The dominant form of economic analysis since the 1880s has been equilibrium analysis. While equilibrium had been used by classical economics to explain what regulated market prices, it did not consider it as reflecting any real economy. This was because classical economics analysed capitalism as a mode of production rather than as a mode of exchange, as a mode of circulation, as neo-classical economics does. It looked at the process of creating products while neo-classical economics looked at the price ratios between already existing goods (this explains why neo-classical economists have such a hard time understanding classical or Marxist economics, the schools are talking about different things and why they tend to call any market system "capitalism" regardless of whether wage labour predominates of not). The classical school is based on an analysis of markets based on production of commodities through time. The neo-classical school is based on an analysis of markets based on the exchange of the goods which exist at any moment of time.
This indicates what is wrong with equilibrium analysis, it is essentially a static tool used to analyse a dynamic system. It assumes stability where none exists. Capitalism is always unstable, always out of equilibrium, since "growing out of capitalist competition, to heighten exploitation, . . . the relations of production . . . [are] in a state of perpetual transformation, which manifests itself in changing relative prices of goods on the market. Therefore the market is continuously in disequilibrium, although with different degrees of severity, thus giving rise, by its occasional approach to an equilibrium state, to the illusion of a tendency toward equilibrium." [Mattick, Op. Cit., p. 51] Given this obvious fact of the real economy, it comes as no surprise that dissident economists consider equilibrium analysis as "a major obstacle to the development of economics as a science — meaning by the term 'science' a body of theorems based on assumptions that are empirically derived (from observations) and which embody hypotheses that are capable of verification both in regard to the assumptions and the predictions." [Kaldor, The Essential Kaldor, p. 373]
Thus the whole concept is an unreal rather than valid abstraction of reality. Sadly, the notions of "perfect competition" and (Walrasian) "general equilibrium" are part and parcel of neoclassical economics. It attempts to show, in the words of Paul Ormerod, "that under certain assumptions the free market system would lead to an allocation of a given set of resources which was in a very particular and restricted sense optimal from the point of view of every individual and company in the economy." [The Death of Economics, p. 45] This was what Walrasian general equilibrium proved. However, the assumptions required prove to be somewhat unrealistic (to understate the point). As Ormerod points out:
"[i]t cannot be emphasised too strongly that . . . the competitive model is far removed from being a reasonable representation of Western economies in practice. . . [It is] a travesty of reality. The world does not consist, for example, of an enormous number of small firms, none of which has any degree of control over the market . . . The theory introduced by the marginal revolution was based upon a series of postulates about human behaviour and the workings of the economy. It was very much an experiment in pure thought, with little empirical rationalisation of the assumptions." [Op. Cit., p. 48]
Indeed, "the weight of evidence" is "against the validity of the model of competitive general equilibrium as a plausible representation of reality." [Op. Cit., p. 62] For example, to this day, economists still start with the assumption of a multitude of firms, even worse, a "continuum" of them exist in every market. How many markets are there in which there is an infinite number of traders? This means that from the start the issues and problems associated with oligopoly and imperfect competition have been abstracted from. This means the theory does not allow one to answer interesting questions which turn on the asymmetry of information and bargaining power among economic agents, whether due to size, or organisation, or social stigmas, or whatever else. In the real world, oligopoly is common place and asymmetry of information and bargaining power the norm. To abstract from these means to present an economic vision at odds with the reality people face and, therefore, can only propose solutions which harm those with weaker bargaining positions and without information.
General equilibrium is an entirely static concept, a market marked by perfect knowledge and so inhabited by people who are under no inducement or need to act. It is also timeless, a world without a future and so with no uncertainty (any attempt to include time, and so uncertainty, ensures that the model ceases to be of value). At best, economists include "time" by means of comparing one static state to another, i.e. "the features of one non-existent equilibrium were compared with those of a later non-existent equilibrium." [Mattick, Op. Cit., p. 22] How the economy actually changed from one stable state to another is left to the imagination. Indeed, the idea of any long-run equilibrium is rendered irrelevant by the movement towards it as the equilibrium also moves. Unsurprisingly, therefore, to construct an equilibrium path through time requires all prices for all periods to be determined at the start and that everyone foresees future prices correctly for eternity — including for goods not invented yet. Thus the model cannot easily or usefully account for the reality that economic agents do not actually know such things as future prices, future availability of goods, changes in production techniques or in markets to occur in the future, etc. Instead, to achieve its results — proofs about equilibrium conditions — the model assumes that actors have perfect knowledge at least of the probabilities of all possible outcomes for the economy. The opposite is obviously the case in reality:
"Yet the main lessons of these increasingly abstract and unreal theoretical constructions are also increasingly taken on trust . . . It is generally taken for granted by the great majority of academic economists that the economy always approaches, or is near to, a state of 'equilibrium' . . . all propositions which the pure mathematical economist has shown to be valid only on assumptions that are manifestly unreal — that is to say, directly contrary to experience and not just 'abstract.' In fact, equilibrium theory has reached the stage where the pure theorist has successfully (though perhaps inadvertently) demonstrated that the main implications of this theory cannot possibly hold in reality, but has not yet managed to pass his message down the line to the textbook writer and to the classroom." [Kaldor, Op. Cit., pp. 376-7]
In this timeless, perfect world, "free market" capitalism will prove itself an efficient method of allocating resources and all markets will clear. In part at least, General Equilibrium Theory is an abstract answer to an abstract and important question: Can an economy relying only on price signals for market information be orderly? The answer of general equilibrium is clear and definitive — one can describe such an economy with these properties. However, no actual economy has been described and, given the assumptions involved, none could ever exist. A theoretical question has been answered involving some amount of intellectual achievement, but it is a answer which has no bearing to reality. And this is often termed the "high theory" of equilibrium. Obviously most economists must treat the real world as a special case.
Little wonder, then, that Kaldor argued that his "basic objection to the theory of general equilibrium is not that it is abstract — all theory is abstract and must necessarily be so since there can be no analysis without abstraction — but that it starts from the wrong kind of abstraction, and therefore gives a misleading 'paradigm' . . . of the world as it is; it gives a misleading impression of the nature and the manner of operation of economic forces." Moreover, belief that equilibrium theory is the only starting point for economic analysis has survived "despite the increasing (not diminishing) arbitrariness of its based assumptions — which was forced upon its practitioners by the ever more precise cognition of the needs of logical consistency. In terms of gradually converting an 'intellectual experiment' . . . into a scientific theory — in other words, a set of theorems directly related to observable phenomena — the development of theoretical economics was one of continual degress, not progress . . . The process . . . of relaxing the unreal basis assumptions . . . has not yet started. Indeed, [they get] . . . thicker and more impenetrable with every successive reformation of the theory." [Op. Cit., p. 399 and pp. 375-6]
Thus General Equilibrium theory analyses an economic state which there is no reason to suppose will ever, or has ever, come about. It is, therefore, an abstraction which has no discernible applicability or relevance to the world as it is. To argue that it can give insights into the real world is ridiculous. While it is true that there are certain imaginary intellectual problems for which the general equilibrium model is well designed to provide precise answers (if anything really could), in practice this means the same as saying that if one insists on analysing a problem which has no real world equivalent or solution, it may be appropriate to use a model which has no real-world application. Models derived to provide answers to imaginary problems will be unsuitable for resolving practical, real-world economic problems or even providing a useful insight into how capitalism works and develops.
This can have devastating real world impact, as can be seen from the results of neoclassical advice to Eastern Europe and other countries in their transition from state capitalism (Stalinism) to private capitalism. As Joseph Stiglitz documents it was a disaster for all but the elite due to the "market fundamentalism preached" by economists It resulted in "a marked deterioration" in most peoples "basic standard of living, reflected in a host of social indicators" and well as large drops in GDP. [Globalisation and its discontents, p. 138 and p. 152] Thus real people can be harmed by unreal theory. That the advice of neoclassical economists has made millions of people look back at Stalinism as "the good old days" should be enough to show its intellectual and moral bankruptcy.
What can you expect? Mainstream economic theory begins with axioms and assumptions and uses a deductive methodology to arrive at conclusions, its usefulness in discovering how the world works is limited. The deductive method is pre-scientific in nature. The axioms and assumptions can be considered fictitious (as they have negligible empirical relevance) and the conclusions of deductive models can only really have relevance to the structure of those models as the models themselves bear no relation to economic reality:
"Some theorists, even among those who reject general equilibrium as useless, praise its logical elegance and completeness . . . But if any proposition drawn from it is applied to an economy inhabited by human beings, it immediately becomes self-contradictory. Human life does not exist outside history and no one had correct foresight of his own future behaviour, let alone of the behaviour of all the other individuals which will impinge upon his. I do not think that it is right to praise the logical elegance of a system which becomes self-contradictory when it is applied to the question that it was designed to answer." [Joan Robinson, Contributions to Modern Economics, pp. 127-8]
Not that this deductive model is internally sound. For example, the assumptions required for perfect competition are mutually exclusive. In order for the market reach equilibrium, economic actors need to able to affect it. So, for example, if there is an excess supply some companies must lower their prices. However, such acts contradict the basic assumption of "perfect competition," namely that the number of buyers and sellers is so huge that no one individual actor (a firm or a consumer) can determine the market price by their actions. In other words, economists assume that the impact of each firm is zero but yet when these zeroes are summed up over the whole market the total is greater than zero. This is impossible. Moreover, the "requirements of equilibrium are carefully examined in the Walrasian argument but there is no way of demonstrating that a market which starts in an out-of-equilibrium position will tend to get into equilibrium, except by putting further very severe restrictions on the already highly abstract argument." [Joan Robinson, Collected Economic Papers, vol. 5, p. 154] Nor does the stable unique equilibrium actually exist for, ironically, "mathematicians have shown that, under fairly general conditions, general equilibrium is unstable." [Keen, Debunking Economics, p. 173]
Another major problem with equilibrium theory is the fact that it does not, in fact, describe a capitalist economy. It should go without saying that models which focus purely on exchange cannot, by definition, offer a realistic analysis, never mind description, of the capitalism or the generation of income in an industrialised economy. As Joan Robinson summarises:
"The neo-classical theory . . . pretends to derive a system of prices from the relative scarcity of commodities in relation to the demand for them. I say pretend because this system cannot be applied to capitalist production.
"The Walrasian conception of equilibrium arrived at by higgling and haggling in a market illuminates the account of prisoners of war swapping the contents of their Red Cross parcels.
"It makes sense also, with some modifications, in an economy of artisans and small traders . . .
"Two essential characteristics of industrial capitalism are absent in these economic systems — the distinction between income from work and income from property and the nature of investments made in the light of uncertain expectations about a long future." [Collected Economic Papers, vol. 5, p. 34]
Even such basic things as profits and money have a hard time fitting into general equilibrium theory. In a perfectly competitive equilibrium, super-normal profit is zero so profit fails to appear. Normal profit is assumed to be the contribution capital makes to output and is treated as a cost of production and notionally set as the zero mark. A capitalism without profit? Or growth, "since there is no profit or any other sort of surplus in the neoclassical equilibrium, there can be no expanded reproduction of the system." [Mattick, Op. Cit., p. 22] It also treats capitalism as little more than a barter economy. The concept of general equilibrium is incompatible with the actual role of money in a capitalist economy. The assumption of "perfect knowledge" makes the keeping of cash reserves as a precaution against unexpected developments would not be necessary as the future is already known. In a world where there was absolute certainty about the present and future there would be no need for a medium of exchange like money at all. In the real world, money has a real effect on production an economic stability. It is, in other words, not neutral (although, conveniently, in a fictional world with neutral money "crises do not occur" and it "assumed away the very matter under investigation," namely depressions. [Keynes, quoted by Doug Henwood, Wall Street, p. 199]).
Given that general equilibrium theory does not satisfactorily encompass such things as profit, money, growth, instability or even firms, how it can be considered as even an adequate representation of any real capitalist economy is hard to understand. Yet, sadly, this perspective has dominated economics for over 100 years. There is almost no discussion of how scarce means are organised to yield outputs, the whole emphasis is on exchanges of ready made goods. This is unsurprising, as this allows economics to abstract from such key concepts as power, class and hierarchy. It shows the "the bankruptcy of academic economic teaching. The structure of thought which it expounds was long ago proven to be hollow. It consisted of a set of propositions which bore hardly any relation to the structure and evolution of the economy that they were supposed to depict." [Joan Robinson, Op. Cit., p. 90]
Ultimately, equilibrium analysis simply presents an unreal picture of the real world. Economics treat a dynamic system as a static one, building models rooted in the concept of equilibrium when a non-equilibrium analysis makes obvious sense. As Steven Keen notes, it is not only the real world that has suffered, so has economics:
"This obsession with equilibrium has imposed enormous costs on economics . . . unreal assumptions are needed to maintain conditions under which there will be a unique, 'optimal' equilibrium . . . If you believe you can use unreality to model reality, then eventually your grip on reality itself can become tenuous." [Op. Cit., p. 177]
Ironically, given economists usual role in society as defenders of big business and the elite in general, there is one conclusion of general equilibrium theory which does have some relevance to the real world. In 1956, two economists "demonstrated that serious problems exist for the model of competitive equilibrium if any of its assumptions are breached." They were "not dealing with the fundamental problem of whether a competitive equilibrium exists," rather they wanted to know what happens if the assumptions of the model were violated. Assuming that two violations existed, they worked out what would happen if only one of them were removed. The answer was a shock for economists — "If just one of many, or even just one of two [violations] is removed, it is not possible to prejudge the outcome. The economy as a whole can theoretically be worse off it just one violation exists than it is when two such violations exist." In other words, any single move towards the economists' ideal market may make the world worse off. [Ormerod, Op. Cit., pp. 82-4]
What Kelvin Lancaster and Richard Lipsey had shown in their paper "The General Theory of the Second Best" [Review of Economic Studies, December 1956] has one obvious implication, namely that neoclassical economics itself has shown that trade unions were essential to stop workers being exploited under capitalism. This is because the neoclassical model requires there to be a multitude of small firms and no unions. In the real world, most markets are dominated by a few big firms. Getting rid of unions in such a less than competitive market would result in the wage being less than the price for which the marginal worker's output can be sold, i.e. workers are exploited by capital. In other words, economics has itself disproved the neoclassical case against trade unions. Not that you would know that from neoclassical economists, of course. In spite of knowing that, in their own terms, breaking union power while retaining big business would result, in the exploitation of labour, neoclassical economists lead the attack on "union power" in the 1970s and 1980s. The subsequent explosion in inequality as wealth flooded upwards provided empirical confirmation of this analysis.
Strangely, though, most neoclassical economists are still as anti-union as ever — in spite of both their own ideology and the empirical evidence. That the anti-union message is just what the bosses want to hear can just be marked up as yet another one of those strange co-incidences which the value-free science of economics is so prone to. Suffice to say, if the economics profession ever questions general equilibrium theory it will be due to conclusions like this becoming better known in the general population.