<p>ECONOMICS：New Classical Versus Neoclassical Framework</p><p>&nbsp;</p><p>Xiaokai Yang<br/>The first draft: 1997.<br/>The final version: October 1999<br/>at Harvard University</p><p>&nbsp;</p><p>&nbsp;</p><p>&nbsp;</p><p>This textbook belongs to a new species of economics textbook. It differs from Marshall’s<br/>first generation of economics textbook that separates the analysis of demand and supply<br/>from the analysis of individuals’ decisions in choosing their levels of specialization. It<br/>differs from his marginal analysis of demand and supply based on neoclassical<br/>dichotomy between pure consumers and firms. This book begins from an analysis of<br/>individual consumer-producers’ decisions in choosing levels of specialization, and then<br/>applies inframarginal analysis (total benefit-cost analysis across corner solutions in<br/>addition to marginal analysis of each corner solution) to investigate how the network size<br/>of division of labor in society is determined in the market place. According to this<br/>inframarginal analysis, demand and supply are two sides of the division of labor (Allyn<br/>Young, 1928). Hence demand and supply are determined not only by resource allocation<br/>for a given network pattern of division of labor, but also by the network pattern of<br/>division of labor.<br/>Also, this textbook differs from Samuelson’s prototype of the second generation of<br/>economics textbook. It does not have a dichotomy between microeconomics and<br/>macroeconomics. Since a particular level of division of labor is associated with a certain<br/>size of market network, the extent of the market and aggregate demand are determined by<br/>individuals’ decisions in choosing their levels of specialization that yield the network<br/>size of division of labor for society as a whole. Hence many macroeconomic phenomena,<br/>such as unemployment and business cycles are some special features of the complicated<br/>network of division of labor.<br/>In this text non-linear programming, dynamic programming, and other nonclassical<br/>mathematical programming are employed to resurrect the spirit of classical mainstream<br/>economics within a modern body of formalism. Since the spirit of the book is older than<br/>neoclassical economics, while its body is younger than neoclassical economics, we<br/>would like to address the new species New Classical Economics.<br/>Despite the innovation in this text, it keeps the continuity of the mainstream of<br/>economics through a synthesis of the existing and emerging branches of economics.<br/>Neoclassical microeconomics based on the dichotomy between pure consumers and<br/>exogenously given firms is covered in the text. But possible corner solutions and<br/>inframarginal comparative statics of general equilibrium (discontinuous jumps of<br/>endogenous variables across corner and interior solutions in response to changes in<br/>parameters) in the neoclassical framework are emphasized. Neoclassical trade theory is<br/>synthesized into the text by highlighting its features of inframarginal comparative statics<br/>that generate jumps of equilibrium trade pattern across corner and interior solutions<br/>(chapter 12). New trade theory developed by Dixit and Stiglitz (1977), Krugman (1979,<br/>1980, 1981), Ethier (1982), and others is covered in chapter 11. New equilibrium game<br/>models, such as the models of sequential equilibrium of Milgrom-Roberts and Kreps-<br/>Wilson and the model of commitment game of Dewatripont-Maskin, are covered and<br/>applied to analyze the relationship between endogenous transaction costs and network<br/>size of division of labor in chapters 4, 9 and 12.<br/>iv<br/>New models that formalize the notion of endogenous transaction costs caused by<br/>moral hazard and information asymmetry, the theory on structure of residual rights and<br/>incomplete contract, and the new theory of the firm are covered in chapters 9 and 12.<br/>These models are extended in this text to explore the relationship between endogenous<br/>transaction costs, evolution of division of labor, structure of property rights, and<br/>emergence of the institution of the firm. New endogenous growth models (AK models,<br/>R&amp;D based models, and models with endogenous evolution of division of labor) are<br/>covered in chapters 21, 22, 23, and 24. The different endogenous growth models are<br/>compared in the light of recent empirical work that tests them against observations.<br/>Several new classical general equilibrium models are used to develop an overarching<br/>framework for explaining all micro and macro phenomena. It is shown that when the<br/>network size of division of labor is endogenized in a general equilibrium analysis,<br/>marginal comparative statics for a given pattern of the network can address conventional<br/>microeconomic resource allocation problem, while inframarginal comparative statics<br/>explain discontinuous jumps of the equilibrium size of network of division of labor and<br/>related aggregate variables across different structures. The inframarginal comparative<br/>statics (or dynamics) can then explain emergence of money, business cycles, and<br/>unemployment from division of labor. Hence, for our grand synthesis, macroeconomic<br/>analysis and microeconomic analysis are just at two different levels within an integrated<br/>framework.<br/>Many insights of Buchanan, Cheung, Coase, and North into transaction costs,<br/>property rights, institution of the firm, and contract are formalized in the text. Challenges<br/>posed by nonlinear evolutionary economics (see Nelson, 1995, Conlisk, 1996, and<br/>references there) and by the Austrian School (see Kirner, 1997, and references there)<br/>against the mainstream are taken and absorbed into the text. For instance, the concept of<br/>Walrasian sequential equilibrium is developed in chapter 24 to predict concurrent<br/>evolution of economic organisms and evolution of information acquired by society<br/>through social experiment with various organisms using price mechanism. The recursive<br/>paradox, which means that a decision problem based on bounded rationality cannot be<br/>well defined, raised by nonlinear evolutionary economists is solved in a well closed<br/>dynamic general equilibrium model based on adaptive behaviors and bounded rationality.<br/>The dynamic equilibrium model substantiates the proposition in nonlinear evolutionary<br/>economics that concurrent evolution of organisms and information about organisms<br/>acquired by society involves uncertainty of the direction of the evolution as well as a<br/>certain tendency of the evolution (Nelson, 1995).<br/>This text can be used at two different levels. Since each chapter includes a part of<br/>descriptive intuition behind the formal models and mechanism at work, with aids of<br/>graphical illustrations, the text can be used for third or fourth year (micro or macro)<br/>economics courses and third or fourth year courses of development economics, trade<br/>theory, industrial organization, economics of transaction costs and property rights,<br/>economics of contract and institution. The focus for the undergraduate courses is on<br/>training of economic thinking. If the text is used for the purpose, questions for<br/>assignments and examinations can be chosen from the questions in the end of each<br/>chapter and difficult algebra and exercises in the end of each chapter can then be skipped.<br/>The text can be used for a microeconomics course at graduate level. It can be used as<br/>a reference in graduate courses of macroeconomics, development economics, growth<br/>v<br/>theory, economics of transaction costs and organization, economics of contract and<br/>institution, industrial organization, trade theory as well. The focus for the graduate<br/>courses is on formal basic training as well as on innovative, creative, and critical<br/>economic thinking. For the part of basic training, students are asked to pay more attention<br/>to duplication of major models in the text and to work out main exercises in the end of<br/>each chapter. One hour spent on duplicating the models is as effective as 8 hours spent on<br/>listening and reading. The formal training is characterized by strong accumulation effects.<br/>If each model covered in the text is duplicated and well understood, the studies will<br/>become increasingly easier. But if one of the major models cannot be duplicated or a<br/>lecturer is missed out, the studies may become increasingly more difficult later on.<br/>For the part of creative and critical thinking, students are asked to pay more attention<br/>to the trial-error process in designing models and in choosing one from many possible<br/>frameworks. Not only all original ideas must stand the test of rigorous deduction, of<br/>logical consistence, and of empirical evidences, but also insights that might be too<br/>sophisticated to be formalized by any available mathematical instruments are encouraged.<br/>Questions and exercises in the end of each chapter include many good thesis topics for<br/>master and Ph.D. programs. Free assistance can be obtained for such programs from the<br/>author upon request.<br/>The text can be used for a one-year course. For this case, the teacher may pay more<br/>attention to basic training in the first semester which may cover parts I-V. Then more<br/>attention may be paid to encouraging creative, independent, and critical economic<br/>thinking in the second semester. If it were used for a semester course, the teacher might<br/>choose major chapters in parts I-V, then quickly outline main results in other chapters<br/>with the aids of graphical illustrations.<br/>This text is a response to increasing demand for a text and a survey from which<br/>technical substance of new classical economics and inframarginal analysis can be<br/>systematically learnt. It covers many new research results of new classical economics and<br/>inframarginal analysis and compares the new classical framework with the neoclassical<br/>one. Some of the new research results are published for the first time. I hope that the<br/>reader will experience exciting intellectual adventure and find inframarginal analysis of<br/>network of division of labor as a bridge between the mainstream economics and this era<br/>of networking.<br/>Since new classical economics can be applied to many fields of economics, we are<br/>developing a franchise network to promote teaching, research, and publications of new<br/>classical economics and inframarginal analysis. One of many franchise units is<br/>Development Economics, by Jeff Sachs and Xiaokai Yang, which applies new classical<br/>economics to development economics, synthesizing it with other new research in this<br/>field. This book will be published by Blackwell as well. Other possible franchise units<br/>under consideration include Economics of Property Rights and Transaction Costs and<br/>New Classical Trade Theory. If you are interested in involvement in this franchise<br/>network, please contact us at <a href="mailto:xiaokai_yang@ksg.harvard.edu">xiaokai_yang@ksg.harvard.edu</a> or xiaokai.yang<br/>@buseco.monash.edu.au. We will provide training support and all necessary information<br/>about technical substance for working out a book applying new classical economics to a<br/>field of economics.<br/>Too many individuals and institutions contribute to this project. I am first greatly<br/>grateful to my teachers back to Princeton University, Hugo Sonneschein who taught me<br/>vi<br/>the theory of general equilibrium, Edwin Mills who taught me development economics<br/>and urban economics, Gene Grossman and Avinish Dixit who taught me trade theory and<br/>new general equilibrium models with increasing returns, Gregory Chow, Whitney Newey,<br/>Anguish Deaton, and Richard Quandt who taught me econometrics, Joseph Stiglitz, Barry<br/>Nalebuff, and Sanddy Grossman who taught me information economics and game theory,<br/>Alan Blinder and John Taylor who taught me macroeconomics, and William Baumol,<br/>Michael Katz, and Robert Willig who taught me Industrial Organization.<br/>I am also greatly indebted to my coauthors of various research papers which are covered<br/>in this text: Jeff Borland, Been-Lon Chen, Wen-Li Cheng, Ben Heijdra, Geoff Hogbin,<br/>Chien-fu Lin, Monchi Lio, Mong-Chun Liu, Pak-Wai Liu, Siang Ng, Yew-Kwang Ng, Babu<br/>Nahata, Bob Rice, Jeff Sachs, He-Ling Shi, Guangzhen Sun, Ian Wills, Jianguo Wang, Karyiu<br/>Wong, Shuntian Yao, Dingsheng Zhang, Yiming Zhao, Lin Zhou. I have benefited<br/>immensely from comments and criticisms on research papers and books that relate to this<br/>text from Ken Arrow, Gary Becker, Avner Ben-Ner, Fischer Black, James Buchanan,<br/>Steven Cheung, Cyrus Chu, Eric van Damme, Herbert Dawid, Jurgen Eichberger, Karl<br/>Farmer, John Gallup, Robert Gilles, Oliver Hart, Heinz Kurz, Lachie McGregor, Douglas<br/>North, Lloyd Reynolds, Peter Ruys, Andrei Shleifer, Hugo Sonnenschein, Sherwin Rosen,<br/>Donald Smythe, Willy Spanjers, Guoqiang Tian, Andrew Warner, Chenggang Xu, Gang Yi,<br/>Weiying Zhang, and participants of numerous seminars and conference sessions. Many<br/>students at Harvard University, Monash University, Peking University, Chinese University<br/>of Hong Kong, University of Hong Kong, National University of Taiwan, and University of<br/>Louisville provide useful feedback to the teaching of the materials covered in this text.<br/>Special thanks go to Jeff Borland, Sherwin Rosen, Monchi Lio, Mei Wen, and Julan Du for<br/>drawing several references cited in the text to my attention. Mei Wen and Yiming Zhao have<br/>done an excellent job to draw many graphs in this text. My gratitude also goes to six<br/>anonymous referees of the draft of this text.<br/>The financial support for this project and related research from the Center for<br/>International Development at Harvard University, Australian Research Council, Chinese<br/>University of Hong Kong, National Taiwan University, Institute of Economics of Academia<br/>of Sinica, the National Sciences Council of the Republic of China, China Economic<br/>Guanghua School of Management, Peking University, and Centre for Economic Research<br/>at Tilburg University is gratefully acknowledged.<br/>Last, but not least, without love, patience, and strong support of my family, this book<br/>would never exist in this world. I hereby express my deepest love and thanks to my wife,<br/>Xiaojuan Wu and kids, Xiaoxi, James, and Edward.<br/>Of course, any remaining errors are solely my own responsibility.<br/>Xiaokai Yang<br/>August, 1999, at Harvard University</p><br/>