2. Chicago price theory: a view from Virginia

In 1946, James Buchanan enrolled at the University of Chicago to pursue his Ph.D. in economics. Buchanan's class notes from his three courses in price theory are in the process of being archived for future use by scholars at George Mason University.Footnote ⁶ Buchanan learned Chicago price theory from Knight and then two sections with Milton Friedman, newly hired in 1946. Buchanan often stressed that prior to Knight's class he was a socialist in political leanings, but after a few weeks of attendance he understood the power of the price system to coordinate economic affairs so that peaceful cooperation and productive specialization would be achieved among free individuals. On that first day of Knight's class, Buchanan's notes have Knight explaining the following:

The required textbooks for Knight's class were Marshall's Principles of Economics and Stigler's The Theory of Price. The reading list that was provided to all graduate students formed the common-knowledge of economic theory during the 1930s–1940s. It also contained Bohm-Bawerk, Wicksteed, Wicksell, Mises, and Hayek. Recently, Economics in the Rear-View Mirror posted the reading list of Jacob Viner's price theory class from Milton Friedman's notes, and we can see that Menger, Wieser, and Bohm-Bawerk were featured prominently.Footnote ⁷ From our perspective, it is important to stress that these syllabi provide evidence that, circa 1930s and 1940s, the so-called ‘Austrian school’ was simply part of the common knowledge that all students of ‘neoclassical’ price theory were expected to learn.Footnote ⁸ For example, in Jacob Viner's lecture notes, dated June 17, 1930, Viner remarks the following:

In that first set of notes from Knight's class, Buchanan is learning about the important insights of the classical economists, such as the role of prices and market competition in generating economic coordination, the difference between the physical sciences and the social sciences, and the moral framework of liberalism. Buchanan's vantage point is unique because his student experience falls smack in the middle of the transition from the first generation of the Chicago price theory tradition (dominated by Knight and Viner) to the second generation (dominated by Friedman and Stigler).

As Hammond, Medema and Singleton (2013: xiii–xxvii) explain, although a discernible continuity exists in the history of Chicago price theory, there are also tensions and points of disjunction at a methodological and applied level of analysis. As stressed in several of the interpretative papers on the teaching of economics at Chicago (found in Vol. 1), Knight was decidedly non-empiricist in a way that the later Chicago School would come to be defined by their strong commitment to empiricism. On a slightly different yet also critical point for our narrative, Buchanan stressed a disjuncture between what he termed the ‘Old Chicago School’ and the ‘New Chicago School’, emphasizing how the latter tended to ignore the institutional framework within which economic activity takes place. Thus, the ‘New Chicago School’ didn't pay enough attention to how dysfunctions in the institutional framework could distort the operation of the market economy leading up to the Global Financial Crisis of 2008 (see Buchanan, Reference Buchanan2010).

3. A neglected branch of Chicago price theory

Throughout the time covered in this collection, the intellectual alternatives of Chicago price theory included not only German historicism, American institutionalism, and Keynesian macroeconomics, but also through the Cowles Commission (later Foundation) the formalistic development of competitive equilibrium theory, which eventually embodied a new consensus in the economics profession. The underlying element unifying the Chicago price theory tradition, which differentiated it from its intellectual alternatives, is its recognition of rational choice as being an essential part of economic science. As Frank Knight argues, ‘there is a science of economics, a true, and even exact, science, which reaches laws as universal as those of mathematics and mechanics.’ Although in economics we cannot address the specific content of economic behavior, we can discuss the universal laws with respect to form. ‘We cannot tell what particular goods any person will desire,’ Knight argues, ‘but we can be sure that within limits he will prefer more of any good to less, and that there will be limits beyond which the opposite will be true’ (Reference Knight1997: 127).

However, Knight did not equate economic science as a whole with rational choice. Rather, economics as a science consisted of the logic of rational choice, which was deductive, as well as subsidiary empirical propositions of time and place, namely institutions. While Knight considered pure economic theory as a priori and a necessary condition for ‘the analysis of social interaction and coordination through the price mechanism’ (Reference Knight1997: 132), he did not consider it sufficient for understanding how relative price adjustments structure the trade-offs of rational decision-making as well as how such adjustments generate a tendency toward equilibrium. As Knight states, the general laws of economics:

For Knight, economics was a social science, but a science nevertheless. To earlier generations of economists, as emphasized by Knight, there were certain universal propositions about how the world worked that could be expressed in various languages, including mathematics. From the classical political economists to Frank Knight, economists were all apriorists of some sort or another.Footnote ¹⁰ Far from out of step, this is the way that economic theorizing was done by classical economists as well as economists of the pre-WWII Chicago School.

The contemporary consensus in economic reasoning constitutes an alternative to this Knightian tradition, one in which the language or form in which arguments are made is what is considered universal, but there are no unifying propositions about how the world works. We refer to this new consensus as ‘formalistic historicism’, which represents a vision of economic science in which human action reveals only particular truths specific to time and place, not universal economic laws, yet uses formal language (i.e. mathematics) to prove any particular proposition, purging the human actor of any choice within an institutional context. Therefore, under a given set of institutional conditions, the logic of choice does not yield a tendency toward a unique equilibrium, but a multiple set of possible equilibria which does not necessarily hold in all the cases with similar circumstances.Footnote ¹¹ Economic theory as conceptualized by Knight (and his contemporaries, such as the Austrians) is simply rejected by the 21st century Formalistic Historicists in the same way classical economic theory was rejected by the German Historicists of the 19th century (see Boettke, Reference Boettke2012: 316–329).

A great history of modern economic thought project would be to survey the dominant price theory texts in the elite Ph.D. programs and its impact upon the character of economic thinking 10–20 years hence. Prior to Mas-Colell et al. (Reference Mas-Colell, Whinston and Green1995), there was Kreps's A Course in Microeconomic Theory (Reference Kreps1990), which was preceded by Varian's Microeconomic Analysis (Reference Varian1978) and before that there was Henderson and Quandt's Microeconomic Theory: A Mathematical Approach (Reference Henderson and Quandt1958), and so forth until you trace back to Stigler and to Marshall. But the character of economics shifts with each core textbook used to teach economics. Samuelson's approach in Foundations of Economic Analysis (Reference Samuelson1947) compels us to view economic theory differently than Friedman's Price Theory (Reference Friedman1962), or Stigler's The Theory of Price (Reference Stigler1946), let alone Alchian and Allen's University Economics (Reference Alchian and Allen1964). In opposition to the shared understanding of early neoclassical economics, the subsequent developments in post-WWII economic analysis demonstrate that Walrasian economics was different from Marshallian economics, and Wicksteedian economics is different from both. Chicago price theory is repeatedly described as Marshallian, but perhaps more accurately, at least in the Knight/Viner/Simons tradition, it was Wicksteedian. Friedman once famously said that we curtsey to Marshall, but we walk with Walras, and that may ultimately be accurate for the Friedman/Stigler/Becker tradition. But for Knight, it might have been more accurate to say that he didn't curtsey or walk, but instead waltzed with Wicksteed, as economics was in his hands an elegant dance through the complexities of life.Footnote ¹²

Gary Becker often said that from Friedman he learned that economics is not just a clever game to be played by smart academics, but a vital tool for understanding the world in which we live. There is something in that claim that sets Chicago price theory apart from the teaching of economics at other elite centers of economic research and graduate education. Cleverness is no doubt valuable in an individual thinker, but not as much as creativity, and certainly not as much as the consistent and persistent pursuit of the logic of economic analysis and careful empirical analysis.

It has been quipped that the difference between Chicago and Harvard/MIT in terms of graduate student education goes as follows: ‘We study the same models of the market and the price system as they do at Chicago, but at Chicago they actually believe the models, where at Harvard/MIT we don't’. In many ways this characterization translates into the ‘saltwater’ versus ‘freshwater’ debates of economic discourse. The ‘freshwater’ thinkers rely on abstract models of the economy to show the superiority of free markets while the ‘saltwater’ economists show the fragility of these models to real-world imperfections. As economists trained in the Virginia School of Political Economy, where the point is to reconcile and marry the best ideas from property rights economics (Alchian), law and economics (Coase), public choice analysis (Buchanan), and market-process economics (Mises, Hayek, and Kirzner), we believe that both Harvard/MIT and Chicago had framed the debate the wrong way.

We value the Chicago persistence to the economic approach to human behavior, and the Harvard/MIT skepticism of unrealistic depictions. But in the engagement between the two, the Harvard/MIT skeptic often seems to be on better intellectual footing by insisting on some realism of assumptions. The complexities of economic reality cannot be so easily swept under the intellectual rug through ‘as if’ maneuvers. However, from the perspective of the sort of early neoclassical institutionalism we are articulating, both the modern Chicago and Harvard/MIT schools of thought are guilty of the fact that their modeling of prices as sufficient statistics is as serviceable to defenders of the market as well as its critics. They allow the economist either to condemn capitalism for failing to measure up to the model of perfect competition, or to praise capitalism as a utopia of perfect knowledge and rational expectations. Whether the TPE assumption is held as an ‘as if’ description of reality in the case of Chicago economists or as a normative benchmark for policy evaluation in the case of Harvard/MIT economists, in ‘both cases the heuristic value of equilibrium is sacrificed’ (Boettke, Reference Boettke1997: 24, emphasis original).

In a world of uncertainty and constant change, the equilibrium model aids the analysis by a ‘method of contrast’, enabling the theorist to isolate the consequences of change. What the Chicago TPE and the Harvard/MIT ‘market failure’ schools miss is that the ‘success’ or ‘failure’ of market prices to deliver information is fundamentally a contextual question of a comparative institutional nature. Both strands of economic thinking were essentially institution-free accounts of an institutionally laden reality they were striving to explain, especially as compared to the analysis of the Classical School and the early Neoclassical School we have been talking about.

In short, from this perspective, the Chicago TPE ‘solves’ the problem by denying it, while the Harvard/MIT ‘market failure’ denies that any solution is possible within the system. Rather than deny the problem of market failure ex ante or deny any solution ex post, a more fruitful endeavor is to understand how individuals ‘solve’ the problem of coordinating their diverse and often competing economic plans through the price system. Institutional problems demand institutional solutions. This is the main point that was stressed by the Chicago price theory tradition from Knight/Viner/Simons to Alchian/Buchanan/Coase.

Perhaps it is useful to contextualize the transformation of the professional consensus from the time of Knight/Viner/Simons to the emerging post-WWII Chicago School of Friedman/Stigler/Becker. The post-WWII Chicago School was up against a much different intellectual adversary than what Knight/Viner/Simons faced throughout their careers. The ideas of Thorstein Veblen, Ruxford Tugwell, Adolph Bearle, and Gardner Means, let alone the ideas of William Forster and Waddill Catchings and even unreconstructed J. M. Keynes no longer had the same argumentative thrust they possessed in the 1920s and 1930s. In American academic circles, Samuelson's Economics (Reference Samuelson1948) and Foundations of Economic Analysis (Reference Samuelson1947) had effectively cornered the educational market at the undergraduate and graduate level, respectively, and in the process transformed opinion among economic researchers and teachers so that the prevailing conventional wisdom by 1960 was the neo-Keynesian synthesis focus on macroeconomic aggregate demand volatility, and microeconomic inefficiency due to monopoly power, externalities, and public goods. As we have stressed, for this essay we leave the macroeconomic debate alone.

In microeconomics there were three ways in which the academic economist responded to the Samuelsonian argument concerning pervasive ‘market failure’, emphasizing (1) conceptual clarity, (2) the role of institutional arrangements, and (3) entrepreneurial solutions. For ease of exposition, we will combine comparative institutional analysis with entrepreneurship into one category and juxtapose with conceptual clarity. From the ‘price theory as prophylactic’ perspective, the different types of argumentative response highlights the alternative evolutionary path the Knight/Viner/Simons price theory tradition took in providing conceptual clarity in economic thinking. While the Friedman/Stigler/Becker branch stressed conceptual clarity, the Alchian/Buchanan/Coase branch made the additional move of providing an institutionally robust response.

An institutionally robust argument takes into account problems associated with the mobilization of knowledge dispersed throughout the economic system, and of opportunistic behavior associated with ensuring incentive compatibilities in any proposed institutional remedy to social ills. Private actors, as well as public entities, must continually adjust and adapt to the circumstances of knowledge problems and the problems of opportunism. To ignore these problems is only to doom the proposed institutional solutions as impracticable due to incoherence and vulnerability to strategic behavior on the part of opportunistic actors.

In the subsections that follow, we will compare the Friedman/Stigler/Becker branch of Chicago price theory with the Alchian/Buchanan/Coase branch in terms of these two argumentative strategies. What will be shown is that conceptual clarity, exemplified by the use of the TPE by Friedman, Stigler, and Becker, while powerful, has weaknesses that can only be eliminated by making the more institutional/entrepreneurial argumentative turn made by Alchian, Buchanan, and Coase. To sharpen our exposition, consider the recent critique of the market economy offered by George Akerlof and Robert Shiller in Phishing for Phools:

How would the different approaches take up their challenge? Conceptual clarity would reveal the intellectual incoherence in Akerlof and Shiller's presentation. On the other hand, the institutional/entrepreneurial approach would begin by stating, for sake of argument, that Akerlof and Shiller have indeed identified a potentially serious problem. However, the analysis would emphasize how alternative institutional arrangements and entrepreneurial innovations in the market can ameliorate the identified failures. From an institutional/entrepreneurial perspective, today's inefficiencies are tomorrow's profit opportunities for alert individuals who can correctly identify and fix the problem. It is these ‘inefficiencies’ that give rise to the entrepreneurial market process.

4. Chicago economics, welfare economics, and constitutional political economy

Whether or not the TPE conceptually clarifies market phenomena also has implications for public economics, welfare economics, and the role of the economist as a reformer. To understand this, we can contrast the arguments made by Stigler in ‘The New Welfare Economics’ (2013 [1943) Vol. III) and Buchanan (Reference Buchanan1959) in ‘Positive Economics, Welfare Economics, and Political Economy’. Whereas Buchanan's approach to welfare economics focuses on modifying the rules of the game, Stigler proceeds to argue for conceptual clarity within the given structure of existing rules.

Stigler argues that at ‘the level of economic policy, then, it is totally misleading to talk of ends as individual and random; they are fundamentally collective and organized. If this conclusion be accepted, and accept it we must, the economist may properly exceed the narrow confines of economic analysis. He may cultivate a second discipline, the determination of the ends of his society particularly relevant to economic policy’ (2013 [1943] Vol. III: 628). Stigler concludes that the role of the economist is to infer that voters have chosen an economic policy because they wanted it, and to say otherwise would mean that economists are substituting his or her value judgments for those of voters, abandoning their role as a scientist for that of a reformer (2013 [1943] Vol. III: 629).

Like Stigler, Buchanan takes the prevailing policy consensus as given, but in contrast to Stigler, he uses it as a starting-point, as opposed to an end-point, in the economist's role of recommending reform policies, namely by discovering alternative institutional rules for generating patterns of exchange, production, and distribution. Unlike Stigler, Buchanan combines the reformist zeal that often motivates the student of economics in a manner not inconsistent with his role as a positive economic scientist. Where Stigler saw only conflict born on inconsistency, Buchanan sees the possibility for the rebirth of the grand tradition of political economy. ‘Political economy’, Buchanan insists, ‘has a non-normative role in discovering “what is the structure of individual values”’ (Buchanan, Reference Buchanan1959: 137 emphasis added).

According to Buchanan, political economy entails two levels of analysis that must be studied. The formation of the rules of the game is the pre-constitutional level of analysis and the strategic play of the game within the established rules is the post-constitutional level of the analysis. In Buchanan's rendering of constitutional political economy, the two levels of analysis must be engaged since relevant questions about law and order cannot be answered unless the social philosophical analysis of ‘good’ rules is informed by the predictive analysis of how different political institutions will operate.

Buchanan's approach provides hope for the possibility of reform while avoiding the pitfalls of social engineering. The positive role that the economist can play in policy formation is one of ‘diagnosing social situations and presenting to the choosing individuals a set of possible changes’ (Buchanan, Reference Buchanan1959: 127). The scope for those changes must be limited to ‘those social changes that may legitimately be classified as “changes in law”, that is, changes in the structural rules under which individuals make choices’ (Buchanan, Reference Buchanan1959: 131).

The political economist contributes to science and reform by analyzing alternative institutional arrangements and offering changes in the rules of the game as hypotheses to be tested in the arena of collective action. In devising such changes in the rules of the game, Buchanan stresses two critical building blocks. The first building block concerns the position of the status quo. The positive political economy of reform must begin with the ‘here and now’, and never some imaginary start state where opposition to change is non-existent. In doing this, Buchanan is not attributing any normative weight to the status quo, but insisting that this must be the starting point of any assessment of relevant alternatives. The second building block is the compensation principle. Any shift in the rules of the game will change the nature of the payoffs in the game. Those who currently gain from the status quo will lose, while others currently not in a position of privilege with respect to existing institutions will gain from the change. The winners must compensate the losers in the proposed change, not because the losers have any normative claim to their existing benefits but because, unless compensated, the beneficiaries of the status quo will fight to defeat any proposed changes in the structure of rules. Buchanan's conception of positive political economy has both positive and normative implications, which ‘may be summed up in the familiar statement: There exist mutual gains from trade’ (Reference Buchanan1959: 137, italics original).

For Buchanan, the task of economists is broader than the study of the efficiency propositions of the market; it also includes ‘the study of all such cooperative trading arrangements which become merely extensions of markets as more restrictively defined’ (Reference Buchanan1964: 220). In contrast to the understanding of markets in terms of ubiquitous efficiency, Buchanan argued that such an ‘overly restricted conception of market behavior’ neglects the propensity of individuals to discover voluntarily more inclusive institutional arrangements within which efficiency emerges. Efficiency considerations are not eliminated from Buchanan's conception, since the ‘motivation for individuals to engage in trade, the source of the propensity, is surely that of “efficiency”’ (Buchanan, Reference Buchanan1964: 219). The proposition that exchange must be extended to the constitutional level of rules is not inconsistent with the tendency towards efficiency within a given institutional context.

Contrast Buchanan's project with the latter-day Chicago price theory approach. The TPE approach insists that intellectual consistency demands that economists model individuals as always doing the best they can given their situation, and then extrapolates from that individual proposition to a system-level proposition that any arrangement so achieved, if it survives, must – by definition – be the best arrangement in the feasibility set. There is no doubt that this understanding of the Chicago price theory tradition proved to be extremely productive, as evidenced especially in the work of George Stigler and Gary Becker. Look at whatever practice one finds in the world of human affairs – be it in the ordinary business of life, or the most exotic practice from disparate cultures ancient as well as modern – and apply the TPE assumption in a consistent and persistent manner and you generate explanations that are easily translated into testable hypotheses. This economic approach to human behavior comes across as the natural development of the logic of economic reasoning from first principles. How can anyone object to such a basic formulation of human purposiveness in striving to better their condition in the face of given constraints?

Our point here is not to assert that all assumptions must be completely realistic. Economic theory would be impossible under such an intellectual restriction. But the policy relevance of assumptions independent of the predictive power of a theory also matters. In other words, if positive economics is to advance and make fruitful contributions to public policy, then they must have a bearing on the appropriate institutional arrangements in which individuals can strive to ameliorate social conflict and achieve greater social cooperation under the division of labor.

Friedman's review of Abba Lerner's The Economics of Control (1944) provides a good example of how logical economic reasoning divorced from the institutional context within which economic decision-making takes place is irrelevant for public policy conclusions.Footnote ¹⁸ Friedman's main criticism is that ‘Lerner writes as if it were possible to base conclusions about appropriate institutional arrangements almost exclusively on analysis of the formal conditions for an optimum’ (Reference Friedman1947: 415). As Friedman states, ‘Lerner's acceptance of the price mechanism does not, however, mean acceptance of the particular institutional arrangements with which the price system is historically associated, namely, a free-enterprise exchange economy characterized by private ownership of the means of production’ (Reference Friedman1947: 407). For Friedman, ‘the formal analysis is almost entirely irrelevant to the institutional problem’ (Reference Friedman1947: 405). By expressing his analysis as if economic decision-making occurred in an institutional vacuum, Lerner could not appreciate the administrative problems of the policies he proposed or their social and political ramifications.

Friedman's arguments against Lerner are particularly relevant in another respect for discerning the proper prophylactic against popular fallacies about the market economy. Institutional arrangements must ultimately be judged by their ‘noneconomic implications, of which the political implications – the implications for individual liberty – are probably of the most interest and the ethical implications the most fundamental’ (Reference Friedman1947: 415–416). The irony is that the economist who wishes to defend the efficiency of the market by utilizing the TPE, namely by hermetically sealing any market situation from the presence of market failure, is also trapped under the same logical straightjacket from making any public policy recommendations or proposals of institutional reform. The logical implications of the TPE for welfare economics and public policy is best stated by Stigler in his ‘Law or Economics?’:

By this logic, Stigler argues, the presence of interest groups lobbying for import tariffs on sugar is efficient because they have stood the test of time. Although consumers incur deadweight losses from such tariffs, the sugar program is regarded as efficient once the economist takes into account the greater costs of removing the tariffs, namely giving the present discounted value of these capitalized rents to sugar farmers, the cost of which exceeds the dispersed benefit of lower sugar prices to consumers.

The Chicago price theory tradition shared by Knight, Simons, and Viner to Friedman, Stigler and Becker has provided a bulwark for understanding the role of competitive markets in assuring an efficient utilization of resources in an economy, and undermining the case for extensive government intervention in that economy. However, as Frédéric Bastiat argued, the ‘worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended’ (Reference Bastiat1996: 107). Once the baton was passed to the post-WWII generation of economists at the University of Chicago, the emphasis on the multifaceted way that individuals continually adjust and adapt, guided by the price system, to realize the mutual gains from trade and the wealth creation from entrepreneurial innovation was placed in the background of analysis. What came to the foreground of economic analysis was a defense of competitive markets by exercising a denial of criticisms through clarification of conceptual errors – most importantly the costs that were too often ignored – rather than an engagement showing how critics were cutting the story short too soon and failing to notice how the identified inefficiency sets in motion an entrepreneurial discovery process that would also cease to be agitated when the ‘inefficiency’ was eradicated.