Political Economy: Critique of Neoclassical Economics

1
Political Economy Critique of Neoclassical
Economics

• Wrong answers to the wrong questions Equilibrium

2
Last week, Supply

• Theory of the firm a shambles
• Profit maximisation formula wrong. When amended
• PC PriceMarginal Cost impossible
• PMRMC for profit maximisers
• Competition monopoly produce same results
• If costs lower, monopoly better than PC
• Welfare loss due to profit-maximising behavior,
  not monopoly
• Theory irrelevant to real world anyway
• This week
• General Equilibrium cant be in equilibrium
• General Dynamics needed, not general
  equilibrium

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From one to many

• Previous lectures flaws in (Marshallian) model
  of single industry
• This lecture Ignoring flaws in Marshallian
  model(!), flaws in (Walrasian) model of entire
  economy
• The dilemma
• Equilibrium in one market can be disturbed by
  disequilibrium in another
• What are conditions that will give
  equilibriumequality of demand supplyin all
  markets?
• First person to consider this Leon Walras (1874)
• Real-world equilibrium involved use of some
  commodities to make others, dynamic price
  output setting, product innovation

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Walras General Equilibrium

• Walras abstracted from all this
• Pure exchange model (all quantities of all goods
  already given and pre-allocated)
• Traders simply wish to exchange surplus
  commodities for desired ones
• Even so, out of equilibrium trade would disturb
  income/wealth distribution
• Above equilibrium sellers gain income, below
  equilibrium lose
• Non-equilibrium system might never converge
• Invented fiction to avoid problem
• No trades allowed in any market until all markets
  in equilibrium
• Prices set by impartial costless Auctioneer

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Walras General Equilibrium

• First, let us imagine a market in which only
  consumer goods and services are bought and sold
  Once the prices of all these goods and services
  have been cried at random , each party to the
  exchange will offer at these prices those goods
  or services of which he thinks he has relatively
  too much, and he will demand those articles of
  which he thinks he has relatively too little for
  his consumption during a certain period of time.
  The quantities of each thing effectively demanded
  and offered having been determined in this way,
  the prices of those things for which the demand
  exceeds the offer will rise, and the prices of
  those things of which the offer exceeds the
  demand will fall. New prices now having been
  cried, each party to the exchange will offer and
  demand new quantities. And again prices will rise
  or fall until the demand and the offer of each
  good and each service are equal. Then the prices
  will be current equilibrium prices and exchange
  will effectively take place. (Walras 1874)
• A dynamic but out of time process of price
  adjustment to equilibrium

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Walras General Equilibrium the Process

• Auctioneer makes initial guess at Prices
• Prices determine agents
• Wealth (Prices quantities held)
• Supplies (Stocks held desired for consumption)
• Demands (Quantities desired stocks held)
• Each agent balanced (Prices Supplies Prices
  Demands)
• If all markets in equilibrium, trade occurs
• If not
• Auctioneer increases price for commodities where
  Demand Supply, decreases where Supply Demand
• Agents recalculate Demands Supplies
• Process continues until equilibrium in all
  markets
• Then trade allowed to occur

7
Walras General Equilibrium the Problem

• Will process actually converge to equilibrium
  Prices?
• Walras thought so
• Then the prices will be current equilibrium
  prices and exchange will effectively take place.
• But the problem is
• Change in price in one market affects all others
• Feedback from other markets back to first one
• Feedback effects could overwhelm direct effects
• Walras surmised that
• Direct effects all in correct direction (price up
  where demandsupply, down where supplydemand)
• Indirect effects in any direction, but could
  cancel each other out

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Walras General Equilibrium the Problem

• This will appear probable if we remember that
  the change from pb to pb, which reduced the
  above inequality to an equality, exerted a direct
  influence that was invariably in the direction of
  equality at least so far as the demand for (B)
  was concerned while the consequent changes
  from pc to pc, pd to pd, , which moved the
  foregoing inequality farther away from equality,
  exerted indirect influences, some in the
  direction of equality and some in the opposite
  direction, at least so far as the demand for (B)
  was concerned, so that up to a certain point they
  cancelled each other out. Hence, the new system
  of prices (pb, pc, pd, ) is closer to
  equilibrium than the old system of prices (pb,
  pc, pd, ) and it is only necessary to
  continue this process along the same lines for
  the system to move closer and closer to
  equilibrium. (Walras 1874 1954 my emphasis)

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Walras General Equilibrium the Promise

• (1) Establish correctness of surmise of
  convergence to equilibrium
• (2) Generalise to system with
• (a) Production
• (b) Out of equilibrium exchange
• Unfortunately, didnt even get to 1st base
• From static analysis (going back to Walras and
  Marshall), it is known that, even under very
  plausible circumstances, Walrasian tatonnement
  systems have multiple equilibria Hence it is
  not to be expected that, in a reasonably broad
  class if economic environments every
  equilibrium point of a Walrasian tatonnement
  process will be stable. (Hurwicz 1986 46-47)

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Walras General Equilibrium the Failure

• How should neoclassicals have reacted?
• From a normative and computational point of view
  it is natural to conclude that the possible
  absence of global stability calls for
• a non-equilibrium model of exchange?
• How did they react? (Hurwicz 1986 47-48)
• replacing the Walrasian tatonnement by another
  dynamic process!
• Proposed adjusting individual demand functions!
• Clearly the informational burden of this system
  is greater than that of Walras, but
• one must, in general, be prepared to require a
  bigger message space when stability is demanded.

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Walras General Equilibrium the Failure

• Walras model already fictional
• Abstracts from real-world phenomena of
• Production
• Non-equilibrium exchange
• If it cant necessarily reach equilibrium, what
  hope is there that real-world can?
• But neoclassicals take succour in even more
  unreal assumptions to make model workeven if
  cant be applied to real world
• Pinnacle of this the Arrow-Debreu model of
  general equilibrium

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Walras General Equilibrium the Failure

• Debreu (1959) establishes necessary conditions
  for general equilibrium to exist
• Instantaneous market where all producers
  consumers
• Know the future
• Decide all purchases for all time
• Generalised to uncertain future by
  effectively making past mistakes reversible via
  insurance markets for all possible future events
• Insure against buying an umbrella on days when it
  doesnt rain
• Only have to pay for umbrella if it does rain (
  you need it), not if it doesnt

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Walras General Equilibrium the Failure

• For any economic agent a complete action plan
  (made now for the whole future), or more briefly
  an action, is a specification for each commodity
  of the quantity that he will make available or
  that will be made available to him, i.e., a
  complete listing of the quantities of his inputs
  and of his outputs
• For a producer, say the jth one, a production
  plan (made now for the whole future) is a
  specification of the quantities of all his inputs
  and all his outputs The certainty assumption
  implies that he knows now what input-output
  combinations will be possible in the future
  (although he may not know the details of
  technical processes which will make them
  possible)
• As in the case of a producer, the role of a
  consumer is to choose a complete consumption
  plan His role is to choose (and carry out) a
  consumption plan made now for the whole future,
  i.e., a specification of the quantities of all
  his inputs and all his outputs. (Debreu 1959)

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Walras General Equilibrium the Failure

• The analysis is extended in this chapter to the
  case where uncertain events determine the
  consumption sets, the production sets, and the
  resources of the economy. A contract for the
  transfer of a commodity now specifies, in
  addition to its physical properties, its location
  and its date, an event on the occurrence of which
  the transfer is conditional. This new definition
  of a commodity allows one to obtain a theory of
  uncertainty free from any probability concept and
  formally identical with the theory of certainty
  developed in the preceding chapters. (Debreu
  1959 my emphases)

and get serious!
Let's cut the...
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Walras General Equilibrium the Failure

• A physicists take on this model
• Here is an example at time t0 you plan your
  entire future, ordering a car on one future date,
  committing to pay for your childrens education
  on another date, buying your vacation house,
  placing all future orders for daily groceries,
  drugs All demands for your lifetime are planned
  and ordered in preference. In other words, your
  and your familys entire future is decided
  completely at time zero. These assumptions were
  seen as necessary in order to construct a theory
  where one could prove rigorous mathematical
  theorems. Theorem proving about totally
  unrealistic markets became more important than
  the empirics of real markets in this picture.
  (McCauley 2004 15)

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Walras General Equilibrium the Failure

• Why such unrealistic assumptions?
• Because any even slightly more realistic model is
  provably unstable

Warning!
Warning!

• Serious maths zone approaching!
• Intuition main thing that matters
• Stability of outputs stability of prices in
  conflict

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Can General Equilibrium be in equilibrium?

• Simplest possible real world model
• n markets
• Commodities produced using input-output system
• Spot markets for sale of output (supplydemand)
• All output in year t becomes input in year t1
• Consumption internalised
• Economy growing over time
• For equilibrium,
• Outputs in year 0 must be sufficient for
  production in year 1
• Prices must enable producers to buy all inputs
• Conditions expressed in matrix equations

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Can General Equilibrium be in equilibrium?

• Outputs in year t1 output input transformation
  of inputs in previous period t

Outputs in 2004 areinputs for 2005
Production process derived from productive
input-output matrix
Output in 2005(vector of outputs)

• For stable growth, each sector must grow at the
  same rate (a p.a.)

2005s output of socks,DVD players, etc., is
agreater than 2004s
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Can General Equilibrium be in equilibrium?

• Two conditions on production can be combined
  using matrix maths

The production relation
Has to equal growth condition
Equating them
Rearrange using matrix rules
I is matrix equivalent of 1
So this bit
has to be somehow equivalent to zero for this
equation to be feasible
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Can General Equilibrium be in equilibrium?
is equivalent to zero if

• The expression

its determinant is equal to zero more on that
soon

• Price condition also expressed in matrix equation
• Prices must enable producers to purchase
  necessary inputs
• For equilibrium, relative prices must be constant
  (p)
• Cost of inputs is p (list of prices) times A
  (table of outputs produced from inputs) times
  equilibrium rate of profit p

Table of outputsproduced frominputs
List of prices
Uniform profit rate
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Can General Equilibrium be in equilibrium?

• Rearrange using matrix rules
• Order of multiplication important

• (1) Multiply both sides by inverse of A

• (2) A times its inverse equals I (matrix with 1s
  on diagonal 0s elsewhere)

• (3) Move to LHS

• (4) Group on p

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Can General Equilibrium be in equilibrium?
is equivalent to zero if

• The expression

its determinant is equal to zero

• Matrices have a property called eigenvalues
• Basically, roots (zeroes) of polynomialwhere it
  crosses x-axis
• (1 root for yabx, 2 for yabxcx2, etc.)
• For stability, biggest root must be less than 1
• Problem A A-1 have inverse roots
• If ½ biggest eigenvalue of A, then 2 is biggest
  eigenvalue of A-1.
• Not a problem if all eigenvalues of A
• -½ and -2 both less than zero
• Unfortunately

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Can General Equilibrium be in equilibrium?

• Matrix A derived from table of inputs needed to
  produce outputs
• Input-output table has all non-negative entries
• Cant use negative quantities of commodity as
  input
• Advanced maths theorems (Perron-Frobenius) show
  that As biggest eigenvalue must be 0
• So either A or A-1 (or both) must have root 1
• If A has root of ½ then A-1 has root of 2
• Results
• Either prices or quantities must be unstable
• If system diverges a fraction from stability, it
  will never return
• General Equilibrium will never be in
  equilibrium

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Can General Equilibrium be in equilibrium?

• Intuition
• Walras hoped direct effects of price changes
• Banana supply exceeds demand ? banana price falls
  ? closer to equilibrium
• would outweigh indirect effects
• Banana price fall ? fall in income for banana
  producers ? fall in demand for biscuits ?
  feedback on banana industry
• Maths shows not the case plausible model of
  growing production economy unstable feedback
  effects outweigh direct

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Can General Equilibrium be in equilibrium?

• Neoclassical reactions?
• (1) Its just an artefact of matrices
• (2) Lets find ways to make it stable!
• (3) Lets ignore stability
• (1) Its just an artefact of matrices
• Input-output table strictly linear has rigid
  proportions between inputs (commodities)
  outputs
• Neoclassical production functions nonlinear
  variable proportions, input substitution (labor
  for capital)
• Therefore neoclassical model will be stable while
  IO/matrix/Leontief systems will not

Wrong!
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Its just an artefact of matrices

• Matrix is linear
• like b in y(x)abx only with many variables
• Neoclassical production functions are nonlinear
• like y(x)abxcx2dx3
• But
• Any nonlinear function can be approximated by
  polynomial
• E.g., sin(x)

• Linear bit of sin(x) is x
• Best guess for sin(x) near x0

• Linear bit of production function is IO matrix
• Stability near equilibrium determined by linear
  bit only

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Its just an artefact of matrices

• Nonlinear production function might stop
  prices/quantities becoming crazy
• Negative prices or quantities
• But wont make equilibrium stable
• Multiple supply demand markets cant all be
  in equilibrium
• unless started out there and never disturbed
• which takes us to (2) Lets find ways to make it
  stable!
• First neoclassical to realise instability problem
  was Jorgenson (1960)

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(2) Lets find ways to make it stable!

• If the output system is relatively stable, the
  price system cannot be, and vice versa
  (Jorgenson 1960 895)
• The conclusion is that excess capacity (or
  positive profit levels or both) is necessary
  for the interpretation of the dynamic
  input-output system as a model of an actual
  economy (Jorgenson 1960 893)
• So far so good but then in 1961
• To avoid dual instability, a number of
  re-interpretations of the basic model have been
  proposed In this paper, a third
  re-interpretation is suggested (Jorgenson
  1961 106)

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(2) Lets find ways to make it stable!

• First, the behavior of the system depends not
  only on the technological characteristics of the
  system, but also on the behavior of economic
  decision-makers in each of the sectors of the
  economy. Secondly, the complete system surmounts
  the difficulties associated with dual
  instability by suitable restrictions on the
  initial values of the disequilibrium variables,
  the non-negativity of all economic variables is
  preserved
• Introduced stocks Reserve Bank interest rate to
  try to stabilise model
• Got maths wrong! (See Blatt 1983 134, Jorgenson
  1961 112, 115) System still unstable
• Other equally flawed attempts (turnpike theorems
  etc.) so

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(3) Lets ignore stability

• Dominant model of general equilibrium
  Arrow-Debreu
• Model designed to remove dynamics entirely
• For any economic agent a complete action plan
  (made now for the whole future)
• No time process
• Market occurs once only in history of planet
• All transactions for all time take place at once
• Uncertainty re future abolished
• A contract for the transfer of a commodity now
  specifies, an event on the occurrence of which
  the transfer is conditional. This new definition
  of a commodity allows one to obtain a theory of
  uncertainty formally identical with the theory
  of certainty developed in the preceding chapters.

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Its equilibrium, but is it economics?

• For Walras, general equilibrium theory was an
  abstract but nevertheless realistic description
  of the functioning of a capitalist economy. He
  was therefore more concerned to show that markets
  will clear automatically via price adjustments
  than to prove that a unique set of prices and
  quantities is capable of clearing all markets
  simultaneously. By the time we got to Arrow and
  Debreu, however, general equilibrium theory had
  ceased to make any descriptive claim about actual
  economic systems It had become a perfect example
  of what Ronald Coase has called blackboard
  economics, a model that can be written down on
  blackboards using economic terms like prices,
  quantities, factors of production, and so on,
  but that nevertheless is clearly and even
  scandalously unrepresentative of any recognizable
  economic system. (Blaug 1998)

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Is equilibrium economics?

• Obvious conclusions from general equilibrium
  failures
• If model cant be in equilibrium, then
• economy itself certainly cant be
• economics should model out of equilibrium
  behaviour
• equilibrium analysis cant be economics
• Economics can only develop using dynamics
• Out of equilibrium modeling commonplace in true
  sciences
• Example from meteorology Lorenz model of
  2-dimensional weather system (foundation of
  modern weather prediction)

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Non-equilibrium modeling

• Non-equilibrium models use
• Differential rather than simultaneous equations
• Rate of change of x a function of x
• Computer simulations rather than drawings
• Lorenzs weather model simplified version of
  empirically derived fluid flow equations

x displacement
y displacement
temperature gradient

• Thinking like a (neoclassical) economist, lets
  work out equilibrium

34
Lorenzs weather model

• First step, set all rates of change to zero

yx part of equilibrium (also xy0)
b-z1 part of equilibrium ( z0 if y0)
x2c.z part of equilibrium

• Oh Oh there are 3 equilibria!

the other root of x2
Nope!

• Surely 1 is stable the other 2 arent?

35
Lorenzs weather model

• All 3 equilibria are unstable!
• If system starts at (1), (2) or (3), it stays
  there
• But if disturbed even a fraction, it flies away
• So the system must break down?

Nope!

• Wild dynamic behaviour
• But never nonsense values for x,y, z

• The tiniest push and equilibrium is out the
  window
• But the system cycles rather than breaking down

36
Lorenzs weather model

• And behind the apparent chaos
• A complex pattern of feedbacks between x, y z
• Inspiration for modern science of complexity

37
Meanwhile, back in the economy

• Economy just as cyclical as the weather
• Need models of cyclical behaviour, not
  equilibrium
• Plenty exist, but not developed by neoclassicals
• Neoclassicals almost afraid to think in cyclical
  terms Cant think outside equilibrium square
• Instead Post-Keynesians (Kaldor, Goodwin), some
  Marxists (Foley, Levy), evolutionary economists
  (Schumpeter), chaos/complexity theorists
  (Goodwin, Chiarella) econophysicists (Ponzi)
• An example Goodwins 1967 cyclical growth model
• Based on Marxs verbal model in Capital I

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The Cyclical economy

• a rise in the price of labor resulting from
  accumulation of capital implies accumulation
  slackens in consequence of the rise in the price
  of labour, because the stimulus of gain is
  blunted. The rate of accumulation lessens but
  with its lessening, the primary cause of that
  lessening vanishes, i.e. the disproportion
  between capital and exploitable labour power. The
  mechanism of the process of capitalist production
  removes the very obstacles that it temporarily
  creates. The price of labor falls again to a
  level corresponding with the needs of the
  self-expansion of capital, whether the level be
  below, the same as, or above the one which was
  normal before the rise of wages took place
  (Marx Capital I Chapter 25 Section 1)

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The Cyclical economy

• Marxs model
• High wages ? low investment ? low growth ? rising
  unemployment ? falling wage demands ? increased
  profit share ? rising investment ? high growth ?
  high employment ? High wages cycle continues

• Goodwins mathematical rendition
• Change employment rate growth rate minus
  productivity population growth
• change workers income share Real wage
  growth minus productivity

40
The Cyclical economy

• Neoclassical equilibrium hangup a hindrance on
  real progress in economics

• Cyclical nature of economy can be modelled
• advanced computer tools exist to do it!

Not to mention advanced thinkers...
41
Political Economy Old and New

• Political Economy traditionally included
• Post Keynesians
• Believe Keynes misinterpreted by Samuelson, Hicks
  et al. in Keynesian-neoclassical synthesis
• Reject IS-LM, AS-AD interpretations
• Marxists
• Continue Classical tradition
• Most still believe labour theory of value, some
  dont
• New entrants
• Ecological feminist economists
• Focus on issues ignored by neoclassicals ( to
  some extent other schools)
• Econophysicists

42
Econophysicists

• Physicists applying tools from physics to analyse
  economy
• Reject neoclassical economics as based on false
  analogy to outdated 19th century physics
• E.g. Anyone who has taken both physics
  economics classes knows that these subjects are
  completely different in nature, notwithstanding
  the economists failed attempt to make economics
  look like an exercise in calculus (McCauley
  2004 3)
• See economics as necessarily non-equilibrium
• There is no empirical evidence for stable
  equilibrium, for a stabilizing hand to provide
  self-regulation in unregulated markets.
  (McCauley 2004 4)

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Econophysicists ( mathematicians)

• Emphasise reality empiricism over theory
• Our emphasis is on understanding how markets
  really behave, not how they hypothetically
  should behave as predicted by completely
  unrealistic models. (McCauley 2004 xi)
• Reject neoclassical economics
• An aim of this book is to make it clear to the
  reader that neo-classical theory, beloved of pure
  mathematicians, is a bad place to start in order
  to make new models of economic behavior. This
  includes the neoclassical idea of Nash equilbria
  in game theory. (McCauley 2004 6)

44
And the last word

• Goes to Australian econophysics pioneer John
  Blatt
• The competitive system must not be treated as if
  it should be in, or near, the balanced growth
  state (or, even less realistically, a state of
  static equilibrium). The system, instead, has a
  natural tendency to depart from this state and
  undergo oscillations This conclusion, arrived at
  theoretically, is confirmed by some two centuries
  of empirical observation. It is about time we
  recognize the obvious facts about the system in
  which we live. (Blatt 1983 148)

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Welcome to Political economy!

• Here ends the demolition job on neoclassicism
• Next week, Neil Hart on Post Keynesian economics
• Ideas in my lectures further developed in
• History of Economic Thought (if you havent
  already done it)
• Financial Economics
• Honours courses in Nonlinear Finance, Advanced
  Political Economy
• Possibly next year Managerial Economics

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References

• Blatt, J.M., 1983. Dynamic Economic Systems, ME
  Sharpe, Armonk.
• Blaug, M., 1998. 'Disturbing currents in modern
  economics', Challenge!, 41(3) 11-34.
• Debreu, G., 1959. Theory of Value An Axiomatic
  Analysis of Economic Equilibrium. Yale University
  Press, New Haven.
• Hurwicz,L.,1986. On the stability of the
  tatonnement approach to competitive equilibrium,
  in Sonnenshein, H.F.(Ed.), Lecture Notes in
  Economics and Mathematical Systems.
  Springer-Verlag, Berlin.
• Jorgenson , D.W., 1960. A dual stability
  theorem, Econometrica 28(4), pp. 892-899.
• Jorgenson, D.W., 1961. 'Stability of a dynamic
  input-output system', Review of Economic Studies,
  28 105-116.
• Jorgenson, D.W., 1963. 'Stability of a dynamic
  input-output system a reply', Review of Economic
  Studies, 30 148-149.
• McCauley, J.L., 2004. Dynamics of Markets
  econophysics finance, Cambridge University
  Press, Cambridge.
• McManus, M., 1963. 'Notes on Jorgensons model',
  Review of Economic Studies, 30 141-147.
• Walras, L., 1874, 1900 1954. Elements of Pure
  economics, George Allen Unwin, London.