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NEWTONIAN

MICROECONOMICS

A Dynamic Extension to

Neoclassical Micro Theory

Matti Estola

Newtonian Microeconomics

Matti Estola University of Eastern Finland Joensuu, Finland

ISBN 978-3-319-46878-5 ISBN 978-3-319-46879-2 (eBook) DOI 10.1007/978-3-319-46879-

Library of Congress Control Number: 2016961252

© The Editor(s) (if applicable) and The Author(s) 2017 This book was advertised with a copyright holder in the name of the publisher in error, whereas the author holds the copyright. This work is subject to copyright. All rights are solely and exclusively licensed by the Publisher, whether the whole or part of the material is concerned, specifically the rights of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction on microfilms or in any other physical way, and transmission or information storage and retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology now known or hereafter developed. The use of general descriptive names, registered names, trademarks, service marks, etc. in this publication does not imply, even in the absence of a specific statement, that such names are exempt from the relevant protective laws and regulations and therefore free for general use. The publisher, the authors and the editors are safe to assume that the advice and information in this book are believed to be true and accurate at the date of publication. Neither the publisher nor the authors or the editors give a warranty, express or implied, with respect to the material contained herein or for any errors or omissions that may have been made.

Cover illustration: © Carol Dembinsky / Dembinsky Photo Associates / Alamy Stock Photo

Printed on acid-free paper

This Palgrave Macmillan imprint is published by Springer Nature The registered company is Springer International Publishing AG The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland

Preface

Motivation for the Book

The theoretical framework of mainstream microeconomics, neoclassical micro theory, is in many ways restrictive and sticking to it has prohibited the development of economics into a quantitative science. The main weaknesses of neoclassical analysis are: (1) The assumption of static opti- mization does not allow modeling time dependent processes, such as time dependent price and cost functions of firms and income of consumers. (2) Static profit maximization does not allow increasing returns to scale in firms’ production processes because in that case a profit-maximizing flow of production would not exist. (3) The assumed optimal behavior of economic units prohibits understanding changes in economic quantities, because if every economic unit behaves in the optimal way from its point of view, none will change its behavior and thus observed changes in economies cannot be understood. (4) The static neoclassical theories of a consumer and a firm and their dynamization by dynamic optimization give equal results, if identical target functions are assumed for economic units in both cases. Thus the dynamic theories of a firm and a consumer derived by dynamic optimization as presented in economics textbooks are inconsistent with the corresponding static ones. These claims mean that economics is lacking a consistent dynamic theory of microeconomics, and this is what we introduce in this book.

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Preface vii

testing of economic theories becomes rigorous. (3) The economic ‘forces’ acting upon economic quantities are defined, and these forces explain the observed changes in economic quantities. This is a new framework of modeling in economics, and it is analogous to Newtonian mechanics in physics. (4) In every presented theory, the results are compared with observed real-world behavior. In this way we get a view as to how accurate current economic theories are as compared with observed data. An old truth—everything affects everything—holds in economics. Thus to be able to understand and model economic events, these have to be simplified so that the created models do not get too complex. In modeling, it is important to separate essential factors from unessential ones, and create models by using only essential quantities. Many complex- looking systems consist of various simple systems affecting each other, and in modeling in this way the connections between the systems are revealed. Economic phenomena can be understood in principle at three levels. The first level is intuitive. We understand intuitively that, for example, the more wanted and scarce a good is, the more people are ready to pay for it, and the higher value it has. Another level of understanding eco- nomic phenomena—that is extensively applied in economics textbooks— is graphical presentation. In a graphical presentation, the relation between economic quantities is presented as an increasing or decreasing graph, and this visual presentation clarifies the situation. The third and deepest level of understanding is the exact mathematical formulation of a situation so that the explainable variables (or their time paths) are solved as functions of explaining variables. This deepest level of understanding is required in empirical testing of economic theories because graphical analysis is not accurate enough for rigorous testing. In this book, all three levels of understanding are applied. A part of the results appearing in this book have been published earlier in Estola and Hokkanen (1999, 2007, 2008) and in Estola (2001). Empirical support for the theories presented in this book can be found in Estola and Dannenberg (2012) and in Estola (2011, 2015). However, many of the modeling situations presented in this book have not previously been presented.

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About the Audience

This book is aimed at students of undergraduate and graduate level university courses in microeconomics. Directed especially to those inter- ested in econophysics, the book presents a new methodological bridge between modeling principles in economics and physics. The book starts at an elementary level of economics, however, because the principles of modeling in economics are defined in a new way. However, the core material of the book is aimed at students having taken at least a basic course in economics. The mathematical requirements are knowledge of equations and differential calculus for the main parts of the book, which also includes a mathematical appendix where the applied techniques are presented. All sections in the book, where differential equations are applied, are marked with asterisk to note that these sections are formally more demanding. I have used the contents of the book in my teaching at the University of Jyväskylä during the period (1996–1999) and at the University of Eastern Finland (former University of Joensuu) during (1999–2016) in the following courses: Principles of Economics, Intermediate Microe- conomics, and Advanced Microeconomics. This means that some parts of the book are applicable at introductory and some at advanced level microeconomics courses in universities. I have used the excellent inter- mediate level textbook of physics by Hans C. Ohanian (1989) Physics, Second Edition Expanded, as a model for the presentation of matters. The mathematical level of this book represents in some parts that of Ohanian; however, on average the book of Ohanian applies much more complicated mathematics. With this argument I can claim that the mathematical level of the book is not too high. The first version of this book, Kansantaloustieteen perusteet , was published at 1996 in the Finnish language at the University of Jyväskylä. This new English version of the book includes a few new chapters as compared with the 1996 version, and over the past 20 years all the material in the book has, of course, improved and deepened.

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Estola, M. (2015). Neoclassical and newtonian theory of production: An empir- ical test. Hyperion International Journal of Econophysics & New Economy, 8 (1). Estola, M., & Dannenberg, A. (2012). Testing the neoclassical and the Newto- nian theory of production. Physica A, 391 (24), 6519–6527. Estola, M., & Hokkanen, V.-M. (1999). A dynamic theory of consumer behaviour. In S. B. Dahiya (Ed.), The current state of economic science. Rohtak: Spellbound Publications Pvt. Ltd. Estola, M., & Hokkanen, V.-M. (2007). Asset price dynamics by economic forces. BetrieBswirtchaftliche Forschung und Praxis, 5. Estola, M., & Hokkanen, V.-M. (2008). Consumer, firm, and price dynamics: An econophysics approach. Modeling by economic forces. Saarbrücken: VDM Verlag Dr. Müller.

Contents

1 Economics as a Science 1 1.1 Classification of Economics 3 1.2 The Axioms of Economics 5 1.2.1 Regular Needs of Human Beings 5 1.2.2 Business Competition and Rational Behavior 6 1.2.3 The Birth of Organizations 9 1.2.4 The Principle of Modeling in Economics 12 1.3 Forecasting Human Behavior 14 1.3.1 Predictability of Economic Events 15 1.4 Frameworks of Economic Modeling 16 1.4.1 The Neoclassical Framework and Its Critique 16 1.4.2 Econophysics 19 1.4.3 A Dynamic Extension to Neoclassical Economics 24 1.4.4 Decision-Making Steelyard 26 1.5 A Summary of the Methodological Basis of Economics 30 References 30

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Economics as a Science

Economics is a social science that analyzes the conflict between the almost unlimited needs of human beings, and the limited amount of goods available for the satisfaction of people’s needs. For example, the following questions are studied in economics: (1) Why are certain goods produced in different economies? (2) Whose needs does the production aim to satisfy? (3) Which methods are applied in the production of different goods, and what is the reason for this? (4) How are the prices of goods determined? (5) What kind of institutions and economic units exist in societies, and how they operate? (6) What are the factors that affect the welfare of a society, and how are these factors measured? (7) Which factors cause economic growth? and (8) How have the relations between economic units been developed over time? In the following we denote a definition by the symbol §. §: By an economy we understand a society from the point of view of its economic structure. ˘ §: A good is the term applied to material and non-material products. ˘ A good is thus a shirt, a radio set, a meal in a restaurant, a bottle of wine, a haircut, a soccer game, etc.

© The Author(s) 2017 M. Estola, Newtonian Microeconomics , DOI 10.1007/978-3-319-46879-2_

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§: By consumption we understand the eating or using up of something of value, or the enjoyment of the services of a durable good. ˘ §: By a durable good we understand a good that produces services for its holder during several time units, and which usually has a positive scrap value. ˘ §: By production we understand the process where the inputs of material and labor are used in the construction of goods. ˘ §: Labor consists of the physical and mental work of people in the production of goods. ˘ §: An economic unit is a decision-making unit that consists of one person or a group of people that behave together as one unit. An economic unit has some goals it is willing to reach, and a limited amount of resources for achieving these goals. ˘ §: By resources of economic units we understand the production factors that are used in the production processes of an economy. Resources are, for example, plants, machines, money, labor, raw materials, knowl- edge of production methods, creativity, and so on. ˘ Economic units are, for example, households, investors, firms, trade unions, non-profit making institutions , central bank , local govern- ments , and the government of a country. All these can be seen as independent decision-making units (see Sect. 1.3.1), the decisions of which affect the behavior of the economy they operate. We assume that economic units have defined for them certain goals they aim to achieve, and in this book we do not study the conflicts of interest between people belonging in one economic decision-making unit. We thus assume, for example, that the goals of a trade union are high wages and full employment for its members, even though union members have differing views of the importance of these two conflicting goals. The aim of the science of economics is to measure, understand, and explain how the productive resources are allocated in an economy in a time unit, which part of the resources is actively used, how these resources are combined in various production processes, how the prices of goods are determined, and what kind of a historical process has caused the current situation. In economics, the aim is also to understand and explain changes in these matters and to forecast their future development.