Milton Friedman and The Chicago Approach to Microeconomics

Milton Friedman Chicago, Friedman Theories Summary

The modern modeling approach that has come to dominate the profession has some grounding, too, in the Chicago approach to economics, which ran counter to the formalist approach from the 1950s through the 1970s. The Chicago approach was characterized, first, by a belief that markets work better than the alternatives as a means of organizing society and, second, by its connection to the Marshallian informal approach to modeling.

Milton Friedman (1912- ) was a counterweight to Paul Samuelson throughout the modern period of economics. Friedman summarized his Chicago approach as follows:

In discussions of economic policy, "Chicago" stands for belief in the efficiency of the free market as a means of organizing resources, for skepticism about govern­ment affairs, and for emphasis on the quantity of money as a key factor in producing inflation.

In discussions of economic science, "Chicago" stands for an approach that takes seriously the use of economic theory as a tool for analyzing a startlingly wide range of concrete problems, rather than as an abstract mathematical structure of great beauty but little power; for an approach that insists on the empirical testing of theoretical generalizations and that rejects alike facts without theoty and theory without facts."

Friedman's approach to economics was Marshallian rather than Walrasian. He saw economics as an engine of analysis for addressing real problems and as something that should not be allowed to become an abstract mathematical consideration devoid of institutional context and direct relation to real world problems.

In his consideration of policy issues he combined strong beliefs in individual rights and liberty and in the effectiveness of the market in protecting those rights (see Capitalism and Freedom, 1962). His political orientation was basically pro-market and anti-government. He advocated many policy proposals that at first were seen as radical but later became more acceptable: financing education with vouchers, eliminating licensing in professions, and legalizing drugs.

Around 1950 Friedman produced a number of provocative papers on meth­odology and also a paper on the Marshallian demand curve and the marginal utility of money. In the late 1950s he made contributions to macroeconomics in his Studies in the Quantity Theory of Money (1956). His column in Newsweek was read by many, and a TV series titled "Free to Choose" gave him greater notoriety than most theorists. He won the Nobel Prize in economics in 1976.

Even as Friedman was becoming well known, his Marshallian approach was dying. In part this was because it was seen by many as ideologically or normatively tainted, causing researchers to revert to formalism to avoid ideological bias. An example of what some economists considered to be the normative bias in the Chicago approach to economics can be seen in the Coase theorem, named for Ronald Coase (1910- ), another influential Chicago economist whose work led to the recent field of law and economics. The Coase theorem was a response to the Pigouvian approach, which saw the existence of externalities as a reason for government intervention. In "The Problem of Social Cost," Coase argued that in theory, externalities were not a reason for government intervention, because any party helped or hurt by an action was free to negotiate with others to eliminate the externality. Thus, if there were too much smoke from a factory, the neighbors hurt by the smoke could pay the factory to reduce it.

The Coase theorem has been much discussed in the literature. The general conclusion is that in and of itself the theorem is no more ideological than is the theory of externalities that predisposes one toward government intervention. Issues involving government intervention are complicated, and there is no answer that follows from theory; in modern economics a theory of government failure exists side by side with a theory of market failure. Which is more appropriate depends upon the relative costs and benefits, issues upon which individuals may disagree.

Nonetheless, the Chicago approach has stimulated many new ideas, and it, rather than the more formalist approach, may sow the seeds for major developments in microeconomics in the future. Among those new ideas that have been stimulated has been Armen Alchian's (1914- ) and Harold Dem-setz's (1930- ) work on property rights as underlying markets. Since the Chicago view is that it is best to assume that markets work efficiently, much of the discussion of inefficiency in markets (such as might be produced by monopolistic competition) is misplaced. But markets depend upon property rights; thus, the study of property rights is of paramount importance to econom­ics. What are the underlying property rights? How do they develop? How do they change?

The most important follower of Friedman was Gary Becker (1930- ), who won the Nobel Prize in economics in 1992. He has used microeconomic models to study decisions about crime, courtship, marriage, and childbearing. Becker has shown that the simple-maximization microeconomic model based on the assumption of rational individuals has potentially infinite applications, and recent years have seen it used in widely diverse areas. These incursions of economic theory into other disciplines have sometimes been treated facetiously by those who claim that the economic approach is too simple. In one sense they are right. The ideas and policy conclusions of the "economics of everything" are often simple. But mere simplicity does not make them wrong. Market incentives make a difference in people's behavior, and noneconomic specialists have often not included a sufficient consideration of these incentives in their analyses. But analyses can go astray when only economic incentives are considered and insufficient attention is paid to institutional and social incentives. Unfortunately, given modern economists' training in noncontextual modeling, this is often what occurs.

With the retirement of Milton Friedman and his colleague George Stigler and with Gary Becker's impending retirement, Chicago economics changed, becom­ing more mathematical and less intuitive. Not stopping at simple models, it generalized models along the lines suggested by Varian. Clearly, Chicago has entered the modern school of economics, and the modern school of economics has become quite homogeneous. What one learns in graduate programs at Harvard, Chicago, MIT, Stanford, or any top graduate school, is essentially the same thing.