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Modern Economics As a Flight from Reality

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AS STUDENTS PROGRESS BEYOND ECONOMICS 101, THEY find themselves ascending to the ever more rarefied world of formal mathematical models, where theory has only a tenuous relationship to reality. In the clear-cut equations of economic theory, the flaws of everyday life – such as ignorance and uncertainty – disappear.

Although they are famously quarrelsome, modern economists all reach their widely varying conclusions through the same process: building abstract models on mathematic foundations.

Of course, to reject economic theory because it is too abstract would be inimical to satisfactory economics. We have no choice but to think in terms of models and simplifying assumptions. Otherwise, the world would be too complex to understand. However, some theories are better than others, because even though they’re abstract, they’re relatively realistic.

Too much concreteness drowns analysis in the sea of detail that economists are trying to distill. But too little realism is unscientific; and for all its mathematical precision, it is in this unscientific direction, untethered to reality, that economics has gone.

If theoretical coherence alone were all that mattered, then the main constraint on theoretical exercises would be the human imagination. Interesting puzzles would replace pragmatic solutions to problems encountered in actual economies. Arguably, that is an accurate characterization of most contemporary economic theory. In classrooms and academic journals, the false precision of economic formalism has obscured the messy nature of the real world, where individuals cannot simply assume away issues like the passage of time, the limits of our knowledge, and the uncertainty of the future.


On March 1, 1933, Austrian émigré F. A. Hayek delivered his inaugural lecture at the London School of Economics and Political Science. For reasons I will try to make clear, Hayek was a convinced free marketeer. So his lecture warned against the popular trend toward economic interventionism that had been touched off by the Great Depression. Laissez faire, critics argued, was both unjust and chaotic. Business cycles were seen as manifestations of the inherent contradictions of capitalism. This message possessed a very practical appeal during the crisis, and Hayek warned that public ignorance of basic economic principles might prompt disastrous legislative responses.

But like other members of the Austrian school of economics, Hayek was about to be blindsided by the direction from which interventionist tendencies would come: not only from the public and its political tribunes, but from the very heart of the academic economic tradition of which the Austrians formed one of the main branches.

Hayek would spend the rest of his long life criticizing the unrealistic assumptions that separated the new, interventionist economists from him and his Austrian colleagues. But at first, he was taken by surprise. It was only in retrospect that he came to see that, even in 1933, Austrian economists were different from the neoclassical economic mainstream.

Austrians emphasized the role of knowledge and ignorance, time and uncertainty, change and disequilibrium in economic processes. Non-Austrian economists recognized the existence of such factors as time and ignorance, but soft-pedalled them as market “imperfections.” This innocent shift of emphasis grew into the neoclassical interventionism that caught Hayek unawares. If, as non-Austrians came to see it, the market allowed imperfections, then perhaps the market should be regulated, or replaced.

In the 1930s, the socialist economist Oskar Lange even used neoclassical equilibrium analysis to demonstrate that a planned economy could be as efficient as a market economy — if one assumed that perfect knowledge was available to the central planners. For in that case, the planners could calculate the prices of alternative uses of resources just as the competitive market supposedly does. Socialist planners could draw on knowledge of supply and demand conditions just like economic agents do in the neoclassical, perfectly competitive model. If the orthodox neoclassical model was theoretically coherent, then Lange’s model of market socialism was equally coherent.

In response to Lange’s arguments, both Hayek and his mentor, Ludwig von Mises, started to articulate more clearly and precisely the differences between Austrian economics and the neoclassical orthodoxy. But by this time they were already too far outside of the mainstream to command its attention. Mises and Hayek came increasingly to be viewed as politically motivated pundits of the right, not as serious economists. By 1950 at the latest, the Austrian school of economics was marginalized — to the extent that it became questionable whether it should be considered part of the discipline of economics any more.


In the eyes of professional economists, Austrian economics was soundly defeated by both neoclassical socialism like Lange’s, and by neoclassical macroeconomics like that of John Maynard Keynes. Whereas Keynesianism challenged the ability of capitalism to avoid catastrophes like the Depression, neoclassical socialism challenged capitalism’s efficiency at producing goods and services even under the best of conditions. Either way, markets were deficient, and government correctives seemed to be called for.

What made mainstream economics receptive to these arguments was that it paid only lip service to ignorance, uncertainty, the passage of time, and changes in economic conditions. Meanwhile, Austrians continued to reject government interventionism because, if one does take these factors seriously, interventionism premised upon perfect knowledge in a timeless, changeless equilibrium seems utterly fantastic, hence irrelevant.

In 1947, the gap between the Austrians and the mainstream of neoclassical economics was widened by the publication of Paul Samuelson’s Foundations of Economic Analysis. Samuelson pioneered a synthesis of neoclassical and Keynesian economics, as well as endorsing the neoclassical argument for market socialism. Samuelson also furthered the neoclassical case against the free market in the 1950s, with his development of the theory of market failure.

Samuelson’s tremendous influence can be explained on two levels. First, economists suffer from physics envy. Samuelson’s mathematization of economics promised to complete the transformation of economics into social physics. Second, Samuelson was not only smart, but strategic. Shortly after his Foundations of Economic Analysis became the major textbook in graduate education, his Economics became the leading undergraduate text. Samuelson influenced students on their way in and on their way out.

Within a decade, Samuelson became synonymous with economics, and his hold over the style — if no longer the substance — of economic reasoning has not waned since.

Before Samuelson came along, the model of a perfectly competitive market was primarily used in thought experiments that were supposed to present contrasts to the real world of actual market institutions. Such counterfactual thought experiments illuminated the positive function of those institutions.

For example, why do we need profits? In a world of perfect information, profits would not exist, since producers would know exactly what consumers would be willing to pay for their products, and any producer who charged more than that amount, in order to make a profit, would be put out of business by a producer who charged a little bit less. Given an endless supply of perfectly informed producers, they will compete prices down to the cost of production, leaving no room for any of them to keep any income for herself as profit. This is “perfect competition.” When perfect competition prevails across the economy, an equilibrium is reached from which any change would represent harm to the consumer.

The contrast between this imaginary world and the real world, in which competition and profit coexist, suggests that profits may have some functional significance in coping with imperfect knowledge and incomplete competition.

The functional significance is this: profits guide producers toward the areas of unmet consumer demand. If one producer is making huge profits by selling people product X, then other producers, lured by the prospect of taking some of those profits for themselves, may be induced to start the process of competition that would — given enough time — eventually bid the price down to the cost of production, leaving zero profit. But the zero profit point is rarely reached in a world in which, as time passes, circumstances change. Moreover, the first producer of product X would not have made a profit to begin with unless, beforehand, other potential producers of X had been ignorant of consumer demand for it.

The counterfactual of a perfectly competitive, perfectly informed, zero-profits world therefore suggests that profits are not a useless burden on consumers, one that can be taxed or regulated away without harmful consequences. In the factual world of imperfect information about consumer demand, profits stimulate and guide the competitive process that meets people’s needs.

On the other hand, once profit opportunities are established, competition to seize them can be vicious. Far from holding consumers in a viselike grip, profit-seeking corporations are in a ceaseless race against real and potential competitors to meet consumer demand before it shifts from product X to some new entrepreneur’s invention, product Y.

As counterintuitive as it seems, the corporation is at the mercy of the consumer, not the other way around. And the result of what might first seem like the parasitic profits of the corporation is what we in the real world of capitalism take for granted every day: that the stores are full of things that people want to buy.

This use of perfect competition in thought experiments that, like laboratory experiments, isolate important aspects of a complex reality was reversed by the formalist revolution that Samuelson pioneered. To him, departures of reality from the model of perfect competition highlighted the need for politics to set things straight. Formal models of perfectly competitive equilibrium have represented the hard core of the mainstream economics research program ever since.

This formalist revolution has led economists to focus on building theoretical models, for one of two reasons: either to vindicate the market economy when it approximates the model, justifying laissez faire; or to vilify the market when it deviates from the model, justifying government intervention. Both types of formalism are utopian. Either capitalism is idealized, so that it approximates the model; or capitalism is demonized, and utopian properties are attributed to political processes intended to make reality match the model.

Absent from both types of formalism is the recognition of any possibility but all or nothing. Either the real world exemplifies perfect equilibrium, or it could not even approach that condition without a push from the state.

To see how much idealization is required to reach laissez-faire conclusions using such models, consider the requirements of perfectly competitive equilibrium: not only perfect information, but an infinite number of buyers and sellers, and the costless mobility of resources. These constraints require each market participant to treat prices as given, because prices equal the cost of production — with no profit left over. But with no profit, there is no incentive for anyone to do the things that would push the market in this optimal direction, and no guidance, in any case, as to where that optimum might lie.

The new role played by competitive equilibrium models was fostered by Samuelson’s methodological innovations. Samuelson sought to eliminate the vague assumptions that underlay debates among the “literary economists” of previous generations. Restating economics in the axiomatic language of mathematics, Samuelson argued, would force economists to make explicit what they had previously thought only implicitly. But the techniques of mathematics available to Samuelson required well-behaved and linear functions; otherwise, results would be indeterminate and the promised precision would not be achieved. In order to fit economic behavior into mathematical language, the real world had to be deprived of its complexity. The problem situation of economic actors had to be simplified drastically so as to yield the precise formulations that Samuelson sought.

Samuelson drained economic theory of institutional context and historical detail. Parsimony won out over thoroughness. Economics moved from one side of the cultural divide (the liberal arts) to the other side (the sciences) — or at least that was the self-image of economists, who equated science more with precision than with accuracy.

The physicist does not let the impossibility of making accurate predictions in many real-world contexts, such as meteorology, interfere with her pursuit of the precise formal laws that interact, with unfathomable complexity, in a real-world thunderstorm. Because of the complexities of real-world interaction, it would take a foolish physicist to say that we can abolish imprecise meteorology and use physics to forecast the weather.


Almost simultaneously with Samuelson’s use of equilibrium as a harsh indictment of reality, University of Chicago economists such as Milton Friedman, George Stigler, Gary Becker, and Robert Lucas began to use it as a laudatory description of reality. In their view, real markets come breathtakingly close to approximating the efficiency properties of general competitive equilibrium. And even if a real-world market deviates from the ideal, the predictions of the model approximate behavior in the real world better than alternative models do. Real-world markets, in other words, act “as if” they are in competitive equilibrium.

By collapsing the gap between the perfectionist model and reality, the Chicago school in its purest form does away with the need for intervention of the sort advocated by Samuelson et al. Hence the current reputation of laissez faire as a wildly unrealistic economist’s dogma. In comparison with the implausible assumptions of Chicago-school laissez faire, government regulation has come to be seen as hard-headed realism. But in fact, neoclassical interventionists couple a dystopian misunderstanding of market institutions with a utopian faith in government to improve on such institutions.

The contest between the Chicago school and its interventionist enemies poses a Hobson’s choice. The Chicago school’s use of equilibrium to describe reality conflates the mental and empirical worlds. By contrast, those who use equilibrium models to indict capitalist realities at least recognize that reality isn’t perfect. But they neglect the ways imperfect market institutions approach competitive ideals, so they have an unduly pessimistic view of capitalism — even while they are wildly optimistic about the ability of politics to bring reality up to par.

By ignoring the dynamics of disequilibrium, both traditions obscure the possibility that real-world market institutions may set in motion dynamic processes that help economic agents cope with the human condition: pervasive ignorance, the irreversibility of time, and the inevitability of change.

The Chicagoans’ endorsement of markets raises false hopes that are bound to be dashed. The Chicago school lacks a theory explaining how markets achieve whatever degree of success they do; all the important work, as critics never tire of pointing out, is done by their model’s perfect-knowledge, perfect-competition assumptions. If the Chicagoans could explain something as simple as the dynamic by which profits inspire and guide competition, they could teach their interventionist colleagues that market “imperfections” may actually serve to alleviate scarcity in the real world. But Chicagoans can’t do so, because they adhere to the same static assumptions that interventionists use. This gives them the weaker position in the debate with interventionists, since members of the observing audience are bound to notice that the world isn’t perfect. If politicians can devise interventions that merely promise to solve problems the existence of which Chicagoans deny as impossible, then just establishing the existence of those problems will seem to license intervention, and the Chicago school will be doctrinaire in opposing it.


Pondering the unexpected use of perfectionist formal models to justify intervention in markets, Hayek was moved to produce his seminal contributions to economic theory: “Economics and Knowledge” (1937) and “The Use of Knowledge in Society” (1945).

In these essays, Hayek suggested that the central concern of economics is to explain “how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affairs in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals.”

Economic theory, in other words, should explain observed reality.

For instance, the empirical observation that prices tend to correspond to costs is the starting point of economic science. But Hayek notes that formal neoclassical theory is static, so it cannot discern the dynamic process by which prices allow diffuse cost information to be processed and used by imperfect economic actors — for instance, in their pursuit of profit. Thus, to explain the correspondence of prices and costs, formal theory falls “back on the assumption that everybody knows everything,” and so evades “any real solution of the problem” of how it is that prices tend to be competed down to costs.

Likewise, the economic problem, as stated by Hayek, was not the one posed by standard welfare economics, namely the allocation of scarce resources among competing ends. This way of stating the problem — which leads the neoclassical mainstream to regard general equilibrium as a solution — “habitually disregards” essential elements of the phenomena under investigation, according to Hayek, by ignoring “the unavoidable imperfection of man’s knowledge and the consequent need for a process by which knowledge is constantly communicated and acquired.” To be able to allocate scarce resources among competing ends, we would have to know how scarce they were, how dire were the competing demands, and how best to combine the available resources to meet the demands. But real-world economic actors know none of these things beforehand; they are constantly in the process of learning them, and the question is how they go about it.


To answer such questions about market dynamics, which can be addressed by counterfactual thought experiments but are inexpressible in the language of mathematics, the orthodox model’s assumptions would have to be relaxed. But then it would get overly complex and lose its formal elegance.

This dilemma has dogged a significant strand within orthodox economic thought that, since about 1960, has tried to take up Hayek’s challenge and examine the informational aspect of markets. This research program attempts to grapple with the main feature of economic reality that, in the Austrian view, is obscured by economic formalism: incomplete knowledge. But because the new economics of information is itself formalist in its use of equilibrium models, it has been fated to oscillate between utopianism about the informational properties of real markets and utopianism about the alternatives.

Classical economists of the early and middle nineteenth centuries had focused exclusively upon how prices provided the incentive to purchase more or less of a particular good. The new economists of information recognize that prices serve a communicative function as well. They see that prices transmit vital knowledge about (for instance) relative scarcities.

Chicago’s George Stigler is usually credited with being the first economist to develop an informational model consistent with standard neoclassical price theory. Stigler argued that individuals will search for the information necessary to accomplish their goals in the market, but unlike Hayek, he assumed that they will do so in an optimal manner, by comparing the marginal cost of information with the marginal benefit of continuing to search for it.

In other words, Stigler joined the informational content of markets with the assumption that equilibrium models should be seen as describing actual behavior. In Stigler’s view, there was economic ignorance in the real world, but it was the optimal level of ignorance. The attempt to eliminate the remaining ignorance would entail searches for information that were more costly than the benefits they could produce. Following Stigler, Chicago-school economists such as Armen Alchian and Jack Hirshleifer developed information-search models in which various aspects of the economic system such as advertising, middlemen, unemployment, queues, and rationing take on a new meaning and functional significance.

At the same time, economists who treated equilibrium as a critical norm rather than a reality, such as Kenneth Arrow, Leonid Hurwicz, and Roy Radner, also sought to develop models that accounted for informational imperfections. Where Stigler’s approach extended the assumption of maximizing behavior to the information-search process, predicting that markets would see various practices emerge to economize on the search process and generate an optimal flow of information, the Arrow/Hurwicz/Radner approach argued that in the face of incomplete information, maximizing agents would be unable to coordinate their behavior with others in an optimal manner unless an appropriate mechanism could be designed anterior to the market.

The first approach presupposed the efficiency of market allocations. The second presupposed their inefficiency and the prevalence of market failure. Neither approach adequately dealt with the components of market processes that help economic actors adjust to and learn from real-world disequilibrium.

Among contemporary economists, Joseph Stiglitz and Sanford Grossman have elaborated the second approach more systematically than anyone else. Their research on the informational role of prices has led to a fundamental recasting of many basic questions in orthodox economic theory.

Grossman and Stiglitz understand Hayek to be arguing that prices are “sufficient statistics” for economic coordination, and they conclude that this argument is flawed. In situations where privately held information is important, they contend, market prices will be informationally inefficient, for the market will not provide the appropriate incentives for information acquisition; because of “information asymmetries,” the case for economic decentralization is not as strong as Hayek suggests.

Grossman and Stiglitz’s reasoning, however, begs the question against Hayek by starting from the unrealistic assumption of rational-expectations equilibrium. (Rational-expectations theory is another development of neoclassical orthodoxy, this time from the Chicago direction, which I criticize in the longer version of this article. Given this assumption, they maintain, prices will reveal information so efficiently that no one could gain from the revelation of privately held information. Individual agents can simply look at prices and obtain free what would be costly to acquire privately. This free riding leads to an underproduction of information by the market. Prices, as a result, will necessarily fail to reflect all the available information. Grossman states the supposed paradox as follows:

“In an economy with complete markets, the price system does act in such a way that individuals, observing only prices, and acting in self interest, generate allocations which are efficient. However, such economies need not be stable because prices are revealing so much information that incentives for the collection of information are removed. The price system can be maintained only when it is noisy enough so that traders who collect information can hide that information from other traders.”

This paradox does challenge Stigler’s (Chicago) model of information searching. But Grossman and Stiglitz’s analysis translates Hayek’s view of dispersed knowledge into the language of formal information theory. This leaves out questions of the context and the tacit dimension of knowledge.

In reality, Hayek argued, the kind of “knowledge” that is dispersed among market participants is “knowledge of the kind which by its nature cannot enter into statistics.” The determinants of market prices are not the sort of data that can be treated as a commodity. It is not, therefore, the costliness of information that is essential to Hayek’s story, but rather its dispersal. Its dispersal makes economic knowledge inaccessible except under special, institutionally fragile circumstances. The relevant economic knowledge, as Hayek put it, is knowledge of “particular time and place.” It can be used and discovered only in particular institutional contexts — contexts that are abstracted away in the timeless, placeless formalism of equilibrium modeling.

The fundamental purpose of economic analysis, according to Hayek, is to determine how a dynamic system of production uses dispersed knowledge in a manner that aligns production plans with consumption demands. The price system, an unintentional outgrowth of an institutional environment of well-defined private property rights, serves this aligning function in at least two ways.

First, ex ante, prices transmit knowledge about the relative scarcities of goods to various market participants so they may adjust their behavior accordingly. If the price of a good goes up because it has become more scarce, the effect is to impel consumers to economize in its use.

Second, the price system serves the ex post function of revealing the ultimate profitability or unprofitability of economic actions. Prescient entrepreneurship is rewarded with profits; errors are penalized by losses. Market prices, therefore, not only guide future decisions by conveying information about changing market conditions, but also help market participants evaluate the appropriateness of past market decisions and correct erroneous ones.

Seen in this light, the market process is a matter of dynamic adjustment. What is it an adjustment to? It is, in effect, an adjustment to the gaps between a static equilibrium of universal satisfaction and the many departures from this model that are present in the real world. Each of these gaps between the counterfactual and the factual represent a profit opportunity.

While the assumption of perfect knowledge was essential for modeling the state of competitive equilibrium, it precluded an examination of the path by which adjustment toward equilibrium could be achieved. If the system were not already in equilibrium, one could not explain how it would get there. Omniscience logically results in non-action.

A profit opportunity that is known to all can be realized by none. The knowledge that economic agents rely on to make decisions is not universal and abstract, as it must be if it is to be replicated through either bureaucratic planning or political deliberation. Nor is it magically revealed to market participants through prices, the import of which must, after all, be interpreted, based on the context and the tacit knowledge of the interpreter. It can be interpreted in different ways by different entrepreneurs, drawing on different contexts and theories.

The essence of the price system lies not in its ability to convey perfectly correct and transparently clear information about resource scarcity and technological possibilities, but in “its ability to communicate information about its own faulty information-communication properties,” in the paradoxical words of Israel M. Kirzner. Disequilibrium prices, imperfect as they are, nevertheless provide some guidance in error correction and avoidance, when interpreted correctly. Entrepreneurs who interpret them correctly will tend to profit; those who don’t will tend to go bankrupt. The entire process of entrepreneurial error detection and correction, however, is absent from Stiglerian and Stiglitzian formal models of economic “information,” premised on static equilibrium.


Much economic information is “private” and is held “asymmetrically.” But that doesn’t stop market prices from using this information effectively — albeit not perfectly.

Entrepreneurs act on their competing interpretations of the “meaning” of market prices, which come from the entrepreneurs’ private perceptions of prices in the context of their local “time and place.” The resulting interpretations of how to make a profit don’t need to be explicit or self-aware, and they probably can’t be — any more than literary or historical interpretations can be reduced to articulate formulae that precisely state every tacit assumption. The dynamics of profit and loss select among entrepreneurs’ competing “interpretations” not by rigorously debating them, but by subjecting to an acid test the actions to which the interpretations lead. By making a profit, an entrepreneur whose actions benefit consumers is rewarded, ex post. By incurring a loss, an entrepreneur who produces things consumers don’t want is penalized, and his underlying, tacit interpretation of what prices “mean” is falsified.

The fact that there are losses means that contrary to Stigler, the right level of “information” — or, rather, the perfect overall interpretation of the available information — has not been achieved. But the effect of profits and losses is nonetheless to push markets in consumer-satisfying directions. Contrary to Stiglitz, the “informational” function of prices isn’t to create an accurate synoptic picture of where resources should be “allocated.” In order to be effective, such a picture would have to be accessible to some imagined “public” — whether that public consists of fully informed market participants; or fully informed voters, legislators, or bureaucrats, acting through politics to correct deviations from the ideal allocation. Real-world market prices induce entrepreneurs to serve consumers despite the asymmetry of their information and the subjectivity of it. Trial by fire replaces conscious thought.

By conferring profits and losses, consumers unconsciously reward the effective use of privately held information without anyone having to articulate it. There is no analogue in markets to the political need for transparent deliberation. The error in formal economic modeling is to depict markets as if they are — or should be — an arena of clear reasoning about good data: perfect knowledge of all the necessary information. The reality of imperfect markets is that they work even when they don’t draw on information that is articulate enough to enlighten actors in the public sphere about how to correct “market failures.”

When one grasps the effectiveness of imperfect market processes in helping fallible economic actors discover how to meet changing needs, one will probably start questioning the ability of fallible political actors to duplicate these achievements. Where is there an analogue, in politics, to the price system? — some method of testing regulators’ interpretations of how to meet unmet needs, without requiring well-informed abstract theorizing about a complicated world that is rich with surprising detail? When one interpretation is imposed on everyone through public policy, the scope for inarticulate local innovation enabled by markets is dramatically reduced; and testing the effects of innovation becomes a purely intellectual exercise, one that demands absurdly competent synoptic powers from imperfect people. The “marketplaces” of ideas and of electoral competition are no substitute for real markets. It is democracy, not capitalism, that needs an unrealistic level of “information” if it is to work well.

Economists’ oscillation between perfect-market theory and market-failure theory, both of which take as the terms of debate the formal model of general competitive equilibrium, will inevitably be won by theorists of market failure. It is obvious that the economic world is not perfectly competitive (or even near that state of affairs). Hence the triumph of the interventionism that Hayek forecast in 1933 — not, as he feared at the time, because economic theory had been rejected, but, as he came to realize later, because it had been misconceived.

To address Hayek’s argument seriously, economists would have to drop the false precision of equilibrium models and engage in careful reasoning about imprecise phenomena, such as the passage of time, the limits of our knowledge, the uncertainty of the future, and the discovery of opportunities. Perhaps Hayek’s argument cannot be sustained when confronted in this manner, but we will not know this until eight decades’ worth of formalization is abandoned, and the realities of economic life amoung fallible, ignorant people are reengaged.

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Peter J. Boettke is a professor of economics at George Mason University. A longer version of this article originally appeared in Critical Review, vol. 11, no. 1.






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