Milton Friedman (1953)
Source: Essays in Positive Economics (1953) publ. University of Chicago Press. Just part of one essay is reproduced here.
The abstract methodological issues we have been discussing have a direct bearing on the perennial criticism of “orthodox” economic theory as “unrealistic” as well as on the attempts that have been made to reformulate theory to meet this charge. Economics is a “dismal” science because it assumes man to be selfish and money-grubbing, “a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire of happiness under the impulse of stimuli that shift him about the area, but leave him intact”; it rests on outmoded psychology and must be reconstructed in line with each new development in psychology; it assumes men, or at least businessmen, to be “in a continuous state of 'alert,' ready to change prices and/or pricing rules whenever their sensitive intuitions ... detect a change in demand and supply conditions;” it assumes markets to be perfect, competition to be pure, and commodities, labor, and capital to be homogeneous.
As we have seen, criticism of this type is largely beside the point unless supplemented by evidence that a hypothesis differing in one or another of these respects from the theory being criticised yields better predictions for as wide a range of phenomena. Yet most such criticism is not so supplemented; it is based almost entirely on supposedly directly perceived discrepancies between the “assumptions” and the “real world.” A particularly clear example is furnished by the recent criticisms of the maximisation-of-returns hypothesis on the grounds that businessmen do not and indeed cannot behave as the theory “assumes” they do. The evidence cited to support this assertion is generally taken either from the answers given by businessmen to questions about the factors affecting their decisions — a procedure for testing economic theories that is about on a par with testing theories of longevity by asking octogenarians how they account for their long life — or from descriptive studies of the decision-making activities of individual firms. Little if any evidence is ever cited on the conformity of businessmen's actual market behaviour — what they do rather than what they say they do — with the implications of the hypothesis being criticised, on the one hand, and of an alternative hypothesis, on the other.
A theory or its “assumptions” cannot possibly be thoroughly “realistic” in the immediate descriptive sense so often assigned to this term. A completely “realistic” theory of the wheat market would have to include not only the conditions directly underlying the supply and demand for wheat but also the kind of coins or credit instruments used to make exchanges; the personal characteristics of wheat-traders such as the colour of each trader's hair and eyes, his antecedents and education, the number Of members of his family, their characteristics, antecedents, and education, etc.; the kind of soil on which the wheat was grown, its physical and chemical characteristics, the weather prevailing during the growing season; the personal characteristics of the farmers growing the wheat and of the consumers who will ultimately use it; and so on indefinitely. Any attempt to move very far in achieving this kind of “realism” is certain to render a theory utterly useless.
Of course, the notion of a completely realistic theory is in part a straw man. No critic of a theory would accept this logical extreme as his objective; he would say that the “assumptions” of the theory being criticised were “too” unrealistic and that his objective was a set of assumptions that were “more” realistic though still not completely and slavishly so. But so long as the test of “realism” is the directly perceived descriptive accuracy of the “assumptions” — for example, the observation that “businessmen do not appear to be either as avaricious or as dynamic or as logical as marginal theory portrays them” or that ”it would be utterly impractical under present conditions for the manager of a multi-process plant to attempt . . . to work out and equate marginal costs and marginal revenues for each productive factor” — there is no basis for making such a distinction, that is, for stopping short of the straw man depicted in the preceding paragraph. What is the criterion by which to judge whether a particular departure from realism is or is not acceptable? Why is it more “unrealistic” in analysing business behaviour to neglect the magnitude of businessmen's costs than the colour of their eyes? The obvious answer is because the first makes more difference to business behaviour than the second; but there is no way of knowing that this is so simply by observing that businessmen do have costs of different magnitudes and eyes of different colour. Clearly it can only be known by comparing the effect on the discrepancy between actual and predicted behaviour of taking the one factor or the other into account. Eve the most extreme proponents of realistic assumptions are thus necessarily driven to reject their own criterion and to accept the test by prediction when they classify alternative assumptions as more or less realistic.
The basic confusion between descriptive accuracy and analytical relevance that underlies most criticisms of economic theory on the grounds that its assumptions are unrealistic as well as the plausibility of the views that lead to this confusion are both strikingly illustrated by a seemingly innocuous remark in an article on business-cycle theory that “economic phenomena are varied and complex, so any comprehensive theory of the business cycle that can apply closely to reality must be very complicated.” A fundamental hypothesis of science is that appearances are deceptive and that there is a way of looking at or interpreting or organising the evidence that will reveal superficially disconnected and diverse phenomena to be manifestations of a more fundamental and relatively simple structure. And the test of this hypothesis, as of any other, is its fruits — a test that science has so far met with dramatic success. If a class of “economic phenomena” appears varied and complex, it is, we must suppose, because we have no adequate theory to explain them. Known facts cannot be set on one side; a theory to apply “closely to reality,” on the other. A theory is the way we perceive “facts,” and we cannot perceive “facts” without a theory. Any assertion that economic phenomena are varied and complex denies the tentative state of knowledge that alone makes scientific activity meaningful; it is in a class with John Stuart Mill's justly ridiculed statement that “happily, there is nothing in the laws of value which remains  for the present or any future writer to clear up; the theory of the subject is complete.”
The confusion between descriptive accuracy and analytical relevance has led not only to criticisms of economic theory on largely irrelevant grounds but also to misunderstanding of economic theory and misdirection of efforts to repair supposed defects. “Ideal types” in the abstract model developed by economic theorists have been regarded as strictly descriptive categories intended to correspond directly and fully to entities in the real world independently of the purpose for which the model is being used. The obvious discrepancies have led to necessarily unsuccessful attempts to construct theories on the basis of categories intended to be fully descriptive.
This tendency is perhaps most clearly illustrated by the interpretation given to the concepts of “perfect competition” and “monopoly” and the development of the theory of “monopolistic” or “imperfect competition.” Marshall, it is said, assumed “perfect competition”; perhaps there once was such a thing. But clearly there is no longer, and we must therefore discard his theories. The reader will search long and hard — and I predict unsuccessfully — to find in Marshall any explicit assumption about perfect competition or any assertion that in a descriptive sense the world is composed of atomistic firms engaged in perfect competition. Rather, he will find Marshall saying:, “At one extreme are world markets in which competition acts directly from all parts of the globe; and at the other those secluded markets in which all direct competition from afar is shut out, though indirect and transmitted competition may make itself felt even in these; and about midway between these extremes lie the great majority of the markets which the economist and the businessman have to study”. Marshall took the world as it is, he sought to construct an “engine” to analyse. it, not a photographic reproduction of it.
In analysing the world as it is, Marshall constructed a hypothesis that, for many problems, firms could be grouped into “industries” such that the similarities among the firms in each group were more important than the differences among them. These are problems in which the important element is that a group of firms is affected alike by some stimulus — a common change in the demand for their products, say, or in the supply of factors. But this will not do for all problems: the important element for these may be the differential effect on particular firms.
The abstract model corresponding to this hypothesis contains two “ideal” types of firms: atomistically competitive firms, grouped into industries, and monopolistic firms. A firm is competitive if the demand curve for its output is infinitely elastic with respect to its own price for some price and all outputs, given the prices charged by all other firms; it belongs to an “industry” defined as a group of firms producing a single “product.” A “product” is defined as a collection of units that are perfect substitutes to purchasers so the elasticity of demand for the output of one firm with respect to the price of another firm in the same industry is infinite for some price and some outputs. A firm is monopolistic if the demand curve for its output is not infinitely elastic at some price for all outputs. If it is a monopolist, the firm is the industry.
As always, the hypothesis as a whole consists not only of this abstract model and its ideal types but also of a set of rules, mostly implicit and suggested by example, for identifying actual firms with one or the other ideal type and for classifying firms into industries. The ideal types are not intended to be descriptive; they are designed to isolate the features that are crucial for a particular problem. Even if we could estimate directly and accurately the demand curve for a firm's product, we could not proceed immediately to classify the firm as perfectly competitive or monopolistic according as the elasticity of the demand curve is or is not infinite. No observed demand curve will ever be precisely horizontal, so the estimated elasticity will always be finite. The relevant question always is whether the elasticity is “sufficiently” large to be regarded as infinite, but this is a question that cannot be answered, once for all, simply in terms of the numerical value of the elasticity itself, any more than we can say, once for all, whether an air pressure of 15 pounds per square inch is “sufficiently” close to zero to use the formula s = 1/2gt2. Similarly, we cannot compute cross-elasticities of demand and then classify firms into industries according as there is a “substantial gap in the cross-elasticities of demand.” As Marshall says, “The question where the lines of division between different commodities [i.e., industries] should be drawn must be settled by convenience of the particular discussion. Everything depends on the problem; there is no inconsistency in regarding the same firm as if it were a perfect competitor for one problem, and a monopolist for another, just as there is none in regarding the same chalk mark as a Euclidean line for on e problem, a Euclidean surface for a second, and a Euclidean solid for a third. The size of the elasticity and cross-elasticity of demand, the number of firms producing physically similar products, etc., are all relevant because they are or may be among the variables used to define the correspondence between the ideal and real entities in a particular problem and to specify the circumstances under which the theory holds sufficiently well; but they do not provide, once for all, a classification of firms as competitive or monopolistic.
An example may help to clarify this point. Suppose the problem is to determine the effect on retail prices of cigarettes of an increase, expected to be permanent, in the federal cigarette tax. I venture to predict that broadly correct results will be obtained by treating cigarette firms as if they were producing an identical product and were in perfect competition. Of course, in such a case, some convention must be made as to the number of Chesterfield cigarettes “which are taken as equivalent” to a Marlborough.
On the other hand, the hypothesis that cigarette firms would behave as if they were perfectly competitive would have been a false guide to their reactions to price control in World War II, and this would doubtless have been recognised before the event. — Costs of the cigarette firms must have risen during the war. Under such circumstances perfect competitors would have reduced the quantity offered for sale at the previously existing price. But, at that price, the wartime rise in the income of the public presumably increased the quantity demanded. Under conditions of perfect competition strict adherence to the legal price would therefore imply not only a “shortage” in the sense that quantity demanded exceeded quantity supplied but also an absolute decline in the number of cigarettes produced. The facts contradict this particular implication: there was reasonably good adherence to maximum cigarette prices, yet the quantities produced increased substantially. The common force of increased costs presumably operated less strongly than the disruptive force of the desire by each firm to keep its share of the market, to maintain the value and prestige of its brand-name, especially when the excess-profits tax shifted a large share of the costs of this kind of advertising to the government. For this problem the cigarette firms cannot be treated as if they were perfect competitors.
Wheat farming is frequently taken to exemplify perfect competition. Yet, while for some problems it is appropriate to treat cigarette producers as if they comprised a perfectly competitive industry, for some it is not appropriate to treat wheat producers as if they did. For example, it may not be if the problem is the differential in prices paid by local elevator operators for wheat.
Marshall's apparatus turned out to be most useful for problems in which a group of firms is affected by common stimuli, and in which the firms can be treated as if they were perfect competitors. This is the source of the misconception that Marshall “assumed” perfect competition in some descriptive sense. It would be highly desirable to have a more general theory than Marshall's, one that would cover at the same time both those cases in which differentiation of product or fewness of numbers makes an essential difference and those in which it does not. Such a theory would enable us to handle problems we now cannot and in addition, facilitate determination of the range of circumstances under which the simpler theory can be regarded as a good enough approximation. To perform this function, the more general theory must have content and substance; it must have implications susceptible to empirical contradiction and of substantive interest and importance.
The theory of imperfect or monopolistic competition developed by Chamberlin and Robinson is an attempt to construct such a more general theory. Unfortunately, it possesses none of the attributes that would make it a truly useful general theory. Its contribution has been limited largely to improving the exposition of the economics of the individual firm and thereby the derivation of implications of the Marshallian model, refining Marshall's monopoly analysis, and enriching the vocabulary available for describing industrial experience.
The deficiencies of the theory are revealed most clearly in its treatment of, or inability to treat, problems involving groups of firms — Marshallian “industries.” So long as it is insisted that differentiation of product is essential — and it is the distinguishing feature of the theory that it does insist on this point — the definition of an industry in terms of firms producing an identical product cannot be used. By that definition each firm is a separate industry. Definition in terms of “close” substitutes or a “substantial” gap in cross-elasticities evades the issue, introduces fuzziness and undefinable terms into the abstract model where they have no place, and serves only to make the theory analytically' meaningless — “close” and “substantial” are in the same category as a “small” air pressure. In one connection Chamberlin implicitly defines an industry as a group of firms having identical cost and demand curves. But this, too, is logically meaningless so long as differentiation of product is, as claimed, essential and not to be put aside. What does it mean to say that the cost and demand curves of a firm producing bulldozers are identical with those of a firm producing hairpins? And if it is meaningless for bulldozers and hairpins, it is meaningless also for two brands of toothpaste — so long as it is insisted that the difference between the two brands is fundamentally important.
The theory of monopolistic competition offers no tools for the analysis of an industry and so no stopping place between the firm at one extreme and general equilibrium at the other. It is therefore incompetent to contribute to the analysis of a host of important problems: the one extreme is too narrow to be of great interest; the other, too broad to permit meaningful generalisations.
Economics as a positive science is a body of tentatively accepted generalisations about economic phenomena that can be used to predict the consequences of changes in circumstances. Progress in expanding this body of generalisations, strengthening our confidence in their validity, and improving the accuracy of the predictions they yield is hindered not only by the limitations of human ability that impede all search for knowledge but also by obstacles that are especially important for the social sciences in general and economics in particular, though by no means peculiar to them. Familiarity with the subject matter of economics breeds contempt for special knowledge about it. The importance of its subject matter to everyday life and to major issues of public policy impedes objectivity and promotes confusion between scientific analysis and normative judgment. The necessity of relying on uncontrolled experience rather than on controlled experiment makes it difficult to produce dramatic and clear-cut evidence to justify the acceptance of tentative hypotheses. Reliance on uncontrolled experience does not affect the fundamental methodological principle that a hypothesis can be tested only by the conformity of its implications or predictions with observable phenomena; but it does render the task of testing hypotheses more difficult and gives greater scope for confusion about the methodological principles involved. More than other scientists, social scientists need to be self-conscious about their methodology.
One confusion that has been particularly rife and has done much damage is confusion about the role of “assumptions” in economic analysis. A meaningful scientific hypothesis or theory typically asserts that certain forces are, and other forces are not, important in understanding a particular class of phenomena. It is frequently convenient to present such a hypothesis by stating that the phenomena it is desired to predict behave in the world of observation as if they occurred in a hypothetical and highly simplified world containing only the forces that the hypothesis asserts to be important. In general, there is more than one way to formulate such a description — more than one set of “assumptions” in terms of which the theory can be presented. The choice among such alternative assumptions is made on the grounds of the resulting economy, clarity, and precision in presenting the hypothesis; their capacity to bring indirect evidence to bear on the validity of the hypothesis by suggesting some of its implications that can be readily checked with observation or by bringing out its connection with other hypotheses dealing with related phenomena; and similar considerations.
Such a theory cannot be tested by comparing its “assumptions” directly with “reality.” Indeed, there is no meaningful way in which this can be done. Complete “realism” is clearly unattainable, and the question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories. Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic. Such criticism is largely irrelevant, and, in consequence, most attempts to reform economic theory that it has stimulated have been unsuccessful.
The irrelevance of so much criticism of economic theory does not of course imply that existing economic theory deserves any high degree of confidence. These criticisms may miss the target, yet there may be a target for criticism. In a trivial sense, of course, there obviously is. Any theory is necessarily provisional and subject to change with the advance of knowledge. To go beyond this platitude, it is necessary to be more specific about the content of “existing economic theory” and to distinguish among its different branches; some parts of economic theory clearly deserve more confidence than others. A comprehensive evaluation of the present state of positive economics, summary of the evidence bearing on its validity, and assessment of the relative confidence that each part deserves is clearly a task for a treatise or a set of treatises, if it be possible at all, not for a brief paper on methodology.
About all that is possible here is the cursory expression of a personal view. Existing relative price theory, which is designed to explain the allocation of resources among alternative ends and the division of the product among the co-operating resources and which reached almost its present form in Marshall's Principles of Economics, seems to me both extremely fruitful and deserving of much confidence for the kind of economic system that characterises Western nations. Despite the appearance of considerable controversy, this is true equally of existing static monetary theory, which is designed to explain the structural or secular level of absolute prices, aggregate output, and other variables for the economy as a whole, and which has had a form of the quantity theory of money as its basic core in all of its major variants from David Hume to the Cambridge School to Irving Fisher to John Maynard Keynes. The weakest and least satisfactory part of current economic theory seems to me to be in the field of monetary dynamics, which is concerned with the process of adaptation of the economy as a whole to changes in conditions and so with short-period fluctuations in aggregate activity. In this field we do not even have a theory that can appropriately be called “the” existing theory of monetary dynamics.
Of course, even in relative price and static monetary theory there is enormous room for extending the scope and improving the accuracy of existing theory. In particular, undue emphasis on the descriptive realism of “assumptions” has contributed to neglect of the critical problem of determining the limits of validity of the various hypotheses that together constitute the existing economic theory in these areas. The abstract models corresponding to these hypotheses have been elaborated in considerable detail and greatly improved in rigour and precision. Descriptive material on the characteristics of our economic system and its operations have been amassed on an unprecedented scale. This is all to the good. But, if we are to use effectively these abstract models and this descriptive material, we must have a comparable exploration of the criteria for determining what abstract model it is best to use for particular kinds of problems, what entities in the abstract model are to be identified with what observable entities, and what features of the problem or of the circumstances have the greatest effect on the accuracy of the predictions yielded by a particular model or theory. Progress in positive economics will require not only the testing and elaboration of existing hypotheses but also the construction of new hypotheses. On this problem there is little to say on a formal, level. The construction of hypotheses is a creative act of inspiration, intuition, invention; its essence is the vision of something new in familiar material. The process must be discussed in psychological, not logical, categories; studied in autobiographies and, biographies, not treatises on scientific method; and promoted by maxim and example, not syllogism or theorem.