Alchian on Keynes
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Alchian on Keynes Edward W. Fuller 1 # Springer Science+Business Media, LLC, part of Springer Nature 2019
Abstract This paper examines Armen Alchian’s work on Keynes’s marginal efficiency of capital. Alchian is correct to assert that Keynes’s theory of investment based on the marginal efficiency of capital is flawed. However, Alchian does not emphasize the importance of Keynes’s error. This paper extends Alchian’s analysis to show that Keynes’s marginal efficiency of capital is a significant error. Keywords John Maynard Keynes . Armen Alchian . Marginal efficiency of capital . Net
present value JEL classification E12 . E22 . E43 . G31
1 Introduction Armen Alchian’s paper “The Rate of Interest, Fisher’s Rate of Return over Costs and Keynes’ Internal Rate of Return” (1955) is one of the most important articles in the history of financial economics. Alchian shows that John Maynard Keynes’s marginal efficiency of capital is not identical to Irving Fisher’s rate of return over cost. Moreover, he illustrates that Keynes’s marginal efficiency of capital (also known as the internal rate of return) is problematic, because marginal efficiency of capital rankings can contradict net present value rankings. Today, Alchian’s proof is still used to show finance professionals that the net present value is superior to the internal rate of return. Despite its significance in the history of financial economics, macroeconomists have almost totally neglected Alchian’s paper. Important commentators still incorrectly associate Keynes’s marginal efficiency of capital with Fisher’s rate of return over cost.1 1
For examples, see Champernowne (1964, 182), Patinkin (1976, 80; 1982, 9, 78), Weintraub (1983, 618), Kahn (1984, 146), Tobin ([1987] 1990, 167), Fletcher (1987, 138), Carabelli (1988, 208), Dimand (1988, 185), Fitzgibbons (1988, 120), Skidelsky (1992, 555), O’Donnell (1997, 102), Laidler (1999, 254; 2010, 53), Backhouse and Laidler (2004, 27), Lawlor (2006, 150), Backhouse and Bateman (2011, 24), Kent (2014), and O’Donnell and Rogers (2015, 4n3).
* Edward W. Fuller
1
Palo Alto, USA
E. W. Fuller
Why have macroeconomists neglected Alchian’s paper? Alchian did not emphasize the significance of Keynes’s error. This paper extends Alchian’s analysis to demonstrate that Keynes’s marginal efficiency of capital is a significant error.
2 Alchian’s proof Alchian begins his celebrated paper by stating, “Keynes erroneously alleged that his marginal efficiency of capital is identical with Fisher’s marginal rate of return over cost, and that it is used for exactly the same purpose. Unfortunately Keynes was wrong; they are not the same and they were not used for the same purpose” (1955, 938). Although Keynes developed the marginal efficiency of capital (MEC) independently, he really did believe it was identical to Fisher’s rate of return over cost (RROC).2 In other words, Keynes actually thought his approach to ranking investments was equivalent to Fisher’s approach and thereby possessed all the same properties. He writes in The General T
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