathematically it is obtained in the following manner: first, 
we start with a production function Q = f(K, L) where Q is the level of 
production, K the capital, and L the labor. Later, in order to obtain the 
marginal productivity of a factor, we take the partial derivative of the production 
function with respect to the factor whose marginal productivity we wish to obtain, 
maintaining the other constant. That should be thus because, conceptually, a partial
derivative is that which shows an infinitesimal change in value of a function given an
infinitesimal change in one of the variable which comprise it, maintaining the others 
constant. With this form, in the case of the labor factor we would have that:

               PMgL = ∂Q(K, L) / ∂L
Where: PMgL is the marginal productivity of labor, dQ(K, L) represents the 
increment of production with capital K constant and dL represents the 
increment from the labor factor.
     With that, we already have all the necessary elements for modeling the orthodox 
theory of distribution, that is, for studying how the levels of profits (reward to 
the capital factor) and wages (reward to the labor factor) are determined. Given 
that in the previous chapter we have already spoken sufficiently about the capital factor,
in this we shall center upon the labor factor.
     Without more preambles, let us move to the analysis. How is it, then, that wages are 
determined in orthodox economics? Simple: they are determined like any other price, that 
is to say, in a market equilibrium. In this fashion, there exists for orthodox economics 
something called the labor market wherein the workers are the offerers and the 
businessmen are the demanders, and in which wages (price) and the level of employment 
(quantity) are negotiated.
     Thus, moving to a more thorough analysis, we have on the side of the offer, 
that the workers offer their labor power in a mode consistent with utility theory, 
performing a leisure-income choice of the type:

               Max U(x, l)     s.a : p . x = w . l............................. (1)

Where U(x, l) is a utility function that depends positively on the 
quantity of good x (that is, the greater the worker's consumption level, the 
greater will be her welfare) and negatively upon the quantity of hours l 
dedicated to work (which is to say, the greater the quantity of hours worked, the less 
will be one's welfare). The budget restriction tells us that the expenditure made (p . 
x) will be equal to the labor income obtained (w . l) In this way, the worker 
will offer their labor power following the logic of maximizing their utility subject to 
the budget restriction. Thus then, optimizing, the solution to (1) will be given as:

               UMgL / UMgx = w / p............................................. (2)

     On the demand side, we see that businesses confront a profit maximization 
problem of the type:

               Max Π = p . Q(K, L) - w.L - r.K............................ (3)

Where: Π is the firm's profit level, p is the price of the good 
that is produced and sold, Q(K, L) is their production level with a given level of
capital, w is the reward to the workforce L, and r is the reward to 
capital K which remains constant. Then, optimizing, the solution of (3) will be 
given by:

               PMgL = w / p.................................................... (4)

     Finally, in equilibrium, given that the supply and demand for labor must be equated, 
we shall obtain:

               w / p = UMgl / UMgx = PMgL

     The implications of this result are much more interesting than one might imagine at 
first sight. In the first place, it implies that the real equilibrium wage level
(w / p) is consistent with the needs for consumption and leisure of the workers 
(UMgl / UMgx). And in the second place, it implies that the capitalist pure free 
market system is the fairest system possible from a meritocratic perspective for it
rewards the workers (w / p) in an amount exactly corresponding to their 
contribution to production (PMgL). There was no reason, then, for the good Karl
Marx (along with all the Marxists) to rail against the capitalist system for exploiting 
the workers. Laissez faire capitalism is simply and totally perfect. Yet...can so 
much beauty be assured?

An unproductive concept: the sophistry of "marginal productivity"

     As we had seen at the beginning, the key concept of the orthodox theory of 
distribution is that of marginal productivity since it is starting from that that 
one can evaluate the input of each factor to the production process and, thereby determine
the part of the income generated corresponding to it.
     But, in truth does this treat of a consistent and valid concept? We think not. In 
the first place, because it necessarily depends upon the concept of production
function (the marginal productivity of a certain factor is obtained, mathematically, 
finding the partial derivative of the production function with regard to said 
factor) which, as we have already shown in the previous chapter, is plagued with logical 
and empirical inconsistencies.
     And not only that. Even if we accept the possibility of constructing production 
functions in a consistent fashion, the orthodox concept of marginal productivity would not
be redeemed by that given that in order to obtain the marginal productivity of a factor
--generally labor--it is necessary to assume that the other--usually capital--remains 
constant, which, in general, is factually impossible. Why? Because in actual
production it is almost never possible to isolate the constribution of one factor with 
respect to the other. The utilization of the factors is interdependent.
     For instance, if we were to want to know how only the increases in the labor 
factor influence the growth of production, that is, if we wished to calculate only the 
marginal productivity of labor (PMgL) it is obvious that we must assume capital 
remains constant. Yet can we really ensure that the capital remains constant as against an
increment of employment? Assuming that work is a homogeneous factor (as is assumed in
orthodox economics) an increase in employment would mean increasing the number of workers
per unit of time, which implies that the available capital would be utilized with more 
intensity than what had been habitual before the increment in the employment level.
But then, it would not be remaining constant!
     The orthodox economist could respond this is not so because it is nowhere necessary 
to vary the quantity of capital. But that only shows us that she is not 
understanding the true nature of the problem. In production the amounts of potentially
available capital and labor are not primarily important, but instead rather the 
quantities of capital and labor actually used. If we have a great stock of capital 
and a large number of workers yet do not use them, we simply cannot generate any 
production! Therefore, the relevant concept here is that of utilization more than 
that of availability.
     Having that in mind we can pose the previous argument in a much clearer form: with 
an increase in employment perhaps the fixed capital remains constant, yet not 
its degree of utilization! Consequently, how can we ponder the increment in production
with an increment in the labor factor if it also is changed the utilization of capital? It
truly is a difficult--not to say impossible--task given the continuous interdependence 
between capital and labor that we always observe in reality.
     The distinguished English professor Eric Roll had reason then, in his famous work 
History of Economic Doctrines, to write that: "The notion of a specific 
productivity independently from a factor is an abstraction, and can have no relation to a 
problem as realistic as the justification of a certain level of remuneration. The 
product is the joint result of factors employed in combination, and the 
asseveration that wages are equal to the net marginal product of labor has to be 
considered as only one of the elements of a theory of wages."

A theoretical anomaly quite normal in practice: the Leontief function
and marginal productivity

     As we had explained in the previous chapter, the Leontief production 
functions, which relate the quantities of capital and workforce in fixed proportions, 
if indeed are considered mere "theoretical anomalies" by the orthodox economists, are 
nevertheless the most common in practice. In effect: in the real world it is observed 
that the relationship between the productive factors is more one of complementarity
than of substitution. Capital and labor are strictly interdependent in the 
productive process. Orthodox theory can do little or nothing before the patent realism of 
this assertion.
     Now, as we also had seen the the previous chapter, the Leontief functions do not 
behave at all well in the orthodox production theory. Will they behave better in that of 
distribution? Lamentably no. These functions, just like in reality, are quite maladjusted 
to the entelechies of orthodox economics. Principally because they do not permit obtaining
marginal productivities. What?! Yes, what you heard. If we start from a world where 
production is given in the typical Leontief form Q = min(aK, bL) which is a world 
very similar to the actual, marginal productivity will not exist either for the 
capital factor nor for the labor factor. In effect, mathematically:


     Let us illustrate with an example: if a man (L) is digging a well with a 
single shovel (K), to incorporate a second person maintaining constant the quantity
of shovels, the depth that can be dug per unit of time (PMgL = 0) will not 
increase at all. Why? Because of the constitutive restriction on the production
process to which we are referring: one man, one shovel.
     Thus we see with clarity that, given the constant complementarity between the 
worker and the capital, such a thing as the productivity of labor does not exist 
independently of capital nor the productivity of capital independently of labor. In other 
words, at least in the great majority of instances, marginal productivity as 
conceptualized by Neo-classical economics does not exist.
     We now have, then, analyzed the fundamental concept upon which the orthodox theory of
distribution rests. Now we shall move to analyzing the specific case of the "labor 
market." We shall commence on the side of supply.

A theory that through sloth does not change: leisure and the work offer

     In accordance with the orthodox theory, to decide under what conditions to offer 
their labor power, people confront the sort of decisions known as leisure-income 
decisions where what determines the number of hours they will be disposed to work is 
such which maximizes their welfare equilibrating the hours of leisure with the hours of 
work necessary to get the income with which to finance their consumption.
     Starting from that, as a result of the individuals' leisure-income choices, 
the orthodox theory advances to construct the individual labor offer curve, which 
relates the hours of work that the individuals will offer with the different wage levels. 
Later, adding all the individual labor offer curves, the aggregate labor offer 
curve is obtained, this being that which in its intersection with aggregate labor demand 
determines the employment level and equilibrium wage.
     All this sounds very orderly and pretty, yet there is a small problem... As the 
orthodox theory itself well accepts, starting from a certain point (in general, when too 
many labor hours are being offered) individuals begin to have a much stronger preference 
for leisure than for income and, consequently, are now indisposed to work more hours even 
before important salary increases. Even more: to the degree that the workers' wage levels 
increase fewer work hours begin to be offered. Why? Because the individuals need the 
leisure time to spend and enjoy the income that they obtain from their work. Thus, if 
indeed at the beginning they have a great incentive to exert themselves for better 
remuneration, the moment shall arrive when they commence to value their leisure hours more
than the increments in their wages and, in consequence, will offer fewer hours of labor. 
To understand this logic in more simple terms: one works to live, not lives in order to 
     Now then, if it occurs that individuals behave such as we have just described them 
(and as the orthodox theory fully accepts for analyzing leisure-income decisions) we shall
have to accept that individual labor offer functions do not only proceed in a growing 
direction, which means, as positive functions of the type: "the more the wages, the more 
the hours of work offered," but instead that at a certain point they will cure backwards, 
ending with a shape similar to that of an inverted "C." This is shown in the following 
graphic where w  represents the wage levels and L represents the labor hours


     Yet what is the problem with it? A large problem to tell the truth. Given that the 
market aggregate labor offer curve is obtained by adding the individual work offers it 
will follow that, if these are sloping backwards, the former will present many 
irregularities, now sloping backwards or forwards, generating many points of intersection 
with the aggregate demand curve and, therefore, breaking with the assumed existence of a 
unique and stable equilibrium in the employment and wage levels of the labor market.
     But not only that. Even were we to accept that the labor offer theory of orthodox 
economics is well constructed, one would have to say that it merely deals with a fiction 
proper to the Neo-classical world of the "Alice in Wonderland" type for it is more than 
evident that in the labor markets of real capitalist societies the number of labor 
hours depends practically not at all upon individual "leisure-income choices" but instead 
more on institutional restrictions (think of the 8-hour regime) or upon business 

Is the notion of free and competitive labor markets pertinent? The
institutionalist critique

     As we have seen, the orthodox theory of distribution is based upon the notion of 
"labor markets," that is to say, spaces (not necessarily physical) in which 
businesspersons (demanders) and workers (offerers) mingle to transact employment and wage 
levels in a free and competitive context.
     Yet does this constitute a pertinent notion? Our opinion is no, and we are very 
solidly and decidedly supported by the institutionalist school. Let us see their 
     In the first place, we have the phenomenon of collective bargaining and the 
unions. With regard to this it is interesting to indicate the context in which the 
institutionalist labor focus originated. The institutionalist theory of labor 
markets emerged during the decade of the 1940's in the United States, at a moment when
the syndicates were growing rapidly in that nation and centralized collective bargaining 
was being promulgated. That caused certain economists to consider that the orthodox 
theory of wages had ceased being realistic and relevant. Why? Because collective 
determination of wages in the presence of unions was very far from competitive, this being
above all a qualitative and not merely a quantitative difference. And indeed
the unions are fundamentally political and not so much economic institutions, that act in 
a context of "pressure plays" among the government, the businesspersons and the workers 
themselves following a logic of negotiation over one of optimization.
     As a consequence of the foregoing, the wage comes to be more an administered 
wage than a market wage. And in effect, given this context of collective 
bargaining, the wages become a fruit of conscious human decisions and now not from 
impersonal market forces. Or in any event, as the institutionalists say, instead 
of it being the salary that adjusts to the supply and demand for labor, it is the supply 
and demand for labor which adjusts the wage.
     The second critique by the institutionalist economists of the orthodox theory of 
distribution is based upon the famous theory of the dual labor market. In accord 
with this theory--originally proposed by Doeringer and Piore--there exist two well-
differentiated types of labor markets: primary and secondary.
     The primary labor markets are, by definition, where the "good" work positions 
are found. Their characteristics are: 1) stability and security, 2) high and growing 
wages, 3) constant labor training and education, 4) opportunities for advancement on the 
scale of positions, 5) utilization of advanced and capital-intensive technologies, and 6) 
the existence of effective and efficient unions.
     On the contrary, the secondary labor markets are those where the "bad" 
workforce posts are found. Their characteristics are: 1) instability (because of high 
worker turnover), 2) low and relatively stagnant wages, 3) lack of labor training and 
education, 4) non-existent scales of positions or having few possibilities for 
advancement, 5) use of superceded labor-intensive technologies, and 6) the non-
existence or precariousness of unions.
     Why does this comprise something problematic for orthodox economics? Simple: because
it contradicts that postulate whereby the justice of capitalist distribution is 
"demonstrated," namely, that each worker is paid according to her productivity. And
if indeed duality exists in the labor markets (or, at least, in a large part of 
them) we shall find that wages are now not only and primarily determined by 
individual productivity of the workers but rather instead by the type of labor 
market to which they belong (primary or secondary).
     Perhaps an orthodox economist can object at this point that even accepting the 
existence of duality in the labor markets one need not negate the mobility of the workers 
since it may very well be the case that a worker belonging to a secondary labor market 
increases her productivity and moves to the primary. Obviously this case can occur, and on
occasion does occur. But it is the exception, not the rule. And even more so when 
the characteristics of the secondary labor markets are inter-related and have mutual 
feedback. In effect: as a consequence of the low level of wages paid in this type of 
market, the businessmen have no great incentives to introduce labor-saving technologies 
and, consequently, the productivity of the workers stalls together with their wages (not 
to mention the case where this type of technology is introduced but the wages do not go up
in order to thus obtain greater "profits"). And not only that. The presence of a stagnant 
technology from then on diminishes the opportunities and incentives for workers to improve
their qualifications. Thus, it is not so simple for a worker under these conditions to 
"ascend" to a primary labor market.
     Finally, the third line of critique by the institutionalists has to do with the 
existence of the so-called internal labor markets. An internal labor market can be 
defined as an administrative system of an enterprise that is guided by a set of intra-
institutional rules and procedures to establish prices and allocations of the labor 
     Thus, in accordance with this focus, even were we to accept the orthodox theory of 
the setting of wages via offer and demand we would have to say that its validity ends at 
the enterprise's door, that is, exactly where this theory ought to apply. Why? 
Because from the door onwards the most "universal" and "apodictic" laws of supply and 
demand are immediately replaced, as we have already said, by an entire series of internal 
rules and procedures to determine the positions and salaries of the employees.
     Any economist who may have had the opportunity to know real businesses will 
notice that the existence of those so-called internal labor markets is not a mere 
"bureaucratic anomaly" but instead deals with a widely extended phenomenon in business 
organization and administration. The main reason for that is the need which firms 
(especially medium and large ones) have to reduce labor turnover. In the first place, 
because the replacement costs for personnel usually are quite high (not thinking only of 
monetary ones) and, in the second place, because on investing in the specific 
qualifications of their workers the businessmen are conscious that they should stablize 
the employment in order to obtain a better and sustained return for these investments in 
human capital.
     So, taking as a fundamental referent "free" and "competitive" labor markets in the 
sense that orthodox economics does is nothing more than believing in a theoretical fiction
having nothing to do with reality and that in the final account obscures and complicates
its correct comprehension. And that is well-known by the university professors of 
economics who, on one side, in the shelter of classes, speak of the sacrosanct "free" and 
"competitive" labor markets and, on the other, when leaving the hall, do not confront the 
daily perspective of being displaced from their work by another equally capable person 
willing to work for a lower salary. Thus, in practice, though it may be in an unconscious 
manner, not even they themselves take as a central referent what orthodox theory says...

To each according to their contribution? The multi-product case

     On reading the above critique surely the woke reader will have taken note of an
important detail: if in the internal labor markets the workers are not paid in accordance 
with labor supply-demand but instead more based upon rules and administrative procedures, 
there is no reason to suppose they are paid in correspondence with their marginal 
productivity and, it follows, nor must one assume that capitalist distributions 
are necessarily just.
     In what follows, we shall demonstrate this point mathematically using the 
scheme of orthodox economics itself. For that we shall start from a joint or multi-
product production function, that is, one whose basis is formed not from a single 
product but instead various. Perhaps the reader accustomed to the mono-product 
production functions presented in microeconomics and macroeconomics texts will suspect 
this point of departure. Yet there is no reason. In the first place, because the joint or 
multi-product production functions are perfectly possible in the orthodox theoretical 
scheme. And, in the second place (and this one interest us the most) because they are the 
preferences of reality. In effect, anybody who has not remained solely in the 
textbooks and has been able to study real businesses will have seen in 
practice that what is most common is not that a single homogeneous good is 
produced but rather instead that a whole series of differentiated goods and/ or services 
are, each with its proper price.
     Thus, we have Qi = f(L, K) different goods and/ or services 
produced by the firm, each one with its respective price pi. On the work 
factor side, we denote this with Lj, with j being the business' department, 
occupations or categories. Now wj wage units are paid according to departments or 
occupations and zj rates per worker. On the capital factor side, to simplify, we 
measure it directly as a function of its cost as Mk.
     With this data we shall have the following function for profits:


Where the incomes I are given by the quantities of each good sold multiplied by 
its price and the costs C for the labor costs (wages and benefits) in each 
department together with the costs of capital.
     Now, assuming that we are in the short term, with the capital factor constant and the
labor factor variable, we derive that the businessperson can only maximize profits 
varying the quantity of labor (the price of the product cannot vary because it is "given" 
by the market). Mathematically that will imply equating to zero the derivative of the 
profit function with respect to total labor (the initial L of the joint production 
function). Operating with this equation we obtain that the result of the maximization 
with respect to total labor is given by:


which is actually the formula for payment of wages in the modality of "joint 
production" with social benefits.
     Now, to correctly analyze the marginal productivity we have to consider the labor 
L from two points of view: one, which we have already explained, as a function of 
the m departments, occupations or categories (j) of the enterprise; and 
another, as a function of the quantity of work incorporated into any of the n goods 
and/ or services that the firm produces. Thus, it will follow that:


Then, replacing the corresponding terms of (2) into (1), we derive that the equation for 
the marginal productivity under the modality of joint production will be:


Where the first term is the value of the marginal productivity of labor considered for a 
specific product and the second, the remuneration (wages and benefits) for labor applied 
by specific department and product.
     The implications of this last expression are truly demolishing for the Neo-classical 
distribution theory. And indeed, in accordance with this, it is no longer necessary 
for the businessperson to pay his workers in a specific department or area in accord with 
their marginal productivity. Why? Because for condition (3) to be realized, deduced 
from maximizing profitable conduct, it suffices that the businessperson equate the joint
sum of value for the marginal productivities according to the labor incorporated  into
each one of the commercialized goods and services (dLi / dL).
     In this form, what matters is the equating of the sum of values of the marginal 
productivities to the sum of the wage (and benefit) units considered,  not 
necessarily that each be paid "according to their contribution" (although it might be the 
case that this results, but that would only be by chance or through an ex-
ante administrative policy having nothing to do with the orthodox dynamics of the 
labor market). Or it may occur, to illustrate with an extreme case, that the group of 
workers who effectively contribute 80 percent of the production are only paid ten percent 
of the wage total and that the group who only contribute 20 percent are paid the remaining
90 percent without thereby violating the logic of business optimization which the orthodox
theory proposes. It is enough simply that the sum of salaries be equated with the sum of 
the productivities evaluated, independently of how such wages are distributed among the
people who participated in the productive process.
     How will they determine, then, the wages for each of the business' departments? Most 
probable is that it will be done according to the institutionalist dynamics of 
collective  bargaining, dual labor market and above all internal rules and 
procedures, in which hierarchical power relations and pressure tactics
weight more than the criteria and principles of social and distributive justice.
     In conclusion, the "marvelous" meritocratic distribution system of orthodox economics
fails precisely in that case most common in reality, to wit, the case of joint production 
and by departments, for then it cannot be assured that each worker shall be paid 
according to their marginal productivity. Productivity is disassociated from wages and,
in consequence, all the discussions fall to the ground concerning just distribution under

Is the labor factor merely a cost? A critique from Keynesian and neo-Keynesian 

     Within the schema of profit-maximization of orthodox economics the labor factor, just
like the capital factor, is considered above all as a cost for the businessperson. 
Clearly shown thereby is that, in the so-called "factor choice to minimize costs" that 
orthodox economics postulates, the businessman makes the best decision when she locates 
the lowest level of costs that a certain volume of production is allowed to 
generate, with her function for minimizing costs:

               CT = w.L + r.K

The matter seems sufficiently obvious: given that the labor factor must be compensated 
with a wage, this should be considered primordially as a cost. Yes, will it be only a 
cost? Of course the orthodox economist will respond, no and adduce that the labor factor 
is not only a cost but also a productive factor which, in union with the capital, 
generates the product. However, there are many economists who consider the matter to go 
far beyond that.
     In the first place we have the Keynesian economists. They start from the 
notion of the fundamental psychological law enunciated by Keynes and according to 
which "when real income increases, consumption also increases, although not as much as 
income." In this mode, if they increase one's salary, if in fact he will not spend 
everything, his consumption level will increase. The consequence? That an increase in the 
level of real wages of the workers will imply not only an increase in business costs but 
also will have a synergistic macroeconomic effect since, upon causing the increase 
in consumption among the great mass of workers, it will stimulate aggregate demand for 
goods and services and, therefore, also production. And who will benefit from this 
increase in production? Why (in addition to the economy in general) the businessmen  
     Another group of economists who question the orthodox scheme of minimization of costs
with respect to the labor factor are the neo-Keynesian economists. Their basis is 
the notion of efficiency wages. What are efficiency wages? They are a wage level 
such that it stimulates persons to improve their levels of efficiency and productivity in 
their work. In this instance it follows an inverse logic from that of the Neo-classical 
orthodoxy: it is not that workers are paid little because they are less productive but 
instead that they are less productive because they are paid little.
     According to Romer, the existence of this type of wages is due, basically, to three 
     In the first place, to that a high wage can contribute to increasing the effort of 
the workers when the enterprise cannot control its throughput due to a lack of adequate 
mechanisms for supervision of the productivity.
     In the second place, a high wage also can contribute to improving the capacities of 
the workers at an enterprise by affecting specific aspects that cannot be controlled 
because they occur in a context of imperfect and asymmetric information. That can be the 
case, for example, in the processes of personnel selection. Thus, if we assume that the 
reserve wage of the qualified workers is greater and the business decides to pay wages in 
excess of the market equilibrium, it will attract the more capable workers and, therefore,
increase average labor productivity.
     Finally, a high wage can stimulate a feeling of loyalty in the workers and induce a 
greater effort. Or the contrary, if the workers have the perception that their 
remuneration is inferior to that due they could quit the company, reduce their level of
effort, and resentment can even result in acts of sabotage or negligent behaviors.
     Evidently such a logic has its limitations for it cannot deny that in every way 
productivity is one of the factors that influence the determination of wages (not 
to mention the fact that by doubling the pay of a person this will not necessarily result 
in a doubling of productivity for were this so, it would be sufficient to pay one 
infinitely in order for them to be infinitely productive) but in any case it puts an 
extremely important consideration on the table, to wit: that a person works better when 
they feel well and find themselves in good conditions. But given that the wage level has 
to do with that, it is evident that these are not a mere "cost" but also can be considered
in a certain sense as an investment in human capital.

The final blow: Sraffa's devastating critique of the orthodox theory of distribution

     In the year 1960 the Italian economist Piero Sraffa, founder of the Neo-Ricardian 
school, publishes one of the most feared books in the history of orthodox economics. Yes, 
in effect we are referring to his work Production of Commodities by Means of 
Commodities : prelude to a critique of economic theory.
     Sraffa's principal contribution is this work is to demonstrate that the 
distribution of the economic surplus into profits and wages is above all a social 
phenomenon that is not necessarily dependent upon production. More specifically, what 
Sraffa demonstrates is that the distributive variables (profits and wages) do not in 
themselves depend on the methods of production, nor are resolved with a derivative of the 
production function, nor necessarily correspond with the marginal productivities of the 
factors. In this manner, the problem of the distribution of the economic surplus 
between workers and owners, if not already outside of the field of economics itself, at 
least is so regarding production.
     Yet how is it that Sraffa comes to this surprising conclusion? Consistent with his 
project of actualizing the approaches and focuses of the classical theory in order 
to criticize the Neo-classical theory, he begins by analyzing the problem of 
distribution centering upon the concept of the surplus, that is to say, the income 
generated in the process of capitalist production and re-production that the
owners of capital obtain and which should be divided into salaries and profits.
     Starting from there they construct a linear model of production by which it is
possible to determine the structure of relative prices and of one of the two distributive 
variables (level of profit or wages) with the other variable and technology given 
exogenously, this latter being represented by the physical quantities of the individual 
goods necessary to produce the diverse merchandise.
     As a result of this approximation Sraffa revives Ricardo and Marx's iron law of 
wages. In effect, resolving the system of relative prices in his model confirms that 
the relationship between wages and profits is effectively inverse according to the

               r = R . (1 - w)................................................. (1)

Where r is the level of profits, w the wage level and R the surplus 
(income) to distribute.
     It is obvious why in this expression we say that the relation between wages (w)
and profits (r) is inverse. Given a level of surplus R to distribute, the 
greater are the wages the less will be the profits, and while the profits are greater, 
the wages will be less. The only difference from David Ricardo and Karl Marx is that here 
the wage is paid with part of the surplus, something like in the case of Marx where 
surplus value is defined dividing only the constant capital (c) and not with the 
sum of the constant capital and the variable capital (c + v).
     Now, as Foncerrada aptly observes, "it is important to notice that in Sraffa's scheme
it is not defined which of the distributive variables should be fixed. This means that 
the system remains open to accept an independent theory of wages, such as all the 
classical authors had, furthermore providing an opening--insofar as w is 
paid with part of the surplus--for admitting modern theories about the payment of 
certain compensations to the workers and employees, the non-salaried in general, with
part of the surplus product. A surplus which originally, in the theory, was solely 
utilized for paying the owners of the means of production. Or, in the same fashion, 
one is open to add an exogenous theory of the type of profit to the system. This 
also offers the possiblity, in the modern economy, where there is great mobility of 
capital, of allowing a theory of profits that can be integrated into the system. In other 
words, Sraffa's distributive parameters, not being predetermined, offer a system open 
to theoretical constructions concerning their determination.
     Thus then, as can be gleaned from the foregoing, Sraffa's scheme provides us with a 
more open and realistic model than the Neo-classical for analyzing the distribution 
problem as it really is: a primordially social phenomenon.
     Yet Sraffa's scheme not only offers us constructive possibilities but also 
some very interesting destructive implications (for orthodox economics, that is). 
For if this focus is correct, then now there is nothing sacrosanct about the 
distribution of income for it, instead of reflecting technical relations of 
productivity, will reflect social relations of production determined by the 
relative power of the different groups in society (though, and it is important to 
note, that too is in some measure restricted by the technical limits of production). In 
this way, given a technological framework, the distribution of the net product or social 
surplus will be open in its determination to multiple social forces and, 
 consequently, now will no longer be treated solely as a "technical" matter.
     Yet even if we remain only with the mere technical aspect the orthodox theory 
continues to be highly questionable for there still persists the famous problem of 
"technics reversing" signaled by Sraffa. The reswitching of techniques or 
double-switching of techniques denotes the possibility that a certain technics can 
be more profitable than all possible other technics for two or more values separated by 
profit rate even though other technics may have been more profitable at intermediate 
levels. From that one deduces the also famous capital reversing, which is the 
possibility of a positive relation between the value of the capital and the profit level.
     Why does all this become so inconvenient for the Neo-classical economic theory? 
Simple:  because that assumes that a reduction in the type of interest would lead to the 
use of more intensive capital techniques, and Sraffa, by proving capital reversing 
and reswitching of techniques as theoretical possibilities, casts such a 
supposition to the ground. Specifically, Sraffa demonstrated that that elementary relation
of orthodox economics did not have to be so: starting from an initial equilibrium 
(r0, K0, L0) a reduction in the price of capital
(from r0 to r1) makes its employment more profitable 
at the expense of the labor factor (r1 < r0, K1 > 
K0, L1 < L0) but successive reductions can reverse 
this situation, making a more labor-intensive technology profitable (r2 < 
r1, K2 < K1, L2 > L1).
     The conclusion is immediate and serious: orthodox economics cannot ensure the 
existence of an inverse and monotonic relation between the demand for a factor and its 
price. Thus, the grand implication of the reversion of technics for the marginalist focus 
is that, inasmuch as there ceases being a general relation between the profit rate and the
quantitCy of capital that is utilized, the possibility ends of using the profit rate 
as an indicator of the capital intensity, that is, it no longer functions as an index 
to the scarcity of the capital amount, and it remains in doubt as an instrument for 
allocating resources. From this, Sraffa concludes that: "Investments in the direction 
of the movement of relative prices, confronted with unvarying production methods, cannot 
be reconciled with any notion of capital as a measurable quantity independent of 
distribution and of prices."
     This critique was so convincing that Paul Samuelson himself, a distinguished member 
of the orthodox team in the famous "Holy War" regarding capital to which we have referred 
in the previous chapter, had to recognize that: "The phenomenon of the reversion to a very
low interest rate on a set of technics that had only seemed viable at a very high 
interest rate suggests more than an esoteric technicality. It indicates that the
simple stories of Jevons, Böhm Bawerk, Wicksell, and other Neo-classical authors 
cannot be universally valid. So, as Maurice Dobb said, the reversion of technics 
"gives the 'coup de grace' to any notion of a production function and hence to the 
identical idea of marginal productivity as a determinant of the gain."


     The object of this chapter has been to critically examine the orthodox theory of 
distribution. Basically we have seen that:
     1) The notion of marginal productivity itself can be questioned showing that 
it is almost impossible to calculate it in empirical terms because it proves unviable to 
isolate the contribution of one factor with respect to another in the real productive 
     2) Simply and clearly marginal productivity does not exist when dealing with the 
production modality most common in practice: the Leontief function.
     3) The backward curvature of individual labor offers beginning at some wage level 
places into question the uniqueness of the equilibrium in the labor market and, 
furthermore, the leisure-income model has almost no relevance before the institutional
restrictions of the contracting regimes of the real world.
     4) The notion of "free" and "competitive" labor markets becomes light and even 
insubstantial if we contract it with the approaches of the institutionalist school with 
respect to collective bargaining and dual and internal labor markets.
     5) When the relevant multi-product case is examined, that is to say when more 
than one good is produced, it is found that it is no longer necessary for each 
worker to be paid in accordance with her individual marginal productivity, which 
then opens the door to injust and arbitary forms of distribution as the requisites that 
the orthodox theory imposes are fulfilled.
      6) To consider wages as mere business costs is excessively reductionist if we 
compare it to the Keynesian (synergistic macroeconomic effects of stimuli to 
effective demand) and neo-Keynesian (efficiency wages) visions.
       7) By means of the Sraffa critique it was demonstrated that the 
determination of profits and wages ended by dissociating from production as a purely 
technical phenomenon and, thus, remained open to the influence of multiple social forces 
and the implied power relations.
     All this constitutes a powerful cumulative case against the Neo-classical 
vision concerning capitalist distribution. Accordingly, the orthodox distribution theory 
is nothing more than a myth. May it rest in peace.

                        Chapter 4
                        THE MYTH OF PROFIT MAXIMIZATION

                            "Businesses behave as if rationally seeking to maximize 
                                   their expected profits and possessing complete knowledge
                                   of the necessary information to achieve such a goal."
                                                Milton Friedman, Nobel Prize 1976
The orthodox theory of profit maximization

     In the first chapter of the present book we analyzed the theme of consumer 
rationality. Now, we shall approach the subject of the rationality of the firm.
     The firm, in the capitalist system, is defined above all as the basic 
unit of production. In other words, it concerns "an organization which transforms 
factors into products." With regard to how it does that we have already spoken in 
the two previous chapters. Here we shall be occupited with why. That will carry us 
to the question of the business' objective.
     What is, then, the objective of businesses? A complicated question. Yet again 
orthodox economics has a simple answer: the goal of enterprises is to maximize 
     Such a response seems quite logical. The owners seek to obtain the maximum possible 
profits from their enterprises and these, given that they exist solely and 
exclusively to serve their interests, will seek such a goal. At this point professor 
Nicholson explains that "this focus assumes that the decisions of the business are taken 
by a sole, dictatorial administrator who, in rational fashion, pursues an aim which, 
generally, consists in maximizing the economic profits (or gains) of the business."
     But, what do enterprises do to maximize profits in the Neo-classical scheme? Well, as
always: by means of marginalist analysis, which means, applying differential calculus. We 
shall see how.
     We start from the profit function. These are constituted as the difference between 
the total income and total costs that the firm has in selling and producing a 
specific good, respectively. Thus, the profit function is given by:

               B = I(p, q) - C(q).............................................. (1)

Where B is the profits, I the total income (being a function of price 
p and quantity sold q) and C the total cost (being a function of the 
quantity produced q, which also is equal to the quantity sold).
     Now in order to maximize function (1) we apply the First-order condition, that is, we
equate the derivative of the profits function with respect to quantity, to zero (we take 
the quantity as the variable because the price, at least if we assume perfect 
competition, if given exogenously by the equilibrium of supply and demand in the 
market for the good in question).

               dB / dq = dI(q) / dq - dC(q) / dq = 0........................... (2)

     But since in this case we are analyzing the variation in total income (I) and 
the total costs (C) as a consequence of a variation in the production level 
(q) we derive that dI(q) / dq will be the firm's marginal 
income (IMg) and dC(q) / dq, the marginal cost (CMg). Therefore:

               dB / dq = IMg - CMg = 0......................................... (3)

     From which, finally, we obtain the golden rule for the maximization of 

               IMg = CMg....................................................... (4)

Which tells us that the production level by which the enterprises will maximize profits 
will be that equating the marginal cost with the marginal revenue.
     We can easily understand the above in an intuitive manner: given a marginalist 
scheme, if the owner-manage wishes to maximize profits she will adjust her production to 
the point where she can no longer augment her profits. In this way, while the marginal 
benefits of producing one more unit are positive (BMg = IMg - CMg > 0), she will 
produce additional units up to the point where, if it continues, losses are incurred 
(BMg = IMg - CMg < 0). We are referring, then, to the point where marginal profits
are zero and the golden rule IMg = CMg is fulfilled.
     Likewise it is important to note that in the case of perfect competition--where the 
marginal income, or that is the additional income which the enterprise obtains by selling 
one more unit of the product, equal to the price--the general rule will be the following: 
"A profit-maximizing business should set its production at the level where the marginal 
cost is equal to the price."

No to the "mechanical optimizer"! The Schumpeterian conception of the entrepreneur

     As we just saw, analogously to the case of the consumer, Neo-classical orthodoxy 
postulates a model of mechanistic rationality that reduces the labor of the businessman 
a mere exercise of optimization: they simply should produce there where the marginal cost 
equates to the marginal revenue to maximize profits.
     This sort of conception of the economic problem as a mere optimization problem comes 
from the very definition of economics used by the orthodox Neo-classical 
economists. Thus, following Robbins, they propose that "economics is the science that 
studies human behavior as the relationship between certain given ends and scarce 
means susceptible to alternative uses." Here means and ends appear as given and, 
therefore, everything is reduced to a technical problem of allocation. However, to think 
in this way is to ignore that which the Austrian economists have correctly identified as 
the fundamental element of the economic phenomenon: human action. In effect, human
action is essential and constutionally free and creative and, consequently, not 
circumscribed merely to "given" means and ends but instead is defined precisely by 
discovering and creating new means and ends.
     The latter is especially true for the businessperson. And precisely there is how 
Joseph Schumpeter, one of the most distinguished Austrian economists of the 20th century,
approached his visions of the entrepreneur. In particular Schumpeter conceptualizes the 
entrepreneur essentially as an innovating businessperson. In fact, such is the 
importance which Schumpeter gives to this innovating character of entrepreneurial activity
that he does not conceive the businessman as a "person" or "role" but instead more like a 
function that exists only in the act of innovating: "Whatever the type may be, it 
is only entrepreneurial when it actually brings new combinations into practice, and 
loses that character insofar as it turns into negotiation, when one begins to exploit 
others as they exploited him... The entrepreneurs belong, therefore, to a special type, 
and their conduct is the reason for a very significant number of phenomena... It is 
precisely this 'doing,' this 'putting into practice,' without which possibilities are 
dead, in which the function of the leader consists."
     Thus, then, there is a clear distinction between the mere administrator and 
the authentic entrepreneur: the administrator adjusts passively to the market 
conditions, and the entrepreneur actively creates new market conditions; the administrator
behaves like her competitors, and the entrepreneur outstrips her competitors; the 
administrator operates quasi-bureaucratically, while the entrepreneur innovates.
     With this understood anyone can see that the Neo-clasical theory is nothing more 
than a theory about "mechanical administrators" and not about the dynamic 
entrepreneur. But it is this latter that is truly relevant for studying economic 
change and, therefore, the evolution of the economy. And it is precisely there 
where the great limitation of the orthodox theory resides since it is based simply upon 
optimization and the analysis of comparative statics. Schumpeter very elegantly explains 
it: "The theory in the first chapter (he refers to the orthodox theory) describes economic
life from the viewpoint of the tendency of the economic system towards a position of 
equilibrium, a tendency that offers us the means for determining prices and quantities of 
goods, and which can be described as an adaptation of the data existing at the moment...
Nevertheless, the position of an ideal state of equilibrium in the economic system, never 
reached, despite the constant struggle to attain it (naturally in an inconsistent form) 
changes because of the change in the data. And the theory lacks defenses before this 
latter... It cannot predict the consequences of discontinuous alterations in the 
typical way of doing things; nor can it explain the origin of such productive revolutions, 
nor of the phenomena that accompany them. It can only investigate the new equilibrium 
position following the realization of the alterations. And our problem is precisely the
occurrence of the 'revolutionary' changes, the problem of economic development in a very 
strict sense."
     In this fashion, if one is solely interested in studying the dynamic of "an 
unimportant storefront" they can follow the Neo-classical theory and the method of 
comparative statics. Yet if they are more interested in understanding the relevant 
disruptive changes in the present context of the Third Industrial Revolution what 
they should do is to abandon the sterile scheme of orthodox economics for indeed the world
changes radically... So we should also radically change our theoretical schemas!
     Yet Schumpeter's theory contains an epistemological implication even more destructive
for Neo-classical economics, a true monument to "creative destruction" at the theoretical 
level if we only know how to understand it. In Neo-classical economics everything 
is structured as a function of equilibria: equilibrium between marginal revenue and 
marginal cost, equilibrium between supply and demand for goods, equilibrium between the
supply and demand for factors, etc. Even more: everything moves as a function of 
equilibria. If there is some change in the exogenous data the economy simply adjusts 
towards a new equilibrium. In other words, the economy advances "from equilibrium to 
equilibrium." However, what Schumpeter is correctly telling us is that in the development 
of the economy there is an essential element of innovation that has a dynamic such 
that breaks the "circular current." It is about the businessman who not only discovers 
but also is even capable of creating new economic opportunities transforming the 
economic environment around him. He does not adjust passively to a supposed "equilibrium" 
but instead actively generates disequilibria, which, when they are on the verge of 
becoming "equilibria," will be newly "disequilibrated" through innovation. Thus, in 
reality the economy advances "from disequilibrium to disequilibrium" and, consequently, 
the notion of equilibrium as a structure of the economy is destroyed. What then remains
of Neo-classical theoretization... Understood properly, few words.

"Animal spirits": the problem of uncertainty

     The orthodox theory having established that "the goal of the enterprise is to 
maximize profits" the question of temporality necessarily arises, that is to say: for what
period do we maximize profits; for the present or for the future?
     The question is in no way trivial. It might well occur that the owners do not wish 
for short term utilization to increase at the expense of the long term, and vice versa, 
and even may not have a clear perspective in this regard. Nevertheless, for variety, 
orthodox economics will have quite a simple response to such a complex difficulty. In the 
words of Pepall, Richards and Norman: "We should adapt our usual hypothesis that 
businesses maximize utility to signify that firms maximize the present value of 
all actual and future uses... In the case of problems of a single period this is 
identical to the hypothesis that firms simply maximize their utility." Ergo, the 
businesses maximize the present value of all the uses generated throughout their 
period of operation.
     The implication of this is that for the orthodox scheme of profit maximization to 
keep functioning one must necessarily assume that the businessmen  deal with 
and complete information. Why? Because if we do not have perfect and 
complete knowledge of the future and of all the variables which affect such 
decisions we cannot make optimal decisions much less obtain maximum profits.
Thus Friedman in his defense of the orthodox theory must say that businesspersons, in 
their rational pursuit of maximum profit, act "as if they possessed the complete 
knowledge of the data necessary to achieve such an end."
     Yet, does this fulfill the cited condition in reality? Evidently not. In the real 
world we all (businessmen are not an exception) act with incomplete information. We
are not omniscient. We shall never have perfect knowledge of all the variables and 
conditions that affect our decisions and even less, perfect knowledge of the future. 
Therefore, we confront the problem of uncertainty.
     It was precisely this problem which the great English economist John Maynard Keynes 
took as his starting point to analyze the dynamic of business decisions. In particular 
Keynes distinguishes two types of uncertainty. The first is called probabilistic 
uncertainty and is that which occurs when we can model some future scenarios and 
assign them certain probabilities of occurrence. In this scheme the statistical-
mathematical models function reasonably. The other type of uncertainty is fundamental
uncertainty. Here things are fundamentally uncertain and to assign them specific 
probabilities becomes inconvenient and even ridiculous, such that the statistical-
mathematical models break. In this respect Keynes writes: "The game of roulette is not
subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being
drawn. Or, again, the expectation of life is only slightly uncertain... The 
sense in which I am using the term (fundamental uncertainty) is that in which the 
prospect of a European war is uncertain, or the price of copper and the rate of interest 
twenty years hence, or the obsolescence of a new invention, or the position of private 
wealth-owners in the social system in 1970. About these matters there is no scientific 
basis on which to form any calculable probability whatever. We simply do not know.
     Evidently the orthodox theory is associated with and even circumscribed by the first 
type of uncertainty. In effect, in the significantly few occasions where this problem is 
incorporated (be in in game theory or other schemas) only well-identified possible 
scenarios with well-determined specific probabilities are considered. Yet this type of 
methodology leaves absolutely aside what constitutes the true problem of the 
businessperson (and those who are businessmen, and not orthodox economists, know it 
well): that they constantly have to make decisions in which there are fundamentally 
uncertain relevant variables.
     This is even more relevant insofar as it not only affects particular decisions 
within this or that business project but also the decision with respect to the 
enterprise's mission itself. Why? Because in this case, in order to estimate the 
yields, the businessperson must project herself more into the future and, in consequence, 
the uncertainty increases. Thus, as Keynes said it well, "we have to admit that our basis 
of knowledge for estimating the yield ten years hence of a railway, a copper mine, a 
textile factory, the goodwill of a patent medicine...amounts to little and sometimes 
nothing". Therefore, investment decisions will depend in large part upon the changes 
in the optimism or pessimism with which the businessmen view the present and future 
conditions and opportunities for obtaining profits. To designate these "changes in the 
soul"  which affected entrepreneurial decisions Keynes coined the term "animal spirits," 
wanting to highlight by that that such changes can have very little rational basis.
     Despite its pertinence and plausibility the orthodox economists have tended to reject
the notion of animal spirits as relevant for economic analysis arguing that it, by 
invoking something irrational, lacks explicative power at the scientific level.
     Now then, perhaps said critique was worthy in the day when Keynes had vaguely 
formulated the notion but today it no longer is, at least, is much less so. Thus, as with
the case of the consumer and as we shall explicate further below, advanced paradigms such 
as behavioral economics, experimental economics and neuro-science are untangling the 
specific mechanisms that allow rationally explaining (and even predicting) the 
"irrationality of certain business behaviors.
     Possibly the orthodox economists want to minimize these elements asserting that 
their importance is "marginal." And in effect: confronted by the difficulty of modeling 
fundamental uncertainty there exists the temptation (and convenience) of ignoring it or, 
at least, minimizing its importance. Nevertheless the analysis of it and its implications 
is more important than ever. At least so claim George Akerlof and Robert Schiller, both 
Nobel prizewinners, in their book Animal Spirits: how human psychology drives the 
economy. The central thesis of this book is that "the fundamental economic problem of 
the world is actually the amazing loss of confidence of business" because of the "chaos in
the financial markets which began in 2007 and accelerated until September of 2008." Then, 
given that this "erosion of animal spirits" feeds on itself increasing the pessimism and 
distrust, it will be necessary for "the multitude of plans that are being discussed for 
attacking the global crisis to be judged paying attention to the unknown and inexplicable 
effects they may have upon confidence and 'animal spirits' which Keynes identified 
generations ago." Yet, it is clear, that will not happen if we continue believing in the 
orthodox theory of business rationality.

Maximize profits or minimize losses? The problem of risk

     The problem of uncertainty that we just finished analyzing leads us inevitably to 
consider another important problem for the enterprise's decision, namely: the problem 
of risk. This basically consists in that the businesspersons, by always acting 
under uncertain conditions, constantly confront the possibility that their 
actions do not achieve the awaited results. In other words, their decisions always imply a
     The consequences of this for the orthodox model of business rationality are truly 
destructive. And in conditions of risk the businessperson's rationality will be applied 
more toward guaranteeing a minimum level of reasonable profits or minimizing 
losses than to maximizing profits. This is for three reasons.
     First, through the direct relations that exists between profit and risk. The 
businessmen know well that if they want greater profits they will have to assume greater 
risks. Thus, to seek maximum profits would also imply assuming maximum risk.
Yet since practically nobody wants to do that we would then find that businesspersons 
would not necessarily be guided towards the maximum possible but instead would accept a 
reasonable level of net income in accordance with market conditions (think of the cases of
economic crisis). There is no reason, then, to think that the businessperson must act in 
conditions at maximum, that is solely a theoretical possibility.
     Second, because of the stability which businesses require to be able to plan. In 
effect: every enterprise needs to conserve a minimum level of profits in order to 
be able to carry its plans to completion. In the opposite case, if it always seeks the 
maximum profit, it may result in having an excessively fluctuating utilization 
level and, consequently, it will be extremely difficult for it to realize long-term plans 
because of financial uncertainty. Ergo, one must not only keep in mind the utility but 
also the stability and security. And so the Japanese economist Shigeto 
Tsuru, after having reviewed various instances of real businesses, comments that:
"It became clear that the essential determining criterion of the firm's behavior was more 
that of stabilizing profits for a certain sufficiently long period of time. Even more 
recently, an amendment has emerged in the sense that the goal of the firms should be aimed
at 'maintaining a position of stability for a long period.' In other words, it means that 
in the description of the firm's behavior the term, maximization of security is more exact
than the term, profit maximization."
     Third, since the administrators are more punished for incurring losses than 
rewarded for obtaining profits. Effectively, given the context of separation 
between administration and ownership (whose implications for the orthodox theory we shall
examine later) the enterprises' administrators are more interested in avoiding losses than
in getting the maximum profit. Why? Because while the directors and executives do not 
receive the profits that might result from assuming greater risks (those go to the 
investors) yet can be fired if they incur important losses. Consequently, they will try to
perform their work efficiently obtaining an acceptable level of profits for the investors 
but would not necessarily strive for the maximum profit for that could also put their own 
work stability in danger.
     In this manner if, as often occurs, the maximization of profits increases the risk 
of losses, the administrator, for considerations of fundamental interest (her own 
employment), simply would not risk betting on it. And even more if dealing with a large 
enterprise having power over the market. Therefore Paul Samuelson himself concedes that 
"when the firm comes to have considerable size providing some control over prices, 
it can allow itself to loosen its maximizing activity a little." Or what the orthodox 
economist Carl Kaysen says: "Whereas in a very competitive market the firm has no 
alternative but to seek maximum profits, because the alternative to that is profit 
insufficient to guarantee its survival, in a less competitive market the firm can choose 
between seeking maximum profits or contenting itself with some 'acceptable' profit while 
aspiring to other objectives."

The behavioral economy returns to the fore: the problem of perspective

     According to what we have seen, businessmen always and necessarily act 
in conditions of risk and uncertainty. Now then, these conditions are not simply 
incorporated into the businessmen's decisions without first having been 
subjectively evaluated. And it is precisely here where the behavioral economist 
returns to the fore with the so-called "theory of prospects."
     The theory of prospects was raised for the first time by the psychologists 
Daniel Kahneman and Amos Tversky, in a famous article in 1979 titled "Prospect Theory: an
analysis of decision-making under risk." The principal thesis with this focus is that the 
businesspersons do not really make their decisions on the basis of reality but 
instead more on the basis of perceptions of the latter, presenting systematic 
biases (pessimistic and optimistic) in their evaluations. In this manner, in the 
real world businesspersons act with frequently erroneous subjective models 
which are not corrected even with the furnishing of new information. And indeed, like it 
or not, in the final analysis human beings (the businessmen are no exception) act and 
decide upon the basis of beliefs.
     Yet do not think that the cognitive biases incorporated into beliefs are only 
influential in the perception of information: they also are influential in its mode of 
processing. In effect: more than dealing with a mechanistic optimization scheme of 
complete rationality the business decision process is constituted like a mental 
process of intuitive estimation in which the scenarios and probabilities are 
simplified. That is to say, given limited rationality, and to save time and effort 
in decision-making, the businessmen have to base themselves upon a series of empirical or 
heuristic rules which if indeed they simplify the process also lead to systematic errors. 
"The beliefs are expressed in phrases of the type, 'I think that..., the opportunities 
are..., it is improbable that...,' etc." Occasionally, the beliefs regarding certain 
events are expressed in numerical form as probabilities. We propose that people rely on a 
limited number of heuristics which reduce the complicated tasks of calculation of 
probabilities and of prediction of values to much simpler operations of estimation," write
Kahneman, Slovic and Tversky. What is curious is that not even those "much simpler 
operations of estimation" are carried out in a coherent fashion: in fact the majority of 
people make estimates of probability that do not accord with the laws of 
probability (Bayesians).
     There are, then, no such things as the "rational expectations" that orthodox 
economic proposes. The businesspersons are not gods and, in fact, like any mortals, it 
often occurs that they "trip over the same rock," which means, that they are mistaken 
about it.
     Thus, following this line of investigation, the psychologists have observed that when
risky decisions are made the businessmen are particularly averse to the possibility of 
even a small loss and need  a high yield to compensate for it. In turn, they have found 
that in various cases this is due fundamentally to pessimistic adaptive biases such
that the pain of the loss seems to depend also upon what followed previous losses. Once 
the businesspersons have suffered a loss in general they become even more averse to 
suffering anew.
     Yet there also exist positive biases. For example, the psychologists have found that,
just as it is known that players are disposed to bet large sums of money when luck is in 
their favor, also investors feel more disposed to run the risks of falls or changes in 
market conditions after they have enjoyed a series of unexpectedly high profits. If then 
they suffer a loss, at least they will have the consolation of knowing that in general 
they are doing well.
     In this manner, thanks to the approaches of behavioral economics, we find that the 
great problem of the orthodox theory of business decision is that it assumes the 
businessman is primarily a sort of calculating being who makes her decisions 
on the basis of objective considerations when in reality she, in relating to the 
world through her mind, displays systematic cognitive biases in her 
evaluations and appears influenced  by subjective factors in her decisions. That, 
in turn, conduces to anomalies that systematically distort the assumed efficiency of the 
markets as the behavioral economist Richard Thaler has shown repeatedly in his column 
"Anomalies" published in the Journal of Economic Perspectives between 1987 and 1990
in which he documented various real instances of economic conduct which contradicts
that postulated by Neo-classical economics.

The broken plates of a divorce: the problem of agency

     In the first stages of capitalism the administrator was not distinguished from the 
proprietor, enterprises were small and principally family property. Yet later, with the 
advent of the great anonymous societies and the system of shareholders, there occurred an 
irremediable "divorce" between control and ownership. And not only that, they lead from 
being individuals to being collectives: the set of investors would have the 
ownership and the group of administrators or management would have the 
control. This is a genuinely characteristic fact of of modern economic society...
yet it would seem that orthodox economics has not even found this out.
     That is no exaggeration. Indeed, as Gordon well depicts, "for the majority of 
economists (especially the theorists) the businessman is still the manager-owner." 
And in effect: one of the most famous microeconomics manuals in the world, that of 
professor Nicholson, clearly tells us that "it assumes that the decisions of the 
firm are taken by a single dictatorial administrator."
     But why have the orthodox economists maintained an assumption so distant from 
reality? Simple: because it allows them to operationalize their theories. The assumption 
that ownership goes together with management is not only convenient but also 
necessary for the theoretical and mathematical exercises of orthodox economics with
respect to business activity to function without problems. Therefore, this assumption 
has to be included.
     However one must question this procedure of accomodating assumptions not to reality 
but instead to the requirements of technology. As Bunge says: "It is clear that the 
commandment 'Thou shalt Maximize' is mathematically convenient, since it can be easily 
formulated as a problem of calculating derivatives. Yet economics ought above all to 
represent reality instead of constituting itself as a pretext for playing with 
     Once this is established, we move to a more detailed analysis of the implications the
"divorce" between ownership and administration has for economic theory. Here one must 
commence by stating that this separation between ownership and administration has clear 
advantages: it permits changing ownership without interfering with the operations of the 
company and also that professional administrators are contracted. Nevertheless, it also 
creates problems if the goals of the administrators and owners are not the same. The 
danger is evident: if the administrators are better informed than the investors about 
profit opportunities or if their actions are not observable by the investors, they will 
tend to pursue their own interests or to proportion their efforts to the detriment of 
profit maximization.
     These conflicts between the goals and interests of investors and administrators cause
the so-called agency problem or the problem between the principal and the 
agent. The investors are the principal, the administrators are the agent. But wherein 
does the problem lie? In that the agent can pursue a project or make an investment that is
in her interest yet which does not necessarily maximize the profits of the principal.
     The foregoing leaves the orthodox economists in a very uncomfortable situation. The 
great institutional economist John Kenneth Galbraith illustrates this with quite a 
suggestive example: "...if the traditional commitment to profit maximization is to be 
unheld, they (the administrators) must be willing to do for others, specifically the 
stockholders, what they are forbidden to do for themselves. It is on such grounds that 
the doctrine of maximization in the mature corporation now rests. It holds that the will 
to make profits is, like the will to sexual expression, a fundamental urge. But it holds 
that this urge operates not in the first person but the third. It is detached from self 
and manifested on behalf of unknown, anonymous and powerless persons who do not have the 
slightest notion of whether their profits are, in fact, being maximized. In further 
analogy to sex, one must imagine that a man of vigorous, lusty and reassuringly 
heterosexual inclination eschews the lovely, available and even naked women by whom he is
intimately surrounded in order to maximize the opportunities of other men whose existence 
he knows of only by hearsay."
     However, the investors have devised two very ingenious solutions for this so-called 
agency problem. Lamentably, they deal with partial solutions which, therefore, do 
not redeem the restrictive orthodox postulate of maximization of profits since for 
it to be fulfilled it is necessary for the solution to be total for only 
thus will be maximizing interest of the owners be identified with the administrators' 
conduct. Let us examine these two solutions.
     The first attempted solution was for the owners to sell part of their stock to the 
administrator at a fixed rate such that she also will be interested for the enterprise to 
maximize its gains. Nevertheless, although that provides strong incentives for the manager
to exert effort to make the correct decisions, it also exposes her to considerable risk. 
We recall that the gains of the enterprise depend not only upon the manager's efforts but 
also on exogenous costs and the clashes of demand. As a result the income flow of the 
administrator will be variable and imply a risk, which will reduce her well-being if one 
is dealing with a risk-averse person. Therefore, even if this measure would contribute to 
the administrator procuring greater profits it will not cause her to seek the 
maximum because that would imply a very large risk.
     The second solution that has been proposed is the constitution of a directorate to 
whom the investors delegate the function of hiding what things are actually being done in
regard to their interests. Thus, the work of the directorate will be to control the
administration so the latter will concern itself solely and exclusively with the goal that
interests the investors: the maximization of profits. The problem is that we still must 
respond to the troubling question concerning who "controls the controllers." If the 
investors do not practically know the real conditions under which their companies 
operate and delegate to a directorate the fiscal work of the managers: how can they 
know with certainty that they are performing their labor in the best manner possible at 
all times (which is what the orthodox theory would require)?
     Only two alternative exist: either to be controlled by other, higher directorates or 
to be controlled by means of external audits. Regarding the first alternative it must be 
said that it is simply unworkable as an effective solution because the investors will 
still have the same problem with the new directorates, such that they would have to name a
third group to control the second one and so on ad infinitum.
     Regarding the second alternative we hold that even if it comprises an important 
advance it does not entirely resolve the problem. The external audits are not nor can be 
completely continuous and, furthermore, as good as they might be, nothing assures us--not
even competition  between auditing firms--it will be realized in the most efficient 
possible manner because the problem of information persists, and even more in 
this case, will result in being asymmetric (the internal agents know more than the 
external), imperfect (the auditors cannot have perfect knowledge of the enterprise 
and even less of the market conditions in which it acts) and incomplete (it often 
occurs that information tends to be hidden from the auditors to avoid problems). 
Therefore, the orthodox postulate of profit maximization remains seriously in question.

Consequences of technological change: the power of the technostructure

     As we have seen in the second chapter, orthodox economic theory considers technology 
as something given to the enterprise in an exogenous fashion and which, 
therefore, does not enter into business decisions. However, as we also indicated there, 
under contemporary capitalism the opposite situation seems to prevail.
     In effect: we find ourselves in an historical phase characterized by the complexity 
of the productive processes in which technology is a crucial element. Businesses 
constantly require more control and management of the technology to be applied to their
productive processes and, in consequence, see the necessity of developing 
endogenously by means of an internal system. But who will comprise this system?
Obviously not the managers or the group of administrators who are more occupied with 
decision-making than in developing technology, but instead rather the set of agents, 
technicians and engineers specialized in the different concrete activities of the 
enterprises and that Galbraith baptized with the name of "technostructure."
     We shall cite his own words:  "With the rise of the modern corporation, the emergence 
of the organization required by modern technology and planning and the divorce of the 
owner of the capital from control of the enterprise, the entrepreneur no longer exists as 
an individual person in the mature industrial enterprise. Everyday discourse, except in 
the economics textbooks, recognizes this change. It replaces the entrepreneur, as the 
directing force of the enterprise, with management. This is a collective and 
imperfectly defined entity... It includes, however, only a small proportion of those who, 
as participants, contribute information to group decisions. This latter group is very 
large; it extends from the most senior officials of the corporation to where it 
meets, at the outer perimeter, the white and blue collar workers whose function is to 
conform more or less mechanically to instruction or routine. It embraces all who bring 
specialized knowledge, talent or experience to group decision-making. This, not the 
management, is the guiding intelligence--the brain--of the enterprise. There is no 
name for all who participate in group decision-making or the organization which they form. 
I propose to call this organization the Technostructure."
     Thus, we find that the profound changes operative on the technological conditions of 
production also have affected the structuring of the enterprises with regard to 
organization. Specialized knowledge and its coordination have become the decisive factor 
for economic success. But that requires that men work in groups. Ergo, the power begins to
pass to these groups. Or, put differently, because of the endogenization of 
technological change, an important change has been generated in the very power 
relations of the enterprise: the technostructure has been empowered.
     Fine, fine, but how does this erode the orthodox postulate of profit maximization? In
the following manner: if the members of the technostructure have ever greater decision-
making power in the enterprise they may also influence the latter's objectives 
themselves and nothing assures us a priori that their interests will 
necessarily coincide with those of the investors who, as we have seen, find 
themselves in the most remote circle of the great enterprise. The atomization of ownership
in the form of thousands of stocks will make it impossible for their owners to impose 
their goals upon the members of the technostructure such that the companies will 
tend (subject to certain restrictions, clearly) to basically pursue the goals of the 

A true inconvenience: the possibility of seeking other goals

     "Few tendencies can so suddenly undermine the fundamentals of our free society as the
acceptance by the functionaries of the great anonymous societies of a social 
responsibility other than obtaining the greatest amount of money possible for the 
stockholders," said Milton Friedman. Very well, in the previous section we just threw 
light on the possibility that the members of the technostructure pursue ends different 
from the maximization of profits for the investors. Yet what are those ends different from
profit maximization that the technostructure might pursue?
     According to Galbraith there will basically be two: "first, to minimize the risk of 
loss, and therewith of damage to the autonomy of the technostructure, and secondly, to 
maximize the growth of the firm." We shall analyze these two objectives.
     In the first place there arises the question of why the members of the 
technostructure seek a secure level of profit even when they do not directly perceive any 
of it. Basically one could say that they do it for strategic reasons. It happens that the 
effects of the large and small gains in the technostructure are not symmetrical. When 
profits are slight or when there are losses, the technostructure becomes vulnerable to 
external influence and loses autonomy then the investors, on feeling that their profits 
are not being maximized, might request greater intervention by the board or even solicit 
an external audit. Instead, when profits exceed a certain level, their increase does not 
mean much regarding the autonomy and security of the technostructure. Given the 
asymmetry of information, the investors will believe that their gains are being 
reasonably "maximized," and consequently will allow the technostructure to "work in 
     Approaching now the second objective: why do the members of the technostructure want 
the enterprise to have a maximum growth rate (given the financial limitations, clearly)? 
Simple: because that is the  best means of expanding their power and influence. A business
that depends upon growth and technological development is a business which depends on the 
     And not only that. The expansion of the enterprise is also very important for the 
technostructure because only thus can its members ensure their position in it. A 
progressive technology signifies labor positions and promotions for the technologists. 
Declining production instead means the contrary. Therefore, the members of the 
technostructure will be interested in continual growth in the production, even to the 
point of justifying a relatively unprofitable expansion.
     Yet, why does all this comprise an "inconvenient truth" for the orthodox theory? 
Because it opens the door for business to influence society in such a way that seeks, at 
least in part, to expand the power and influence of the technostructure. In effect: "it 
also reflects the underlying reality which is that the modern corporation has power to 
shape society. And this power does not disappear when the businessman, following 
the advice of economic traditionalists, proclaim that their only purpose is profits. It 
can be used to pursue profits. But this is an exercise of power. There is also 
power to pursue other goals... Power is used, as might be expected, to serve the 
deeper interests or goals of the technostructure, for this possesses the power." And what 
is most worrisome is that there is nothing to assure us a priori that that 
influence will necessarily be positive or result in the welfare of the individuals.
However, to tackle this question is something which exceeds the limits of the present 

IMg = CMg: and where is the evidence?

     According to what we had seen at the start of this chapter, for orthodox theory 
businesspersons maximize their profit by producing up to the level where the marginal 
revenue (IMg) is equal to the marginal cost (CMg). Why? Because the 
businessmen, given that they want to obtain the maximum profits, will keep increasing 
their production up to the point when they can no longer obtain additional profits which 
is only fulfilled when the marginal revenue from selling one more unit of the product is 
equal to the marginal cost of producing it (IMg = CMg).
     So explained, it seems very reasonable to think that businessmen actually act 
following this rule. There is no student of economics who would not say to herself: "Of
course, if I were a businesswoman I would adjust my production in this manner." 
Nevertheless, as we have already seen, there are various reasons to doubt whether it 
occurs this way in the real world. And even were we to accept that the only goal of
a businessperson is to maximize profits that does not imply they necessarily act as if 
they actually did so (which is what Friedman and other orthodox economists 
profess) for one would still have to resolve the non-mechanical problems, the uncertainty,
risk, perspectivism and agency (not to mention the technostructure's empowerment and 
     However, and to the orthodox economists' misfortune, there still remains one 
important question to pose: the question of empirical evidence. Introspectively (that is, 
from the perspective "What would I do if I were the impresario?") it seems very reasonable
to think that business rationality consists of maximizing profits. Lamentably, to science 
it does not suffice that for some or many persons a certain theory seems intuitively 
correct yet instead it is always necessary for it to present empirical evidence of 
its affirmations in order to be considered scientific.
     So then, does clear empirical evidence exist that enterprises actually 
maximize profits in accordance with that proposed by the Neo-classical orthodox scheme? 
The answer is no. The maximization of profits as it is presented in orthodox economics is 
more a deductive abstraction than an empirical reality.
     In this respect the words of the prestigious economist Shigeto Tsuru are eloquent: 
"Since the end of the 19th century, it has been customary to present the theory of the 
firm basing it on the abstract principle of profit maximization. An affirmation of 
elementary economics like that asserting that "a firm determines the quantity it will 
produce as the point where the marginal revenue is equal to the marginal cost" derives in 
reality, mechanically, from the application of that principle. And even though the 
theorists kept having confidence in such abstract affirmations, those economists 
endowed with an empirical mentality have begun to examine, especially post-War, basing 
themselves on demonstrations of the actual behavior of firms and have established that no 
business approached its production plan in terms of equating marginal revenue and 
marginal cost and that, in any event, even dispensing with the technical jargon on the 
economists relative to the marginality of this or that, the number of firms which 
calculate the maximization of profit was relatively small."
     Perhaps an orthodox economist with practical experience advising firms will object: 
"That is false. Often I have been contracted to study the structure of costs and benefits 
for various businesses in order to estimate the optimal production level by means of 
microeconomic analysis." Notwithstanding, such an objection only evidences a lack of 
precise comprehension concerning the type of predictions about reality which the orthodox 
theory ought to make in case it is correct. And if indeed the orthodox principle of profit
maximization were true this would imply that, by the fact of using a principle itself 
incorporated in the rationality of the businessmen, would apply in a direct and
mechanical mode to the dynamic entrepreneurial activity and, thus, it would be 
absolutely unnecessary to contract with advisers to re-apply it!
     It is, then, necessary to distinguish very carefully the "being" of the "should be" 
when approaching this question. The problem is not that the enterprises 
should or should not maximize their profits (which is part of a discussion 
that exceeds the limits of the present work) or to analyze the truism that businesspersons
perform their work seeking a profit but more whether in reality they do or do not 
maximize profits following the dynamic that orthodox economics postulates. And it 
would seem that reality tells us they do not do so. Yet given that scientific theories 
are posed (or should be posed) to explain how reality is and not how it should 
be, we find that the scientific value of the orthodox theory becomes wholly 
questionable in this respect. It is clear that scientific theories must perform a 
simplification of reality in order to study phenomena, but the problem with the orthodox 
theory is that it does not create an "innocent simplification" of the businessperson but 
instead a gross caricature of her.


The object of this chapter has been to critically examine the orthodox theory of the firm.
Basically we have seen that:

1) The vision of the businessman as essentially a "mechanical optimizer" sins of sterile 
reductionism with the Schumpeterian theory of the innovating entrepreneur being
more plausible and pertinent in this respect.

2) Businesspersons do not act "as if they possessed complete knowledge of the necessary 
data" but instead in conditions of uncertainty which often cannot be modeled in an 
exact manner and, thereupon, the "animal spirits" of Keynes are invoked.

3) Since there is no certainty the businessmen  always act under conditions of 
risk and, therefore, their rationality may consist more in guaranteeing a minimum 
level of reasonable profit than in maximizing the profits since that would imply assuming 
too much risk.

4) As the theory of prospects presents it, the businessmen  do not act directly 
upon the basis of reality but instead upon a basis of perceptions held about reality such 
that, like the consumer, they are affected by cognitive biases that vitiate the assumed 
"rational calculus."

5) With separation between ownership and control comes the agency problem and, 
consequently, there now is nothing to ensure a priori that the actions of the managers 
correspond perfectly to the goals of the investors given that the means for correcting 
them only have a contingent and partial effect so that the Neo-classical postulate of 
profit maximization is unredeemed.

6) The greater complexity of productive processes has led to the empowerment of the 
technostructure and that too erodes the postulate of profit maximization for reasons 
similar to those displayed in the problem of agency.

7) Given the above the possibility of pursuing other goals occurs and the members 
of the technostructure in particular might be more interested in the stability of the 
gains and expansion of production than in maximizing the benefits of outsiders.

8) There is little or no empirical evidence that businesses actually produce at 
the point where the marginal cost compares to the marginal revenues, which is exactly what
the Neo-classical theory maintains.

All this constitutes a powerful cumulative case against the Neo-classical 
postulate of the maximization of profits. Thus, the orthodox theory of the firm is nothing
more than a myth. May it rest in peace.

                        Chapter 5
                        THE MYTH OF COMPETITIVE MARKETS

                        "No economic order, without incurring very grave 
                              consequences, can dispense with utilizing, in one form or
                              another, the supreme power of competition."
                                        Friedrich von Wieser, Austrian economist
The orthodox theory of competitive markets

     As already announced in the title, the present chapter will discuss competitive 
markets. Let us begin by defining what a market is. A market is constituted above 
all as a system by which economic agents gather with the object of buying and/ or selling 
goods and services. Specifically, the buyers are seen as "demand" and the sellers as 
     We turn now to the concept of a competitive market. A competitive market is 
one in which many buyers (demand) and many sellers (suppliers) of goods and services 
participate; the sellers compete to be preferred by the buyers, and the buyers, in turn, 
compete for access to the limited offer of goods and services available in the 
     Yet how are the decisions of buyers and sellers in the market coordinated? How are 
the quantities sold ensured to equal those demanded? Well by means of a very ingenious 
mechanism: the price system. Prices coordinate the decisions of the producers and 
consumers in a market. High prices discourage consumption but incentivize production. Low
prices stimulate acquisitions yet discourage production. In this manner, a "bidding" game 
is occurring between sellers and buyers by which an equilibrium price is being 
established that, by simultaneously satisfying the desires of both, will finally equate 
the quantities offered to those demanded.
     For orthodox economics this coordination occurs subject to the famous model of 
supply and demand. In this model the basic elements are the also famous supply and 
demand curves. The supply curve shows us the quantities of the good and/ or service 
that the enterprises are disposed to offer at a determinate price level. It has a 
positive slope: the higher the price the higher the quantity the sellers wish to offer. 
The demand curve, on the other hand, shows us the quantities of the good and/ or service 
which the consumers are disposed to buy at a determinate price level. It has a negative 
slope: the greater the price the lower the quantities that the consumers will want to buy.
     And how are the equilibrium prices and quantities determined. Simple: at the 
point where the supply and demand curves cross. Graphically:


This equilibrium will vary when there are changes or displacements in the supply and 
demand curves, which would occur when there were variations in the factors that affect the
supply and/ or the demand. Among the factors that will affect supply we principally have 
the costs, the technology and the conditions of production. Meanwhile, among the principal
factors that will affect demand we will have the consumers' tastes and preferences and 
their income level.
     Now then, given this dynamic of supply and demand in the market, how is it that the 
businesses, which together comprise supply, determine their production level? In the 
orthodox scheme they do so according to the model of perfect competition. This is 
the fundamental model of orthodox economics since starting from it are constructed all the
other models for analyzing the market.
     Like every model, that of perfect competition is based upon a series of assumptions. 
To wit, these are the following:
1) Assumption of atomicity of the agents: There are many small buyers and 
2) Assumption of homogeneity of the good: A single homegeneous product is 
3) Assumption of the absence of market power: The enterprises cannot influence the 
market price.
4) Assumption of perfect information: All the agents know the relevant variables 
which affect their decisions;
5) Assumption of free entrance and exit: There are no restrictions on the entrance 
or exit of enterprises in the market.
     And how does this model work? In their well-known manual Samuelson and Nordhaus lay 
out for us in a very brief and exact way the key ideas for the functioning and dynamic of 
this model:

1) In conditions of perfect competition there exist many small businesses, each 
one of which produces an identical product (assumption of homogeneity of the good) 
and is too small to affect the market price (it follows that we say in this situation of 
perfect competition that the enterprises are price-takers: they have to accept the 
price which the market has determined).

2) The perfect competitor is confronted by a totally horizontal demand curve (as a 
competitive industry it consists of businesses that are small in relation to the market, 
each one's demand curve segment being nothing more than a very small segment of the 
industry demand curve and thus appear as a totally horizontal curve).

3) The additional income obtained from each extra unit that is sold is, accordingly, the 
market price (in other words, the marginal revenue is equal to the price).

     We now have, then, sufficient elements to be able to establish how a competitive 
enterprise determines its level of production. As we had seen in the previous chapter, and
supposing that the businesses are profit maximizers (something we already questioned) they
will determine their optimal production level at the point where the marginal cost 
CMg) is equal to the marginal revenue (IMg). Now, given that under perfect
competition the marginal revenue is equal to the price, we shall have the following 
"rule for an enterprise's supply under perfect competition: A business should 
maximize profits when it produces at the level where marginal cost is equal to the price."

The fallacy of free and competitive markets: the planning system

     As one gathers from the eloquent quote from Wieser at the beginning of the present 
chapter, for the orthodox theory the "supreme power of competition" is constituted as the 
very basis of any efficient "economic order." One should deduce, then, that the 
indispensable basis of an efficient capitalist system must necessarily be 
competitive markets. But, is that what the history of capitalism shows to us? It would 
seem not. Let us see why.
     At the beginnings of industrial capitalism, that is, in 18th century England there 
did exist more or less free and competitive markets. In effect: there were many buyers and
many sellers, the enterprises were small, they had no great power over the market, the 
products were relatively homogeneous, etc. That was the best way to organize the economy 
is that era since the previous models--feudal and mercantilist--had demonstrated their 
inefficiency in the production of wealth, which, with the ascent of the bourgeoisie, had 
become the principal economic preoccupation. However, the costs of efficiency were high: 
various small enterprises went bankrupt unable to resist the difficult competitive 
conditions of the market. As Galbraith said: "The road towards obtaining growing 
efficiency would require that the losers lose in reality." Nevertheless, it was a price 
that the men of that time were willing to pay. And indeed "in a world that had been poor 
for so long nothing was more important than to obtain an increase in wealth. The remedy
--to liberate men from the restrictions and protections of the feudal and mercantilist 
society and allow them to act for themselves--was sound, as was already becoming manifest.
That was not a compassionate world. Many suffered and many were destroyed beneath the 
severe and unpredictable authority of competition and the market. But many had always 
perished for one or another reason. While now, some began to flourish. This was what had 
to be kept in mind. Now danger and disgrace were not considered, since they had always 
existed, but instead opportunity was considered."
     Nonetheless, towards the end of the 19th century (more or less starting in 1870) with 
the Second Industrial Revolution, a radical change in attitude occurred. Those same small 
businesses which in past times "began to flourish" started to grow, strengthen and 
consolidate. The age of monopolistic capitalism had arrived. In effect: now the 
enterprises were sufficiently large, produced in mass, applied technology ever more 
intensively and handled great investments. Thus then, would it be reasonable to think that
these enterprises would continue submitting with pleasure to the iron discipline of 
competitive markets? Obviously not. They are large enterprises and have much to lose, 
needing safety. Yet, given that to trust all these things to the market would be 
like entrusting them to chance, it was necessary thaqt they commence having control 
over the market itself. And thi"in addition to deciding what the consumer will want 
and will pay, the firm must take 
every feasible step to see that what it decides to produce is wanted by the consumer at a 
remunerative price. And it must see that the labor, materials and equipment that it needs 
will be available at a cost consistent with the price it will receive. It must exercise 
control over what is supplied. It must replace the market with planning."s is how the 
"planned system" is born.
     Under this system the large enterprise possesses a logic and dynamic completely 
different from that of the small competitive enterprise. As Galbraith says, "in addition 
to deciding what the consumer will want and will pay, the firm must take every feasible 
step to see that what it decides to produce is wanted by the consumer at a remunerative 
price. And it must see that the labor, materials and equipment that it needs will be 
available at a cost consistent with the price it will receive. It must exercise control 
over what is supplied. It must replace the market with planning." Consequently, far from  
being controlled by the market, the business has done everything possible so that the 
market remains subordinate to its planning goals.
     For one more connected to reality itself than to the microeconomics textbooks 
the fact that actual capitalism is more related to a "planned system" comprised of large 
enterprises with market power than to a "competitive system" of small enterprises without 
market power will seem a truism. Yet it is necessary to say currently that the contrary is
taught as the fundamental epistemic referent in the great majority of economics 
departments throughout the world.
     We see, then, that the orthodox theory of competitive markets, by remaining almost
the same confronting a tremendously different world, had ended becoming an 
antiquated theoretical piece, worthy of being studied only as part of the history 
of economic thought. Indeed one cannot study capitalism after the Second Industrial 
Revolution with an economic theory that only takes into account that of the First. A 
theoretic revolution is also necessary. If the configuration of the phenomenon changes, 
the theory should change. Objectivity, which is the ultimate goal of science, 
implies conforming to the reality of the object. If orthodox economics does not 
care to, that is already its problem...

Everyone against everyone? The law of duality

     One of the central suppositions of the orthodox theory of competitive markets is that
there exist many buyers and many sellers who compete among themselves. Very well, that 
there exist many buyers who compete among themselves by means of their monetary votes to 
get part of the limited offer of goods we can accept without great problems. However, that
there really exist many identical price-taking enterprises who compete among themselves we
must, at least for the great majority of instances, reject.
     And indeed anyone who knows something about industrial organization knows that
the structure of competition between today's enterprises resembles more a vertical 
positioning scheme with leaders easily identifiable than a horizontal dynamic of 
free competition between identical and equipotent enterprises.
     That is thus principally because of the so-called law of duality. According 
to this "law," enunciated by the "gurus" of marketing Al Ries and Jack Trout, eventually 
every market becomes a race with two participants. What is the implication of that? That, 
contrary to what is propounded by the orthodox theory of competitive markets, competition
between businesses is not a competition of "all against all" but instead more of a 
staired competition in which two enterprises, called leaders, who compete 
strongly between themselves and many followers who more than competing among themselves
limit themselves to maintaining their market position and, at most, to strategically and 
hopefully watch the leaders.
     This already puts the orthodox theory in check given that it is constructed (and 
taught) almost in its totality upon the basis of the other horizontal-competitive schema. 
However, this "law" has a still more corrosive consequence for such a focus, namely: that 
that situation of concentration of competition into two (or maybe three) 
leader enterprises will almost inevitably eventually result as a consequence of the
very dynamic of competitive markets.
     Ries and Trout explain it to us in the following manner: "At the outset, a new 
category is a staircase of many steps. Gradually the staircase becomes a matter of only 
two steps. In batteries it is Eveready and Duracell. In photographic film, Kodak and Fuji.
In car rental, Hertz and Avis. In mouthwash, Listerine and Scope. In hamburgers, 
McDonald's and Burger King. In sport sneakers, Nike and Reebok. In toothpastes, Crest and 
Colgate. When long-run marketing is considered, it can be shown that the battle usually 
terminates in a titanic struggle between too giant players; normally the old brand of 
confidence and the aspirant."
     And not only that. So strong is that "law" that, when the market is mature and the 
two leaders already well-positioned, in fact the great majority of attempts to displace 
them fail. One could say it follows a pattern of the "law of the excluded third": in a 
consolidated market there is practically no space for a "third leader," that being almost 
a contradictio in adjecto.
     Ries and Trout give us a very good example of this last with the case of the United 
States market in sodas: "In 1969, there were three great brands of a certain product. The 
leader had about 60 percent of the market, the number two brand 25 percent and the number 
three had six percent. The rest of the market included as many private brands as minor 
brands. The law of duality suggests that these shares in the market are unstable. 
Additionally the law predicts that the leader will lose market share and that the number 
two will gain it. 22 years later, the market share of the leader dropped to 45 pervent. 
The number two brand has 40 percent and number three has three percent. The products are 
Coca Cola, Pepsi-Cola and Royal Crown Cola, respectively; yet the principle applies to 
any sort of brand... Look what happened to Royal Crown Cola. In 1969 Royal Crown Cola 
revised its system of franchises, 350 bottlers, and employed the ex-president of Rival Pet
Foods, a veteran of Coca-Cola and Pepsi. The company retained Wells, Rich, Greene, a 
powerful New York publicity agency. 'We will go out to kill Coca-Cola and Pepsi,' said 
Mary Wells Lawrence, director of the agency, to the Royal Crown bottlers. 'I hope you 
excuse the expression; but we are going to cut their jugular.' And the only thing killed 
was Royal Crown. In a mature world, third place is a difficult position."
     Obviously these results are not predetermined. The so-called "law of duality" does 
not deal with a physical law. Yet in any event it is based on profound 
observations. Thus Jack Welch, the legendary president and CEO of General Electric, some 
years ago had said that: "Only the businesses which are number one or number two in their 
markets can win in an ever more competitive world. Those who could not were re-organized,
closed or sold." Is this at all compatible with the image of a multitude of small and 
competitive enterprises that orthodox economics has sold us? Is it right that economists 
keep formulating those topics using referents which are openly negated by the biggest 
businessmen, that is to say, the most relevant actors in the phenomenon of the study 
itself? It would seem not. Yet let us keep analyzing...

Market and power: the social structures of the economy

     Another of the essential assumptions in the orthodox theory of competitive markets 
and, specifically, the model of perfect competition is that all the participant 
enterprises are identical in their size, share, cost structures, and price-taking 
condition. In other words, that they are equipotent (having equal power). And what 
is the result of that? A very paradoxical one to tell the truth: that the businesses, 
given that they have the same power but at the same time are too small to have individual
influence upon the market results, end by being impotent (lacking in power) and so
have no option but to serve the needs of society in a mechanical fashion. And that would 
be precisely the great "magic" of the market: that the power of competition finally 
annuls all the power of the businesses.
     Yet, is that relevant or does that focus at least become pertinent for analyzing the 
reality of existing capitalism? Evidently not, for reality tells us something not only 
different but openly contrary to that postulated by the theory: enterprises 
are not equipotent and even less so, impotent. Furthermore: they not only have market
power, meaning capacity to influence prices instead of being limited to price-taking, 
but instead they have ever more power over the market, that is, capacity to mold it
as a function of their goals and interests in place of humbly submitting to it. The 
orthodox theory speaks in its models of im-perfect competition (one sees here that 
the idea of perfect competition is the "touchstone" for all theoretical development), of 
the power of the market, yet never touches power over the market, which is 
much more relevant.
     Curiously one of the theorists who has been most devoted to scientifically studying 
this phenomenon was not an economist but instead a sociologist: we refer to the renowned 
French sociologist Pierre Bourdieu. According to Bourdieu, before being constituted as an 
essentially neutral and participative space in which vendors and buyers meet, markets are 
"fields of force," that is to say, "socially constructed fields of action where 
agents possessing different resources gather to have access to exchange and to 
conserve or transform the active force relation."
     In this "force field," very far from being uniform and competitively distrubuted, 
the true struggle is limited to a small number of powerful rival enterprises
which, instead of reacting passively to a "market situation," are in the process of 
actively molding it.
     And not only that. Such a capacity of molding the market conditions is exercised by 
the enterprises as a function of an interactive and hierarchical structure. 
Thus, "dominant is whoever occupies a position in the structure such that the structure 
acts in their favor. The dominant firms exercise their pressure over the dominated and 
the latter's strategies by means of the weight that that structure possesses, more than 
through the direct interventions which can occur: they define the regularities and 
at times the rules of the game, imposing the definition of the trump cards most 
favorable to their interests and modifying the entire milieu of the other enterprises and 
the system of restrictions which weighs on them or the horizon of possibilities that they 
offer them."
     That is to engage in power relations. And there, seemingly, orthodox theory 
does not enter (or does not want to enter). Power relations in the market are always 
variables "exogenous" to it and therefore cannot "contaminate" their "immaculate" analysis
with such things. But we "heretics," on the other hand, are not afraid of "getting our 
hands dirty"...

Disappearance of the invisible hand: the birth of strategic thinking

     The foregoing brings us directly to the question of strategic thought, to 
wit, that referring to the need enterprises have to formulate their plans for achieving 
their objectives in the market yet keeping in mind that the other enterprises also are 
doing the same. Or, as Dixit and Nalebuff would say at the beginning of their book, 
"strategic thought is the art of gaining on an adversary knowing that she is trying to do 
the same."
     Now a little history. As we know, the First Industrial Revolution, occurring in 
England at the middle of the 18th century, did not have much influence upon strategic 
thought. That was due principally to even though this period was marked by intense 
competition between industrial enterprises virtually all of them lacked the power to 
influence market results to a relevant degree. In fact, the chaotic markets of this era 
led economists like Adam Smith to describe the forces of the market as an "invisible hand"
which in large part remained beyond the control of the particular enterprises.
     Later, with the Second Industrial Revolution, occurring in the United States at the 
end of the 19th century, one began to see business strategy as a way to give form to the 
market forces and, thereby, of influencing the competitive environment itself. The 
"invisible hand" of Adam Smith began to be progressively replaced by what renowned 
historian Alfred Chandler Jr. denominated the "visible hand" of the professional 
administrators and, consequently, "strategic thinking" was originated.
     This situation was ever more consolidated to the degree that capitalism advanced. The
Sixties years witnessed the birth of diverse consulting practices concerning strategy and,
what is more, according to a study performed by the Stanford Research Institute, by
1963 the greater part of the great companies in the United States had already established 
planning departments.
     The guru of administration Peter Drucker was right, then, when he criticized orthodox
economic theory for treating the markets as impersonal forces, out of the control of 
organizations and of individual businessmen now that, in the present era, the era of the 
great corporations, management "implies the responsibility of trying to give shape 
to the economic environment, beginning and carrying out the changes in that environment."
     We see then, in this point like the three previous ones, that the expansion of the 
competitive capitalist market has generated tendencies evidently contradictory to Neo-
classical orthodox theoretization since the latter is based upon mechanistic 
optimization--when dealing with environments of perfect or imperfect competition--
as against the understanding of nature and access to industrial planning. It 
happened, then, that the discretionary power of the economic agents acquired a decisive 
importance and the mechanistic conceptions of the market ceased being relevant (not to 
mention those of the atomists).
     Given this, economic theory could not support that nascent reality and enclosed 
itself in the cult of the absolute free market, a mathematically pure and immaculate god 
who, behind the heavens of scientific abstraction, was free of all the mortal 
contingencies of historical development of the economy. Starting from that the economists 
imposed a methodological line which necessarily did without the study of the historical 
evolution of the economic structures. Such a situation persisted until our own days and 
explains in large part why orthodox economic theory is seen increasingly in contradiction 
to the facts of the real world. Therefore, it is not exact to see that orthodox economics 
is ahistorical; it is clearly anti-historical!

Some scissors that should be cut: the supply and demand curves

     During the second half of the 19th century there was a very strong debate among the 
economists, namely: whether the "value" of goods was determined by their costs of 
production or from the utility (well-being) that the consumers obtained. The first thesis 
was maintained by the classical economists (Adam Smith, David Ricardo and Karl Marx) while
the second was maintained by the marginalists (Jules Dupuit, Carl Menger and Stanley 
     So then, at the end of the century the British economist and father of the Neo-
classical school Alfred Marshall terminated this debate by means of his ultra-famous 
model of supply and demand. According to it, it is the forces that act behind 
supply and demand which determine the value. They should be conceived like two blades of a
scissors: it is useless to ask which of the two is that which cuts (and thereby the 
denomination of these curves as "Marshall's scissors").  Behind demand is marginal 
utility, reflected in the demand prices of the buyers; and behind supply will be 
marginal costs.
     We now shall pass to a critical analysis of the supply and demand model or, if one 
prefers, to "cut Marshall's scissors." In the first place it must be said that it is 
supported more by an abstract mathematical deduction than by the empirical
study of reality. In effect: perhaps the majority of students in the first phases of 
economics think that supply and demand curves are the consequence of empirical induction,
yet the truth is that the manner of drawing them is purely theoretical. In the real world 
neither supply and demand curves nor equilibrium prices are observed but instead only 
determinate prices at determinate moments. Consequently, to assume that the prices of 
the products we encounter in the supermarket or the warehouse arrive determined by supply 
and demand and therefore demonstrate the validity of the model is nothing more than to 
fall into a petitio principii or fallacy of circular reasoning (that is to 
say, we presuppose what we wish to demonstrate).
     And not only that. If it is true that the prices of the goods which we find in the 
supermarket or the warehouse come to be determined by supply and demand, why is it that, 
in general, they are so stable? This question is tremendously pertinent. It is that were 
it true that supply and demand are what determine prices one would expect those to be 
exceedingly unstable and changing. Why? Because the factors that are behind supply and 
demand are extremely changeable. In effect: behind supply we have the costs, the 
technology and the conditions of production and, in the case of demand, we have the tastes
and preferences of the consumers and the level of incomes. Whoever tells us (even in the 
name of the sacrosanct céteris páribus assumption) that these factors remain
constant simply lives on another planet (or is constructing an empirically  irrelevant
     We shall move now to analyzing the supply curve. Here we must begin by indicating 
that not even in the orthodox theory do supply curves always exist. In monopolies no 
supply curve exists. Nor in the different models of oligopoly. It only exists under 
perfect competition and monopolistic competition (competition between firms with market 
power who have similar but not identical products).
     Yet even those models are based on arbitrary assumptions, since they assume 
decreasing marginal returns in order to construct the marginal cost curves that, 
according to the orthodox Neo-classical theory, are identified with the supply curve 
starting at its growing segment. However, empirical research suggest that it is frequently
the case that firms have constant marginal returns, even increasing, and excess 
established capacity, such that the supply curve might be horizontal or backward-
bending, which could cause it to have more than one intersection with the demand curve 
and, thus, that there is more than one market equilibrium!
     And there is still more. As Sraffa demonstrated in 1960 in his work Production of 
commodities by means of commodities, given that "the prices of goods depend upon the 
methods of production and on distributive variables and by changing these prices of the 
goods can move in any direction, the marginal cost curve has no grounds to form the 
supply curve, because it is not feasible to construct a curve of offers of goods."
     Now, we direct our darts towards the demand curve. According to the orthodox theory 
the demand curve of a market results from the summing of the individual demand curves, 
assuming constant and clearly defined preferences. Yet that seems clearly unreal. Few of 
us could say with security how much we would consume of a certain good at various price 
levels and even less what will be our preferences day after tomorrow.
     Yet even if we were to accept these unrealistic assumptions, there is no reason to 
suppose that all the individual demand curves have the same slope (the individuals are not
clones!) and so the summation of them very probably would have abrupt discontinuities in 
the form of a saw. Resulting in there being no way of ensuring a priori the 
existence of a unique crossing point with the supply curve, nor that the resulting prices 
would be equilibriums.
     We see, then, that if indeed the supply and demand curves have come to form part of 
the stock of common sense of many a careful analysis of them reveals this is far from 
evident. So then, if indeed the factors behind supply and demand influence (though 
not necessarily determine) price formation there is no reason to suppose that they do so 
deterministically as a function of the mechanism of supply and demand as the orthodox 
economic theory proposes.
     In fact, the renowned behavioral theorist Dan Ariely has shown in his book 
Predictably Irrational a large part of what we consider "equilibrium prices and 
quantities" can be due not actually to an equilibrium of supply and demand but instead 
more of an arbitrary coherence created in our mind. "The basic idea of arbitrary 
coherence is this: that despite initial prices (such as those for the pearls of Assad) 
are 'arbitrary,' once those prices have become established in our minds, they give form 
not only to present prices but also to future prices (this makes them 'coherent')."
     Similarly, after performing various studies and experiments, Ariely lashes out 
against the orthodox theory saying: "While the standard economic focus assumes that the 
forces of supply and demand are independent, the type of determinative manipulation which 
we have shown here suggest that they are, in fact, dependent. In the real world, the 
baseline (mental) derives from the promotional prices suggested by the manufacturers, the 
publicity prices, the promotions, the introduction of products, et cetera - all of which 
are variables on the supply side. It seems then that instead of the willingness of the 
consumers to pay influencing the prices, the causality is in a way inverted and it is the 
market prices themselves that influence the consumers' willingness to pay. What this 
means is that demand is not, in fact, a force entirely separate from that of supply." 
Yet if supply and demand now are not totally independent now Marshall's "scissors" with 
their two "blades" becomes meaningless. And that is truly problematic...

Extreme unrealism and contradictions: analysis of the assumptions of the perfect 
competition model

     There is no doubt that the perfect competition model is the fundamental model 
of the Neo-classical theory. However, as it is studied in introductory economics courses, 
its crudity cannot pass unnoticed: its assumptions are not realistic. We shall analyze 
them one by one:

1) Assumption of atomicity of the agents: There are many buyers and many sellers. 
Concerning the unreality of this assumption we have already fully dealt at the beginning, 
especially in discussing the "law of duality." Thus, we shall not expound further upon it.

2) Assumption of homogeneity of the good: Products, understood as the good or 
service as it arrives to the consumer (that is, including its size, form, quality, design,
conditions of sale, et cetera) are identical. Such a supposition is absolutely necessary 
for the model of perfect competition because only if it is fulfilled can it be assured 
that a single market price will exist and, what is more, that the firms will have no 
alternative but to be price-takers. In effect, if the product, such as it arrives to the 
consumers, is identical to the rest, no firm will want to charge more than the market 
price--since then all the consumers would buy it from the other businesses--nor less than 
it - since then it would have lower profits.
     Evidently all this has very restrictive implications. In the real world there are 
almost no enterprises that manufacture absolutely identical products. Perhaps there may be
some exception, as for example the electricity which is distributed to the households. Yet
the norm is to the contrary. The differentiation of products predominates, whether 
it be in size, form, quality, or design. And furthermore, if we follow the famous approach
of the economist Harold Hotelling of considering the spatial location as an 
important differentiating element of the product, we inevitably have to conclude 
that the assumption of a homogeneous, that is to say identical, product is intrinsically 
absurd. For indeed the spatial location is always relevant: the greater the spatial 
distance measured between the consumer and the product's point of sale, the less will be 
the effective relevance that the latter has for her. Therefore, the seller who is closer 
will have a certain "market power" and will be able to charge the consumer a higher price 
(as often occurs with the small sales outlets that locate near or even within university 
communities). Consequently, the only way of ensuring that the products are effectively 
entirely identical, as the perfect competition model requires, is to make all points of 
sale located in exactly the same place! This now is not a problem of mere "realism," but 
instead of logical consistency.

3) Assumption of absence of market power: The enterprises cannot influence the 
market price. The only competitive variable which they can control is their quantity of 
production. Therefore, they have no alternative but to submit to the market price in order
to develop their level of production at the point where this equates to their marginal 
costs. In other words, they have no option but to be price-takers.
     The unrealism of this assumption leaps to view: in reality businesses almost always 
see price as one of their principal competitive weapons. But, in fact, what is most 
curious about this assumption are the paradoxical implications to which it leads. In 
effect: the model of perfect competition, by assuming identical, price-taking firms 
with no market power, necessarily implies a system of clone-like businesses that do not 
actually interact among themselves but instead are limited to informing themselves about 
market prices to later revise production quotas (in a more equitable mode, certainly: 
equal quantities to identical firms). In other words, thus formulated, the model of 
"perfect competition" implies that enterprises simply do not compete!
     This had already been well noted by the distinguished economist Oscar Morgenstern 
when he wrote: "The common sense meaning (of the word 'competition') is one of combatting 
others, of fighting, of trying to put oneself ahead, or at least of preserving one's 
place. It suffices to consult any dictionary in any language to see that this term 
describes a rivalry, fight, struggle, etc. It becomes difficult to understand why this 
word should be used in economic theory in a form that contradicts ordinary language."
     Thus, to speak of absence of market power is in reality to have a very 
limited vision of the matter (if indeed one has any). Competition, true competition
and not the deceitful (not only "simplistic") caricature which the microeconomics 
manuals present, is the mother of monopoly and oligopoly. The small businessman always 
dreams of obtaining a place among the large ones. The businessmen only behave in this 
passive and price-taking way assumed by orthodox economics when there is no choice but to 
do so and, in the event they have fallen into this situation, will always seek a way to 
leave it so as to increase their profits, even if that implies violating the sacrosanct 
rules of the "competitive" game. Yet it does not seem that that has much weight in the 
economics manuals which treat market structures (whether of perfect or imperfect 
competition) as something already given where the agents limit themselves solely to
optimizing their objective functions.

4) Assumption of perfect information: All the agents know all the relevant 
variables that affect their decisions. Clearly this assumption is a requisite no less 
"strict" (read unreal) than the previous ones. It implies that all the world has available
(or can costlessly obtain) all the relevant information to make their decisions. Buyers 
and sellers should know with certainty the exact price of the product and its 
characteristics (quality, size, spatio-temporal disposition, et cetera).
     Very well, what is habitual is that we individuals do not have all the relevant 
information and to obtain it will be very costly (whether in terms of money, time, effort,
emotional stress, et cetera) or even impossible. We do not have complete 
information. Even less do we explore all the possibilities. In effect: most times we 
limit ourselves to considering the products that we habitually buy in the 
establishments where we habitually gather and at the prices they habitually
have. All being humans, the agents who act in the market (be they producers or consumers) 
are more "creatures of habit" than "mechanical and rational optimizers."
     And not only that. The perfect competition model, by assuming that every enterprise 
knows with certainty the exact price at which they will be able to sell their 
products and the exact quantity they are going to sell leaves aside one of the most
important elements that affect the business decision: uncertainty. Yet, as we have 
seen in the previous chapter, uncertainty is an essential characteristic of the 
economic process and to subtract something essential from a phenomenon does not 
leave one with a "simplified phenomenon" but instead simply erases the phenomenon
(that the orthodox economists do not truly abide by the epistemic distinction now between 
simplification and distortion is not our problem)...

5) Assumption of free entrance and free exit: There are no restriction on the 
entrance and exit of firms in the market. Capital is always available to be invested and 
anyone can do so. Industrial plants can be installed or uninstalled in an immediate 
     The unreality of this assumption is more than evident. Firms cannot enter nor exit 
the market from one day to the other as if dealing with a hotel. First, because that 
implies costs. And not only direct economic costs but also transaction costs 
(think, for example, of all the bureaucratic paperwork for it that must be done). Second, 
for obvious technical reasons: industrial plants cannot be installed or uninstalled in an 
immediate fashion.
     Another powerful reason to postulate the unreality of the assumption of free entrance
and exit is the existence of the well-known barriers to entry. A barrier to entry 
is any limitation (legal, economic or institutional) that impedes the incorporation of new
enterprises into a specific industry. Among the most common barriers to entry we have the 
licenses, the patents, the exclusive control of resources, and economies of scale. Such is
their importance that Michael Porter himself considers them explicitly in his famous Model
of the Five Competitive Forces.
     We see, then, reasons in excess to conclude that the model of perfect competition is 
terribly unrealistic. And this does not deal with a mere "simplification of reality" as 
the orthodox economists pretended but instead that it is a scheme which is in open 
competition with reality! It is one thing to take a certain distance from reality 
and another very different is to adopt the contrary. It becomes, then, ingenuous to 
expect useful predictions from such and unrealistic model and even less coherent 
explanations of how reality functions starting from it. And here we have not only echoed 
the truism that the model is not realistic but we also have indicated various points which
put seriously in question its epistemic coherence and pertinence themselves.
We shall pursue that.

A terribly imperfect theory: logical inconsistencies of the perfect competition 

     As we know, the perfect competition model is the central part of the economist's 
education. In fact, when the young economist recognizes a diagram in which appear a supply
function and a demand function, there immediately activates in her mind everything she 
has been taught concerning perfect competition and its attractive implications. 
However, as we just saw, it deals with a tremendously unrealistic model. Yet that is not 
the worst. In fact, as we shall show below, the model of perfect competition has many 
important logical inconsistencies.
     Thus, for instance, one of the great logical inconsistencies incurred by the perfect 
competition model is that which confounds a small influence with an absolutely non-
existent influence. For if it indeed is true that, because of their situation as price-
takers, none of the firms having the capacity to influence the price, the summation of 
their null influences cannot be greater than zero!
     Precisely analyzing this is what the great heterodox economist Steve Keen has argued,
that under perfect competition the demand curve of an individual company is not 
horizontal, as orthodox economics proposes, but instead equal to the market demand curve,
since if we sum any number of flat curves, the result will be a flat (horizontal) curve 
and not one having a slope. But given that the market demand curve in the Neo-classical
model has a slope, this requires that the individual demand curves of the firms also have 
a slope.
     Be that as it may, in any case it becomes clear that if we consider that many firms 
exist the influence of each of them upon the market price cannot be zero. Anyone can 
confirm this by means of a simple exercise: 1) calculate the equilibrium price in a 
numeric example of the model of perfect competition with a number "n" of businesses in the
equilibrium, 2) now remove one of the firms from the initial quantity "n" and return to 
calculate the equilibrium price. Does it coincide with the first?
     We see, then, that the perfect competition model leaves unresolved the relation 
between the number of firms and the competitive (price-taking) activity. That in a 
numerical exercise we can calculate the number of firms which fit in a competitive market
tells us nothing about the number of firms for which "market power" is negated in the real
     Even so the most theoretical orthodox economist could respond that in his most 
rigorous algebraic formulation the perfect competition model does not exactly assume the 
existence of "many" buyers and "many" sellers but more the existence of infinite 
buyers and infinite sellers, such that, by being dispersed among an infinity of 
enterprises, the market power of each one of them will be null.
     To this we must respond that the existence of infinite enterprises is an absolute 
factual impossibility for there cannot be a real infinite multitude. And not only that, 
but it carries us to various logical absurdities. For example, if having infinite 
enterprises in the initial situation it happens that because of changes in the market 100 
of them should leave, how many will remain? Well, still an infinity (infinity - 100 = 
infinity), that is, the same quantity as at the beginning!
     In synthesis, the model of perfect competition is not only unreal, but also absurd.
Failed recursion: the "false Messiah" of successive approximations

     Let us return now to the question of the unreality of the perfect competition model. 
How do the orthodox economists confront this lack of realism? Simple: they minimize it 
saying that all scientific models are unrealistic to some degree. However, as we have 
already said, the model of perfect competition is not a mere innocent 
simplification of reality but instead is openly in contradiction to reality.
Yet the orthodox Neo-classical economists still have a reply. The say: "This model is only
the basis and principle of our research program. Later, starting from that we shall 
proceed by elaborating other more realistic models of perfect competition, with market 
power, differentiated products, barriers to entry, and uncertainty. The student only must 
have patience. Little by little, to the extent she advances in her coursework, she will 
begin seeing ever more realistic models." We have here, then, the great method of 
recursion which orthodox Neo-classical theory has discovered for its irrealism: the method
of successive approximations."
     The first thing that must be said with regard to this is that in reality we are 
dealing with a giant fraud. In effect: during the first phases of their career the 
students are made to believe that they will be studying ever more realistic models, yet 
later, once the models of imperfect competition (monopoly, oligopoly and monopolistic 
competition) have been explained in passing, courses in economic theory return to being 
more unrealistic and abstract. Anybody can verify this by referring to any advanced 
microeconomics or advanced macroeconomics text. Accordingly Martin Shubik, in his famous 
article "A Curmudgeon's Guide to Microeconomics," reports that "the textbooks are rare 
which bother to indicate to the students that there are various different institutional 
forms with which an enterprise can operate. The more elementary is the textbook, the more 
probable that it contains information about different forms of organization. However, 
whenever our study becomes advanced, we do not bother to differentiate between 
General Motors and a small bakery. There are different institutional forms in Samuelson's 
basic text, but not in his Foundations."
     Yet even leaving this aside, it must be said that the orthodox approach of successive
approximations to reality starting from unrealistic models utilizes an absolutely 
unfortunate strateby because, by so proceeding, it concludes by converting reality to a
sort of "special case" of the theory!
     And not only that. The method of successive approximations, if indeed it can be 
appropriated for systems in which the parts are not intrinsically interrelated, can never 
do so for complex or holistic systems, in which the elements in fact are 
intrinsically interrelated and possess emergent properties. Now then, as the
economists of the Austrian school have repeatedly observed, this is what occurs with the 
structures of competition and the market. In these the information, the risk, the 
uncertainty, the technology, and the relative power of the participants should 
never be considered as exogenous elements that later can be introduced into 
the system maintaining the previous basic structure intact because, when the system has an
holistic structure with emergent properties, every time a new element is added the 
entirety of the system is reconfigured anew.
     It is precisely because of the foregoing that the orthodox Neo-classical theory can 
never construct sufficiently realistic models not even through its method of successive 
approximations. By always maintaining the same deterministic structure it can never
construct "open models," but can only move from one closed system to a slightly bigger 
closed system. The standard mathematical formulation, if indeed it allows playing 
theoretical ping-pong and formulating amusing exercises, sterilizes any 
intent towards holistic analysis, which is what is really suitable for the 
structures of competition and the market. Thus Shubik, referring to the model of 
duopoly (competition between two firms with market power) declares that "Personally, I
like the theory of duopoly. I like it better than crossword puzzles. Nevertheless, if 
I forget the distance that separates the very simplified models which we study from the 
actual firms and markets in our society, it will cause great damage to myself and to my 
     Finally, with respect to the method of successive approximations, to tell the truth, 
we find that in the process of constructing our (supposedly more realistic) new models, 
the majority of times many of the false previous assumptions are maintained and, what is 
more, new false assumptions are added with the goal of ensuring the deterministic-
mathematical "closure" of our system. In this manner, falsehood upon falsehood are 
accumulated and the promise of eliminating the false assumptions is never fulfilled. 
Therefore, the method of successive approximations, or successive closures, perhaps should
be called the "method of successive falsehoods." But what is certain is that it comprises 
a "false messiah" for it does not redeem the orthodox theory of competitive markets from 
its lack of realism. And nor does it redeem the young economics students who want to 
better understand reality and end being swindled by their professors (who in turn were 
swindled when they were students).


     The object of this chapter has been to critically examine the orthodox theory of 
competitive markets. Basically we have seen that:
     1) The single idea of a planning system puts seriously into question the 
pertinence and relevance of the notion of competitive markets since in that type of 
scheme, because of the very necessities which the industrial system imposes, enterprises 
feel compelled to substitute planning for the market in order to obtain stability and, 
thereby, their operational capacity.
     2) Likewise, the law of duality, which postulates that eventually every market
will become a race between two participants, makes practically unworkable the idea of 
atomicity of competitive agents.
     3) Under the actual conditions of capitalism the firms not only have market power but
also power over the market, which is much more important yet even so the orthodox 
theory passes over it.
     4) Strategic thinking, which implies the capacity of the firms to directly 
mold the conditions of their environment, displaces Adam Smith's "invisible hand" 
replacing it with the "visible hand" of the managers of the large enterprises.
     5) The famous model of supply and demand remains seriously challenged by the 
conceptual difficulties of coherently specifying the supply and demand curves, with
important empirical anomalies like the generic stability of prices and the 
possibilities of mere arbitrary coherence as have been noted by behavioral 
     6) The principles assumed by the model of perfect competition (atomicity of the 
agents, homogeneity of the good, absence of market power, perfect information, and free 
entrance and free exit) are not mere and innocent "simplifications" of reality but instead
are in open contradiction with it and, consequently, conclude by obscuring and 
making its comprehension difficult.
     7) Problems of logical consistency are also found given that, seemingly, a 
very small influence is confused with a non-existent influence in reference to the 
capacity of the firms to affect the price in the perfect competition model, as well as 
other questions related to the factual impossibilities of infinites and the slope of the 
market demand curve.
     8) The method of "successive approximations" is highly questionable since it results 
in converting reality to a sort of special case of the theory, does not correctly 
capture the holistic ontological structure of the phenomenon of the market and 
continues to maintain absolutely unrealistic and arbitrary assumptions solely in 
order to conserve the mathematical apparatus.
     All that constitutes a powerful cumulative case against the Neo-classical 
postulate of perfect competition and the mechanistic structuring of the market in terms of
supply-demand. Ultimately, the orthodox theory of competitive markets is nothing more than
a myth. May it rest in peace.

                        Chapter 6
                        THE MYTH OF MARKET EFFICIENCY
                        "As every individual, therefore, endeavours as much as 
                              he can both to employ his capital...such that its produce 
                              may be of the greatest value...He generally, indeed, neither 
                              intends to promote the public interest, nor knows how much 
                              he is promoting it...He intends only his own gain, and he is 
                              in this, as in many other cases, led by an invisible hand 
                              to promote an end which was no part of his intention...By 
                              pursuing his own interest he frequently promotes that of the 
                              society more effectually than when he really intends to 
                              promote it."
                                                Adam Smith, father of Economics
The orthodox theory of market efficiency

     In this chapter we shall broach the theme of the efficiency of markets. As opposed to
the previous chapters we shall not treat only one but instead two formulations of this 
theme, to wit: the Neo-classical and the Austrian.
     We commence with the Neo-classical. According to the Neo-classical school the concept
of efficiency corresponds with Pareto optimality, which "is present when 
there is no means of reorganizing production or consumption such that the satisfaction of 
any person is increased without reducing the satisfaction of another." And when is this 
achieved? Well when "the sum of consumer and producer surplus are maximized."
     We just introduced two new concepts: consumer surplus and producer surplus. 
Consumer surplus is the extra value obtained by persons consuming a good compared 
to what they have paid for it. For its part, producer surplus is the extra value 
producers receive by selling a good compared to the marginal costs incurred to produce it.
     And now, the key question: what economic system is that which maximizes the sum of 
consumer and of producer surplus? "Well the system of perfectly competitive markets!" the 
Neo-classical economists will respond. Thus we have, for example, one of the great 
representatives of the Neo-classical school, Paul Samuelson, who tells us: "One of the 
most profound results in all economics is that perfectly competitive markets 
assign resources efficiently." Why? Because in them "every firm has chosen its level 
of production such that the marginal cost equates to the price" wherein, under equilibrium
(P = CMg) the final consumer will be willing to pay that price which exactly covers the 
producer's costs and, therefore, a situation will result in which "the economy extracts 
the maximum quantity of production and satisfaction from its resources" thereby 
maximizing the economic surplus (consumer surplus + producer surplus). Graphically:

However, in what refers to this focus, it is necessary to make one important 
clarification: for Neo-classical economics the concept of efficiency has nothing to
do with equity. "Even if the economy is efficient, this does not imply anything 
with respect to the justice of the distribution of income." And indeed according to 
the orthodox Neo-classical conception, for efficiency to exist it suffices that society 
as a whole obtains the maximum possible welfare from its resources, independently
of how this may be distributed.
     We turn now to the focus on market efficiency held by the Austrian school. According 
to them markets are efficient because, on the one hand, being founded upon consumer 
sovereignty, it always procures maximum satisfaction for them, distributing production
in the most efficient mode possible; and on the other, because with all the "dispersed 
knowledge" concentrated in the prices, it allows producers and consumers to coordinate 
their plans in a spontaneous and rational manner.
     In order to explain the first point we base ourselves on the approach of Ludwig von 
Mises, one of the most prominent mentors of the Austrian school. According to Mises, the 
capitalist free market system is the most efficient of any imaginable for, being  based 
upon "consumer sovereignty," it only offers the producer one way to become rich: serving 
the consumers. We have here the hard discipline of the market.
     In his famous treatise Human Action (1949) Mises illustrates this in quite a 
suggestive manner: "The direction of all economic affairs is in the market society a
task of the entrepreneurs. Theirs is the control of production. They are at the helm and 
steer the ship. A superficial observer would believe that they are supreme. But they 
are not. They are bound to obey unconditionally the captain's orders. 
The captain is the consumer. Neither the entrepreneurs nor the farmers nor the 
capitalists determine what has to be produced. The consumers do that. If 
a businessman does not strictly obey the orders of the public as they are conveyed to him 
by the structure of market prices, he suffers losses, he goes bankrupt, and is thus 
removed from his eminent position at the helm. Other men who did better in satisfying the 
demand of the consumers replace him." In this way, Mises continues, on the difference 
between economic and political power: "A 'chocolate king' has no power over the 
consumers, his patrons. He provides them with chocolate of the best quality and at 
the cheapest price. He does not rule the consumers, he serves them. The consumers...
are free to stop patronizing his shops. He loses his ’kingdom’ if the consumers prefer 
to spend their pennies elsewhere."
     We have here, then, the essence of the "invisible hand" of which Smith spoke at the 
beginning of the chapter: the egoistical businessman who cares nothing about 
the needs of his neighbors and is only concerned to make more money ends, by virtue of
consumer sovereignty, behaving like a saint, since the only way he has to make more
money is by producing and selling those goods that the consumers most desire and need, in 
other words, caring about the needs of his neighbors. In this manner, seeking only 
one's individual welfare results in providing, without intending to, the social 
welfare in the most efficient mode possible.
     Now, to explain the second reason why the Austrian school postulates the intrinsic 
efficiency of markets we shall follow one who, in the opinion of many, is the most 
important and recognized of the liberal Austrian economists: Friedrich von Hayek. 
According to Hayek the fundamental problem of the economy is that of coordination
and the fundamental element for this to occur in a rational and efficient manner is 
information. In this schema, there can only be perfect coordination--and, 
therefore, maximum efficiency--where there is perfect information.
     So then, very much to the contrary of the Neo-classical economists, Hayek rejects 
(and very decidedly, to be sure) the assumption that "practically all of us deal with more
or less perfect knowledge," in other words, the assumption of perfect information. 
Yet, how then to demonstrate that the market system is the most efficient? In quite an 
ingenious way: appealing to the "marvel" of the price system as a synthesizing mechanism 
for the "dispersed information." In his very famous 1944 work, The Road to Serfdom,
he writes: "The very complexity of modern conditions makes competition the only method by 
which a coordination of affairs can be adequately achieved. There would be no difficulty 
about efficient control or planning were conditions so simple that a single person or 
board could effectively survey all the facts. But as the factors which have to be taken 
into account become numerous and complex, no one centre can keep track of them. The 
constantly changing conditions of demand and supply of different commodities can never be 
fully known or quickly enough disseminated by any one centre. Under competition--and 
under no other economic order--the price system automatically records all the relevant 
data. Entrepreneurs, by watching the movement of comparatively few prices, as an engineer 
watches a few dials, can adjust their activities to those of their fellows...This is 
precisely what the price system offers under the regime of competition and something 
which no other system can, even potentially, realize."
     Pursuing a similar perspective to the standard theoretical scheme the hypothesis 
of efficient markets proposed by Eugene Fama of the University of Chicago became 
dominant, according to which active prices in the financial markets would tend towards 
their fundamental value given all the publicly available information. Ergo, not only the 
markets for standard goods and services but also the financial would be efficient and, 
consequently, the stability of the whole economy would be assured. Any crisis, therefore, 
could only be caused by an "unexpected exogenous shock" but never would come from the 
functioning of the market system itself.

The markets are not omnipotent! The problem of market failure