Review of Political Economy

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A Critical Review of the Rationale Approach to the

Microfoundation of Post-Keynesian Theory

Christian Schoder

To cite this article: Christian Schoder (2017): A Critical Review of the Rationale Approach
to the Microfoundation of Post-Keynesian Theory, Review of Political Economy, DOI:
10.1080/09538259.2017.1315932

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REVIEW OF POLITICAL ECONOMY, 2017
http://dx.doi.org/10.1080/09538259.2017.1315932

A Critical Review of the Rationale Approach to the

Microfoundation of Post-Keynesian Theory
Christian Schoder
The New School for Social Research, New York, USA

Abstract ARTICLE HISTORY

While modeling macroeconomic interactions, post-Keynesians Received 28 November 2015
propose rationales to verbally motivate the choice of behavioral Accepted 28 March 2017
equations. This informal approach to microfoundation results in
KEYWORDS
inconsistencies and fuzzy arguments. The rationales for different Post-Keynesian economics;
behavioral rules are mutually inconsistent, require strong and microfoundations;
nontransparent assumptions, or refer to highly endogenous macroeconomic
variables that are not part of the model. The postulated methodology; economic
behavioral rules are invariant to endogenous changes in the rationales; economic
microenvironment, whereas the rationales imply that they adjust modelling
endogenously. The prevailing assumption of purely backward-
looking expectations is neither theoretically nor empirically JEL CLASSIFICATION
B41; B50; E12
satisfying. The article concludes that revisiting the issue of
microfoundation within the post-Keynesian framework may be a
rewarding line of research. Furthermore, post-Keynesians should
be open to various microfoundations as long as models feature
the core of post-Keynesian theory—the principle of effective
demand.

1. Introduction
The core behavioral hypotheses of post-Keynesian models are typically anchored in sty-
lized empirical observations such as the Keynesian consumption or Kaleckian investment
function (Taylor 2004; Godley and Lavoie 2012). While the need for ‘microfoundations’ is
highly debated (see King 2012), many post-Keynesians indicate a desire to provide verbal
‘rationales’ for postulated behavioral relations (and not only empirical evidence) – the
‘rationale approach to microfoundation.’1 In this spirit, Kriesler (1987), Lavoie (1992,
2014) and Hein (2008) discuss in depth the post-Keynesian behavior rationales and are

CONTACT Christian Schoder schoderc@newschool.edu

1
Consider the debate on the determinants of business investment in post-Keynesian growth models. Rationales are typically
put forward to justify the choice of variables to be included in the investment function. Robinson (1962, p. 86) emphasizes
the importance of the profit rate and argues that

profit influences investment not only by providing the motive for it but also through providing the means. Gross
retained profits finance an important part of the gross investment of firms. Moreover, the amount that a firm
puts up of its own finance influences the amount that it can borrow from outside.

Similarly, Kalecki (1954, p. 91) argues that profits raise investment due to larger internal funds and easier access to exter-
nal funds: ‘The access of a firm to the capital market, or in other words the amount of rentier capital it may hope to
obtain, is determined to a large extent by the amount of its entrepreneurial capital.’ Providing a different rationale,
Bhaduri and Marglin (1990, p. 380) argue that,
© 2017 Informa UK Limited, trading as Taylor & Francis Group
2 C. SCHODER

the standard references for the microfoundations of post-Keynesian theory. It seems fair to
claim that many post-Keynesians see their behavioral assumptions as well anchored in
consistent microfoundations that, in contrast to orthodox economics, do not rely on
inter-temporal optimization or rational expectations.
However, if you do not formally model the stories you tell in order to justify behavioral
relations, you hide crucial assumptions and run the risk of being inconsistent. The article
argues that the rationales provided in the post-Keynesian literature are mutually inconsist-
ent or rely on strong assumptions. Instead of providing verbal rationales for their behav-
ioral relations, post-Keynesians should consider modeling the microstructure underlying
their macroeconomic model.
To illustrate and evaluate the post-Keynesian rationale approach to microfoundations I
present a neo-Kaleckian-type model that synthesizes Hein (2008, ch. 13.3), Hein and
Stockhammer (2010), and Godley and Lavoie (2012, ch. 11); then I discuss the transpar-
ency, consistency, and completeness of its microfoundations. In order to make microfoun-
dations simple, and the argument as general as possible, the framework includes minimal
behavioral relations.2 While the model chosen best illustrates my point, the criticism is not
about the specific model used but about the conventional approach to justify behavioral
relations in general.
The review points toward the following shortcomings of the rationale approach to
microfoundation. First, the rationales provided independently for different behavioral
rules within the same model run the risk of being mutually inconsistent. For instance,
the rationales provided for both the price decision and the target utilization rate are
related to monopoly power and market structure (Kalecki 1971). Yet they are typically
treated independently in the behavioral equations of the model.
Second, this article identifies behavioral inconsistencies between the postulated macro-
level rules and the micro-level rationales that are provided to back them up. The rationales
typically imply that the representative agent pursues objectives such as choosing the target
utilization rate to optimize market-expansion prospects. Such goal-oriented behavior
implies that the rules of behavior adjust to possibly endogenous variations in the economic
environment. For instance, the target utilization rate will respond to changes in the degree
of monopoly, which in turn may depend on the power of labor unions and, hence, on the
unemployment rate. Yet, the postulated rules do not take into account changes in the
microenvironment. Rather, they implicitly consider the agent to be unable or unwilling

an investment function which depends simply on the rate of profit is insensitive to the influence of the existing
degree of capacity utilization, e.g. it neglects the possibility that, despite a high profit margin, investors may not
be inclined to invest in additional capacity if massive excess capacity already exists.

Another example for the crucial role that rationales play in justifying behavioral relations is the debate on whether or not
to include wealth in the consumption function. Godley and Cripps (1983) and Godley and Lavoie (2012) make a case for
including wealth in the consumption function by pointing out that otherwise consumption theory would suggest that
the stock of wealth goes to infinity. Finally, extensions of a baseline model or modifications of its behavioral assumptions
typically induce the authors to provide corresponding micro-level rationales. Stockhammer (2005–06), for instance, dis-
cusses business investment in the context of a shareholder orientation of firms and uses formalized microconsiderations
to make his point.
2
Extensions of the baseline model make it harder to develop consistent microfoundations. Hence, our critique applies even
more to the vast literature extending the baseline model to study issues related to the growth effects of monetary policy
(Lavoie 1995a; Hein 2008; Hein and Schoder 2011), the growth effects of institutional changes on financial markets
(Stockhammer 2005–06; Meirelles and Lima 2006; Lima and Meirelles 2006; Hein and Schoder 2011), as well as the
growth–distribution nexus in an open-economy (Blecker 1989; Araujo and Lima 2007).
 REVIEW OF POLITICAL ECONOMY 3

to adapt its behavior to an endogenously changing environment—a behavioral property

referred to as ‘lethargic.’
Third, to make a behavioral rule consistent with its rationale, strong assumptions about
economic behavior are required, but they are not made transparent. The rationale for a
constant target-utilization rate below unity market-structure considerations, for instance,
assumes away the labor market influence on the degree of monopoly—a crucial mechan-
ism in post-Keynesian models of endogenous distribution.
Fourth, the rationales regarding behavioral rules often refer to variables that are not part of
the model. If they were, they would be highly endogenous. For instance, the price and invest-
ment decision rules rely heavily on concepts such as market concentration, risk of market
entry, and collateralized borrowing. These variables are absent in the standard post-Keynesian
models, but are used to justify behavioral rules even though they are endogenous.
Fifth, post-Keynesians adhere to the idea of formal modeling when it comes to the
interaction of macroeconomic variables such as growth and distribution. Yet behavioral
hypotheses postulated on the micro level, for instance, to establish a causal relation
between consumption and income, are anchored in verbal considerations rather than
formal modeling. This may be perceived as an inconsistency of methods.
Finally, post-Keynesian models consider expectations to be purely backward looking--
despite the emphasis on forward-looking, but non-rational, expectations in much of Keynes.
Section Two discusses the concepts of microfoundations, goal-oriented behavior, and
lethargic behavior. Section Three presents a post-Keynesian model and evaluates the trans-
parency, consistency and completeness of the rationales typically provided to back up the pos-
tulated behavioral assumptions. Section Four concludes and discusses possible ways forward.

2. Methodological considerations of microfoundation

Microfoundation concerns the behavior of economic as-if agents underlying a macroeco-
nomic model. No two real agents actually behave in exactly the same way, and the interaction
of all agents with their economic environment gives rise to macroeconomic patterns that
macroeconomic theory seeks to explain. To do so, making simplifying assumptions regarding
the heterogeneity of behavior across agents cannot be avoided. Regardless of its degree of het-
erogeneity, any microfounded macroeconomic model assumes highly stylized economic
agents. Yet the question of how any stylized agent relates to the real-world agents whose
behavior it should characterize is delicate—the more so the lower the degree of heterogeneity
among agents. One approach may be to study the behavior of a single real-world agent, and
model the stylized agent accordingly. Yet, the stylized agent may not be representative of the
other real-world agents. Rather than the behavior of a single real agent, the stylized agent
should characterize the average behavior of all relevant real agents even though none may
behave exactly like that in reality. Hence, any microfounded model assumes that economic
decisions are made as if agents exhibited a certain pattern of economic behavior. The issue
for economic theory is to model the as-if agent so that behavioral hypotheses are as represen-
tative as possible.3
3
For example, consider Kalecki’s (1971) theory of the price for the individual firm. To aggregate the postulated behavioral
relation, Kalecki intentionally assumes away vertical disintegration industries ‘hoping that the factors he left out were of
little importance relative to those he left in’ (Harcourt 1987, p. xi). Kalecki implicitly postulated that the aggregate pricing
relation was as if a representative firm sets the price with a markup on unit variable costs (Steedman 1992).
4 C. SCHODER

I define ‘the microfoundations of an economic model’ as a consistent and complete

explanation of a set of behavioral relations characterizing the economic choice of as-if
agents with all assumptions made transparent. In economics, explanations require a
theory, which for consistency must be free of contradictions. The respective hypotheses
for explaining any two different behavioral relations (e.g., consumption and labor
supply) need to be mutually consistent. Completeness requires that the micro theory
explains the entire set of behavioral relations of the model. Transparency requires that
all assumptions regarding the micro theory are made explicit. In contrast to microfounda-
tions, I define ‘rationales’ as the attempt to verbally motivate a common behavioral
hypothesis in the post-Keynesian research paradigm.
Goal-oriented behavior implies that the agent seeks to achieve a well-specified purpose
when making an economic choice and is able to compare the outcomes of two different
choices. Evaluating the consequences of two choices will induce the agent to revise its
rule of behavior. The purpose can be characterized by a set of preferences or a payoff func-
tion. As I argue below, post-Keynesian rationales implicitly assume that agents pursue
objectives, including optimization of well-being, growth, and cost.
Lethargic behavior is a behavioral rule determining economic choice with the property
that endogenous changes in the economic environment do not feed back into the behav-
ioral rule itself. For instance, the Keynesian consumption function relates consumption to
current income with an assumed constant marginal propensity to consume. The as-if
agent is assumed to be lethargic with respect to this rule of behavior. The agent will not
adjust the marginal propensity to consume to endogenous changes in the economic
environment for three reasons.
First, the agent does not have a purpose when making a choice such as consumption for
a given income. Different consequences of differing choices do not systematically and con-
sistently feed back into the agent’s conventionally chosen rule of behavior simply because
the agent does not care. Second, the agent may have a purpose but cannot compare the
consequences of any two choices. These two views of economic behavior are at odds
with most of the underlying rationales put forward to justify lethargic behavioral relations.
Finally, there is the possibility of indifference between two choices despite differing
payoffs due to sufficiency. The agent seeks to achieve a certain payoff through the
choice made. Yet, as long as the differences in payoffs stay beyond a certain threshold,
the agent is indifferent and will not adjust to sufficiently low changes in the environment.
This setting allows for lethargic behavior and prevents feedback-sensitive behavior–as long
as the differences in the payoffs associated with any two choices are small. Lethargic indif-
ference between two payoffs may well characterize the behavior of a single agent. Yet, it
seems implausible for describing average behavior and, under the assumption of a repre-
sentative agent, for describing the decisions of the as-if agent the microfoundation seeks to
model. Under the homogeneous-agents paradigm in the post-Keynesian literature, a
behavioral relation postulated to govern the representative as-if agent’s decision making
should approximate the average behavior of all real-world agents rather than the behavior
of a single real-world agent.4

4
Shaikh (2016, ch. 3), pointing out that aggregate relations are emergent properties of heterogeneous micro behavior, may
be interpreted along these lines. In particular, he argues that a downward-sloping, aggregate demand curve may arise
even though, under agent heterogeneity, individual demand curves do not. Under assumed agent homogeneity, taking
the demand curve to not be downward sloping based on microeconomic evidence would be misleading. The appropriate
 REVIEW OF POLITICAL ECONOMY 5

3. The behavioral anchoring of a post-Keynesian model

Having developed these categories for classifying microfoundation types, I review the rel-
evant literature focusing on the synthesis of Hein (2008, ch. 13.3), Hein and Stockhammer
(2010), and Godley and Lavoie (2012, ch. 11). I show that the behavioral relations such as
the consumption function, investment function, and price-setting equation are typically
stated as lethargic rules. Justifying these behavioral relations, which is the core endeavor
of Lavoie (1992, 2014), is based on rationales that suggest agents follow goal-oriented
behavior and even optimize choice.
I use a simple closed-economy, Kaleckian-type model representative of much post-Key-
nesian work, including models with Harrodian, Kaldorian, or Marxian closures (Duménil
and Lévy 1999; Shaikh 2009; Skott 2010; Setterfield 2013). Then I raise the following
criticisms:

. The rationales provided for different behavioral rules within the same model tend to be
mutually inconsistent. I call the rationales for two particular behavioral relations, A and
B, ‘inconsistent’ if A has an implication contradicted by an implication of B and vice
versa.
. The assumptions required to align rationales with their corresponding behavioral rules
are not transparent.
. The rationales imply that agents exhibit goal-oriented behavior while the postulated
behavioral rules suppose agents are lethargic.
. The justification of behavioral rules often involves endogenous variables that are not
part of the model.
. Macroeconomic arguments are put forward formally, while microeconomic arguments
are presented verbally.
. Purely backward-looking expectations contradict Keynes’s own work and empirical
evidence.

3.1 The setting

Post-Keynesian growth models characterize the goods market featuring real aggregate
output on the supply side and real aggregate consumption and real aggregate capital
investment on the demand side. The supply side is characterized by a fixed-coefficient pro-
duction technology, according to which nondepreciating and nontraded capital and labor
are combined in order to produce a homogeneous output good used for both consumption
and capital investment. Fixed costs of production arise. Even though the output good can
be stored (as capital), just-in-time production is assumed in the Kaleckian variant of the
model in order to eliminate inventories. Labor has to be compensated by a nominal wage
per working hour that is assumed to be a collective policy variable—constant and the same
for anyone providing labor. Accounting requires that aggregate sales equal aggregate
expenditures, or in the textbook IS-notation, that aggregate saving equals aggregate invest-
ment. The core feature of a post-Keynesian model is the principle of effective demand,
according to which aggregate demand drives output. This implies that investment

demand schedule assigned to the as-if agent should be downward sloping despite contradicting microeconomic
evidence.
6 C. SCHODER

precedes savings. Investment drives savings through changes in income. Hence, the invest-
ment decision is independent of the saving decision. Moreover, Keynesian unemployment
needs to prevail. A shortage of working hours supplied at a given real wage will never con-
strain production. Hence, post-Keynesian models are typically concerned with three
markets: goods, labor, and external finance.
Regarding agents participating in the economy, I follow Hein (2008, ch. 13.3) and
Hein and Stockhammer (2010) by assuming that the economy is populated by house-
holds and firms. Households split into laborers and rentiers. In particular, our
economy is populated by N l laborers each deciding on their consumption (which is
constrained to equal their income) and their labor supply; N r rentiers each choosing
consumption that (for a given income) implies the supply of bank deposits or
savings; and N f firms each choosing its labor demand, price of its goods, capital invest-
ment, and financial structure (which implies demand for bank loans and profit distri-
bution policy). Hence, savers and investors are institutionally separated. The
household’s consumption choice at a given income determines the supply side of
the external finance market. The firm’s investment decision and financial structure
decision (the latter pins down retained earnings and required bank loans) determine
the demand side.5
Despite the existence of a market for bank finance, for simplicity I assume the interest
rate to be zero.6 Note that price setting by the firms fixes the shares of wages and profits in
total income. There is no feedback from the goods market to income distribution. Finally,
the state of the labor market does not feed back into the economy.

3.2 Technology
Following Lavoie (2014, ch. 3), I assume firm k produces according to
Yk = min (Lk , uk Kk ) (1)

5
A variation is to not distinguish between laborers and rentiers, and to assume that household propensities to consume out
of wage and profit income differ (Lavoie and Godley 2001; Godley and Lavoie 2012, ch. 11; Schoder 2014). Households
now choose consumption and labor supply, and firms choose labor demand, prices, investment, and profit distribution.
This modification also institutionally separates savers from investors. The challenge for a consistent microfoundation in
this setting is to deal with the consumption–labor supply interaction of the household. Since the article’s aim is to discuss
the rationales underlying the simplest post-Keynesian model with an institutional separation of the investment and
saving decision, I do not apply this setting here. In contrast, early post-Keynesian models consider agents who
provide labor services (workers) and agents who own the means of production and manage the production process (capi-
talists). Workers do not save, and their only decision variable is labor supply—an assumption shared in much of the new-
Keynesian literature. Capitalists decide on labor demand, prices, investment, consumption (which implies new bank
deposits) and implicitly bank loans. A variant populates the economy with agents providing labor services and
owning the means of production (households) and agents managing the production process (firms). Again, the house-
hold’s only decision variable is the labor supply since all income is consumed. Firms are institutions and do not consume.
Their decision variables are labor demand, prices, investment, profit distribution (which implies bank deposits) and bank
loans. In this setting, saving accrues only out of the firm’s profits (classical saving hypothesis). In order for the investment
decision of the single agent to be independent of the saving decision, the existence of a market for external finance has
to be assumed implicitly. Yet in the aggregate, external finance will not be required as investment spending will generate
the profit income such that saving adjusts through the multiplier effect (Rowthorn 1981; Dutt 1984; Taylor 1985; Bhaduri
and Marglin 1990). Since the same agent makes the investment and saving decisions, providing a consistent set of micro-
foundations will prove difficult. Hence, I change the setting of our model slightly by institutionally separating the invest-
ment and saving decision.
6
The assumption of a zero interest rate is not a strong one in a post-Keynesian framework. This is because the interest rate
would affect the demand for and supply of finance only through the income effect and not through the substitution
effect.
 REVIEW OF POLITICAL ECONOMY 7

where Yk , Lk , Kk and uk denote output, labor input, capital input, and the rate of capacity
utilization. Equation 1 is a Leontief production function that excludes the possibility of
substitution between capital and labor. With this type of production function, one does
not have to address the question of what ratio of capital and labor inputs the firm will
choose.
With respect to Equation 1, for simplicity I first assume labor productivity (Yk /Lk ) to be
unity for all firms. Further, I assume that Keynesian unemployment prevails at any time.
Hence, the labor input is never the binding constraint to production. Second, I define the
rate of capacity utilization (uk ) as the ratio between output (Yk ) and full-capacity output
(Ykc ). With uk = 1, firms produce at full capacity; with a predetermined capital stock, the
availability of capital is a binding constraint to output. I also normalized capital
productivity(Ykc /Kk ), the output produced by one unit of capital at full capacity utilization,
to unity. Third, Yk will be determined by the demand side of the economy. Hence, the pro-
duction function indicates how much labor will be demanded given uk and(Kk ). Fourth,
firms hold idle capital in equilibrium. Fifth, up to full capacity, technology exhibits con-
stant marginal costs and constant returns to scale.

3.3 The laborer’s control variables: consumption and labor supply

The laborer i’s control variables are consumption (Cil ) and labor supply (Ni ), which is con-
sistent with most models in the post-Keynesian literature even though the labor supply
choice is typically not discussed explicitly (Lavoie 2014, ch. 5).

3.3.1 The laborer’s consumption

The assumption that laborers are excluded from the financial markets gives us the behav-
ioral rule for worker consumption–they cannot save and consume all their income. This
gives us


Cil = v L
k[N f k,i
(2)

where v = w/P is the real wage and Lk,i is the firm k’s labor demand for laborer i’s ser-
vices. Note that labor demand pins down employment, and worker consumption
choices are irrelevant. Whatever laborers want to save, they will not succeed, since they
do not have access to the bank. For the purpose of this article, I refrain from discussing
this hypothesis.

3.3.2 The laborer’s labor supply

In most models, including the present one, the labor supply decision does not affect the
economy. Assuming sufficient labor supply at the given wage, the labor supply decision
affects only the unemployment rate, which does not feed back into the economy
(Bhaduri and Marglin 1990; Lavoie 1995a; Godley and Lavoie 2012, ch. 11). Nevertheless,
I carefully review the microfoundation of the post-Keynesian labor supply, for two
reasons. First, in models that include labor-market effects on the economy, for instance
on income distribution (Taylor 2004, chs.7, 9; Sasaki 2013; Schoder 2014; Stockhammer
and Michell 2017), the labor supply decision would be relevant. Second, the rationales
8 C. SCHODER

provided to justify the post-Keynesian labor supply nicely illustrate the challenges faced by
conventional post-Keynesian microfoundations.
Almost all post-Keynesian macro models assume that aggregate labor supply (N) is
constant


N=N (3)
which is based on the empirical observation that the aggregate labor supply responds
inelastically to wage changes (Lavoie 1992, p. 224). Equation 3 violates our definition of
microfoundation since it is not on the micro level.
What microstories do post-Keynesians provide to justify the suggested aggregate
relation in terms of economic theory? Lavoie (2014, ch. 5.4.1) proposes a standard (non-
formalized) framework for deriving a post-Keynesian labor supply curve. Laborers seek to
maintain a certain desired standard of living, expressed as desired consumption (C
l ). The
i

at a given v. Assuming that unem-
laborer chooses an Ni that is just sufficient to reach C
l
i
ployment, y, affects all laborers to the same extent, we have

li
C
Ni = (4)
v(1 − y)
which holds since it is assumed that laborers do not save. Lavoie argues further that the
desired standard of living, C
l , depends on the average income of a reference group for
i
the household. Since rentiers are an obvious reference group for workers, one might
assume that the desired standard of living is proportional to the average rentier’s con-
sumption, with factor g (Setterfield and Kim 2016). However, the desired standard of
living will not exceed what the household could attain under full utilization of its work
capacity for a given unemployment rate, assumed to be unity. Hence,
 
1


= min v(1 − y), g
C
l
C .
r
(5)
i
N r j[N r j

Equations 4 and 5 formalize Lavoie’s argument. For a given standard of living sought by
the laborer, a real wage increase reduces the number of hours worked. Hence, the
supply curve is downward sloping for a given standard of living. Yet, the wage increase
may shift the household to a higher desired consumption level (mediated in our model
through a possibly positive wage effect on aggregate demand and, hence, rentiers’
consumption).
So far, the rationales above constitute an incomplete and fuzzy argument since the
household’s objectives are not made explicit. What justifies Equation 4? The lexicographic
indifference curves drawn by Lavoie (2014, Fig. 2.3) suggest that the laborer’s purpose with
respect to the labor supply choice is to maximize some form of well-being that is assumed
to depend on consumption and leisure. Recalling that the household’s labor supply cannot
exceed one, we can formalize this by assuming

)r ]1/r
u(Cil , Ni ) = [(Cil )r + (c(1 − Ni ) − C
l
(6)
i

where r and c are parameters. With r  −1 and c  1, the utility function represents

l ) being a saturation
Leontief (or lexicographic) preferences, with the standard of living (C i
 REVIEW OF POLITICAL ECONOMY 9

point. For a given standard of living, there is no substitution between consumption and
leisure. Any higher income will be used to reduce the labor supply. These are exactly
the type of preferences suggested by Lavoie (2014, ch. 2.3). The constraint the worker
faces when choosing Ni is

Cil = Ni v(1 − y). (7)

After formalizing Lavoie’s rationales to justify Equation 3, and accepting it as a valid
microfoundation, it is clear that the assumption of constant labor supply is strong.
It is a special case in which, after aggregation over all laborers, a rise in the real
wage is associated with a supply-reducing income-substitution effect that is
exactly equal to a supply-increasing standard-of-living effect and, hence, leaves
hours worked unchanged. Equation 3 is an approximation that ignores effects
that real wage variations may have on the leisure–consumption trade-off of the
laborer’s household. In particular, abstracting away from the link between labor
supply and peer group income is surprising because these peer-group effects have
been emphasized as a crucial pillar of the post-Keynesian theory of choice
(Lavoie 2014, pp. 101–103).7

3.4 The rentier’s control variable: consumption

The rentier household j chooses only consumption (Cjr ), which gives us savings for a given
income. I follow Modigliani (1986) and Godley and Lavoie (2012) by assuming a con-
sumption function relating consumption to current income (comprising distributed
profits and dividends) and wealth,

Cjr = cP Pdj + cB Bj (8)

where cP and cB are the marginal propensities to consume out of all profits distributed to
rentier j (Pj = k[N f Pdk,j where Pdk,j is the profits distributed from firm k to rentier j)
d

and wealth (Bj ). Both parameters are assumed to be equal across rentiers. It is easy to
see that households will consume all their current income if, for the wealth-profit–
income ratio, it holds that u
j ; Bj /Pdj = (1 − cP )/cB .8
7
Another justification for Equation 3 is provided by Lavoie (1992, p. 224), which most post-Keynesian macro models rely on:
‘Once we realize that the aggregate supply curve of labor may take just about any shape … we might as well simplify
this part of the analysis and assume that the supply curve of labor is vertical in the short run.’ If this argument were
sufficient for assuming the labor supply to be constant, then one may ask why post-Keynesians would not conclude,
for instance, that aggregate demand should better be assumed to be independent of income distribution given the
observation that it is highly contested whether demand is wage or profit led. Another argument is based on the obser-
vation that most jobs feature an institutionally determined number of working hours that do not depend on the real
wage (Eichner 1987). As Lavoie (2014, p. 317) put it, ‘the choice is simply between working the number of hours
imposed by the institutional norm and turning down the employment.’ One crucial question is: What affects this
choice? Reservation wage considerations may suggest that the participation rate increases with the real wage,
causing the labor supply curve to be upward sloping instead of vertical as Equation 3 implies. Manifold heterodox con-
tributions on non-standard labor markets exist, some of which Lavoie (2014) discusses. Yet, they are not implemented in
post-Keynesian macro models, which tend to share the labor supply function in Equation 3.
8
Various other forms of consumption function can be found in the literature. Many of them exclude the wealth effect (Hein
2008, ch. 13.3; Hein and Stockhammer 2010). Godley and Cripps (1983) and Godley and Lavoie (2012) have criticized this
assumption from a behavioral perspective as it implies that saving households accumulate an infinite stock of wealth for a
given level of income since they save a positive amount every period. Other consumption specifications exclude the
wealth effect and add a constant that would be stock-flow consistent but prevents a steady state in a growth context
(Davidson 2011). Hence, stock-flow consistent variants typically assume a wealth effect on consumption.
10 C. SCHODER

Substituting into the definition of saving, Ḃj = Pdj − Cjr , the consumption rule in
Equation 8 can be expressed as a wealth accumulation rule that characterizes the supply
of new bank deposits:
 
cB
Ḃj = (1 − cP ) Pj −
d
Bj (9)
1 − cP
in equilibrium, where cB /1 − cP is the inverse of the target wealth–income ratio (
uj ) and
1 − cP is the propensity to save out of income, which measures the speed by which savings
adjust to the target. Hence, one could perceive the rentier’s consumption choice as being gov-
erned by a desired long-term wealth–income ratio (
uj ), as well as by the desired speed of
adjustment to the target that cP implies. Note that cB will then also be determined implicitly.
What determines the desired wealth–income ratio and the desired speed of adjustment?
Post-Keynesians assume these variables to be constant and calibrate them according to
empirical observations. One common justification for taking
uj and cP as exogenous par-
ameters is convention. The possibility of unforeseen events, such as a permanent income
loss or a medical emergency, inducing the reasonable household to accumulate a savings
buffer may motivate a non-zero target wealth–income ratio (Marglin 1984, p. 364). The
notion of a hierarchy of needs implies that households fill their consumption basket
first with goods they direly need (Maslow 1943; Lavoie 2014, p. 100). Increasing saving,
therefore, becomes increasingly painful in terms of well-being for a given income level.
In the case of just one homogeneous consumption good as assumed in our and indeed
most post-Keynesian models, a utility function with decreasing marginal returns would
represent these preferences. Hence, households prefer to smooth consumption over
time. For a given desired wealth–income ratio, a beneficial speed of adjustment yields a
high utility given the trade-off between reaching the desired wealth–income ratio
quickly and not cutting too deeply into basic needs through fast wealth accumulation.
Equation 8, equivalent to the labor supply choice in Equation 3, characterizes consumption
of a lethargic agent since the consumption rule does not adjust to possibly endogenous
changes in the economic environment. Yet Lavoie’s (2014, p. 100) rationales, which are
intended to justify a consumption function such as Equation 8 and are built around goal orien-
tation under lexicographic preferences, imply that the parameters are endogenous. Interpret-
ing a positive wealth–income ratio as a convention in a world of fundamental uncertainty and
the speed of adjustment as the attempt to reach the target in a timely manner without cutting
too much into current consumption implies that the parameters of the consumption function
depend on the real interest rate, which is roughly the nominal interest rate (assumed to be
zero) minus expected inflation. This is because the real interest rate affects wealth accumu-
lation (not necessarily only due to intertemporal substitution effects). Since the parameters
in Equation 8 are constant, the consumption function and its rationale are not consistent.

3.5 The firm’s control variables: price, investment, and financial structure
The firm k chooses its price (Pk ), investment (Ik ), and demand for new bank loans ,(Ḋk )
which determine its financial structure.9 Even though the same agent makes these
9
Note that labor demand is not a control variable since it is determined by the technology for a given level of economic
activity.
 REVIEW OF POLITICAL ECONOMY 11

decisions, post-Keynesians assume they are independent of each other. While it is plaus-
ible to assume an institutional separation of consumption choices and corporate decisions,
one might expect that price and investment decisions are coordinated.

3.5.1 Price setting

Firms are assumed to operate under oligopolistic competition, setting price so that unit
revenues exceed unit variable costs, which include only labor costs, by a factor (1 + m),
where the markup m is assumed to be constant (Kalecki 1971, pp. 44–45; Lavoie 1992,
p. 129). Hence, we have
Pk = (1 + m)wLk /Yk = (1 + m)w (10)
which also assumes labor productivity to be one. Because of the assumption of a homo-
geneous markup and wage rate, the price is the same for all firms. The markup implies
the real wage v = 1/1 + m. The core issue to address is what determines the markup
size. This question is not trivial. It is at the core of Kaleckian theory, as it determines
the income distribution between profits and wages. Given the crucial role pricing has
in determining income distribution in Kaleckian theory, it is striking that none of the
popular Kaleckian contributions attempt to model the pricing decision. Instead, a posi-
tive and often constant markup is usually motivated verbally by referring either to
Kalecki’s (1971, p. 168) degree of monopoly or to Kaldor’s (1985, pp. 50–51) profit–
growth trade-off.
According to Kalecki’s degree of monopoly, market concentration is the core determinant
of the markup. The higher the market concentration, the greater the market power of the
firm and the higher the markup can be set without losing market shares. While in the ortho-
dox literature the markup arises from monopolistic competition among profit-maximizing
firms, the Kaleckian firm’s primary concern is its market share.10 Market concentration is
not a variable in our model, even though it is used to justify model-relevant behavior.
Kaldor (1985, pp. 50–51) provided an alternative rationale, arguing that firms set the
markup within two extrema: on the one hand, the objective to grow requires high
markups that generate the high profits needed to finance investment; on the other
hand, the objective to expand market share requires low prices in order to acquire
higher sales. Thus, depending on the constraints given by finance frontiers and market
power, firms choose the optimal markup (Lavoie (2014, chs. 3.3–3.6). According to this
rationale, the markup should be highly endogenous, as prospective sales and finance fron-
tiers depend on current sales and the interest rate. Hence, the pricing rule should be
endogenous to changes in the environment. Yet Equation 10 is stated as a lethargic
rule. Moreover, market shares, market power, and finance frontiers are not part of the
model even though other model variables such as current sales and the interest rate can
be expected to affect these variables.
10
Another core determinant of Kalecki’’s degree of monopoly is the trade unions’ relative bargaining power (Rugitsky 2013).
Extensions of the baseline model use this as the rationale for an anti-cyclical markup (Sasaki 2013; Schoder 2014). As the
economy recovers and the labor market tightens, labor unions get stronger, the degree of monopoly and the markup
decrease, and the real wage increases. Hence, instead of affecting the formation of the nominal wage in Equation 10,
the rationale based on the degree of monopoly implies the trade unions’ relative power to affect the pricing behavior
of the firm for a given nominal wage. Hence, ‘power in the labor market is seen as of little use without some correspond-
ing power in the product market’ (Sawyer 1985, p. 113).
12 C. SCHODER

3.5.2 Investment
Before discussing post-Keynesian investment theory, let us summarize what our model
implies regarding capital. First, the investment decision is assumed to be independent
of the pricing decision. Hence, the firm takes expected sales (Yke ) as exogenous. Second,
the capital stock is predetermined or given in the current period. Through its investment
decision, the firm can affect the next period’s capital stock. Third, the capital stock is firm
specific; therefore, the firm, which is institutionally separated from the rentier household,
makes the investment decision. Fourth, for a given expected level of sales (Yke ), the pro-
duction function in Equation 1, combined with the assumption of Keynesian unemploy-
ment, implies that the expected rate of capacity utilization (uek ) and the level of capital (Kk )
are inversely related. In particular, an increase in demand will increase utilization in the
short run since the capital stock is predetermined. In the longer run, however, the firm
can choose the evolution of its capital stock in response to the evolution of expected
sales, implying a long-term utilization rate. What drives the investment decision?
As Lavoie (2014) argues, post-Keynesian firms care about their capacity utilization; they
want to keep uj low enough to avoid future sales that exceed production capacities. Produ-
cing at almost full capacity may cause the firm to lose market share to competitors and
potential market entrants in case of a positive demand shock (Steindl 1952). Why should
our firm care about losing market share? Lavoie (2014, ch. 3.3) suggests that firms seek
to increase market share in order to increase sales sustainably. If this was the firm’s objective
and if market share was primarily obtained from competitors not being able to accommo-
date their demand, then the lower the rate of capacity utilization, the better it would be for
the firm, given random shocks to demand. Since post-Keynesians also argue that the long-
term capacity utilization rate should not be too low, they implicitly assume the firm cares
about profitability also, which is consistent with the growth objective. Making the plausible
assumption that idle capacity is costly, a decreasing utilization rate raises unit costs and
reduces unit profits. Hence, many post-Keynesians argue that there is a desired rate of
capacity utilization that balances the trade-off between fast expansion and high profits.11
The desire to reach the target rate of capacity utilization (
u), which I assume to be the
same across firms, drives investment. So far, nothing in the model or its behavioral foun-
dation prevents the firm from choosing Ik such that the capital stock adjusts immediately
to its desired level, Kk = Yke /

ue , in order to obtain the desired and expected utilization
rate. Recall the assumption that any demand can be accommodated at any time. Hence,
we need an explanation for why the capital stock does not adjust immediately to the
desired level; that explanation is fundamental uncertainty. In the current baseline model,
firms are aware of their target utilization rate; but the expected utilization rate is fundamen-
tally uncertain. The main behavioral implication is the assumption that investment responds
to the gap between the current rate of capacity utilization and the target rate of capacity
utilization (uk − u
) but not necessarily such that this gap is closed. In particular, it is

11
In contrast, so-called fundamentalists in the post-Keynesian tradition argue that the investment decision in a world of
fundamental uncertainty is too complex to be explained by observable variables, or to be modeled (Shackle 1992,
p. 218). The average firm does not pursue a specific purpose significant and stable enough to explain its investment
behavior over time. In this view, firms do not even follow a lethargic rule. Investment is driven by animal spirits, ‘a spon-
taneous urge to action rather than inaction’ (Keynes 1936, p. 161). Imposing this view on our model implies Kk , and hence
uek , to evolve randomly for a given evolution of Yke . The individual firm as well as the overall economy will periodically hit
the full capacity constraint. Most post-Keynesians do not assume investment to be arbitrary.
 REVIEW OF POLITICAL ECONOMY 13

assumed that
Ik /Kk = ak + b(uk − u

) (11)
where ak = r + 1k includes animal spirits and b indicates how a currently observed utiliz-
ation gap translates into investment.12 1k is a random process and r is the secular growth
rate. As in the literature, I do not allow r or b to vary across firms.13
Equation 11 raises five issues. First, the prudence-induced transition from Kk = Yke /
ue
to Equation 11, as the rule determining investment behavior, does not follow from funda-
mental uncertainty or any of the rationales provided so far. If the target utilization rate is
met at a given (constant) level of expected sales, there is no need to adjust the capital stock
further. In this case the steady-state growth rate of the economy is zero and the model
breaks down.14 The additional behavioral assumption introduced with Equation 11 is
that firms believe the economy will grow at a constant secular rate even if the realized util-
ization rate corresponds to the target. The validity of the model requires assuming that
firms believe in a constant long-term growth rate, something explained neither by the
model nor with any simple rationale.
Second, even if firms expect a tendency for sales to grow by r . 0 for no endogenous
reason, further issues arise. With r . 0 firms will generally not meet their target utiliz-
ation rate. The investment expenses of the firms have a feedback effect on their sales in
the aggregate. Assuming that all agents are homogeneous, a common practice in the
post-Keynesian literature, there is a goods-market equilibrium rate of capacity utilization.
This equilibrium utilization rate (u∗ ) will be positive under some parameter conditions.
The representative firm consistently misses the target because it finds itself trapped in a
situation where its own investment, induced by the attempt to reduce the utilization
rate to the target, raises sales such that the utilization rate is at the same suboptimal
level as before.15
12
The investment function in Equation 11 is found in the literature (Hein et al. 2012). It is the one that is closest to the
rationales above. Any extension, such as including the profit rate (Taylor 1985), the profit share (Bhaduri and Marglin
1990) or the interest rate (Lavoie 1995a), needs an additional behavioral justification. Since the purpose of the
present model is to exemplify a more general critique, I stick to the simple investment function in Equation 11.
13
As in standard post-Keynesian models, investment is not assumed to be a nonergodic or exogenous process even though
it may be subject to large shocks. As in most empirical applications at the firm or aggregate level, animal spirits are boiled
down to some well-behaved random process and can be perceived as equivalent to random shocks to Tobin’s q in the
conventional investment theory (Schoder 2015).
14
In the absence of autonomous consumption or government spending, what is the income level consistent with zero invest-
ment? Since saving has to be zero in this case and given a positive saving propensity out of income, income will have to
be zero as well. Assume r = 0 and evaluate our model economy in equilibrium. As there is no investment, there is no
capital stock and, due to accounting, no household wealth. Then Equation 9 implies that the rentiers’ income has to be
zero in order for no saving to arise.
15
Many suggestions for dealing with this inconsistency have been advanced. Since all of them make the models and the
behavioral relations even more elaborate, the rationales are inconsistent with the model. For instance, Duménil and Lévy
(1995, 1999) suggest that a utilization rate exceeding some threshold will cause inflationary pressures and induce con-
tractionary monetary policy to cut into investment such that ṙ = f (uk −
u) with f (0) = 0 and f ′ , 0. Given the rationales
provided above for pricing and investment, it is not clear where these inflationary pressures come from and why invest-
ment should respond to changes in monetary policy. Skott (2012) argues that firms will try to accelerate investment when
they realize that their investment rule does not yield the desired utilization rate. This could be introduced in our model by
assuming that ṙ = f (uk −
u) with f (0) = 0 and f ′ . 0. This modification generates instability in the aggregate since the
investment rate has a positive own feedback through the impact on the aggregate utilization rate. To obtain global stab-
ility, additional negative feedback mechanisms of an expanding economy on investment behavior must be introduced,
for instance via rising employment or falling profit shares. This expansion of the model makes it even more difficult to
justify it using consistent rationales. Again, the core question is why investment should be driven by anything other than
the objective to get to the target utilization rate. Finally, Lavoie (1995b, 1996), Dutt (1997, 2009) and Schoder (2012)
argue that the target utilization rate adjusts to the equilibrium utilization rate through hysteresis,
˙uk = f (uk −
uk )
14 C. SCHODER

Third, Equation 11 is a lethargic rule; however, the rationale for investment, in particu-
lar for the target utilization rate, implies that the firm trades off between long-term growth
and short-term profitability. Since both growth and profitability are endogenous in the
model, the target utilization rate should also be endogenous.
Fourth, in light of the microstories told to justify the pricing and investment
decisions, their conceptual separation seems inconsistent. At the very least, it is
based on assumptions about the economic setting that are not made transparent. Con-
sider the following thought experiment illustrating the interrelation of pricing and
investment decisions. Suppose there is a shock to the degree of monopoly, which is
unrelated to competition, raising the markup and, hence, prices. This does not
affect the investment decision in the model. Yet, it should. At a given target utilization
rate, profitability will go up while the long-term growth prospects have not changed.
The firm will find it beneficial to lower the target-utilization rate. Finally, the assump-
tion that pricing is not used to deter market entry despite the importance of this strat-
egy for long-term growth seems rather strong. The behavioral separation of the
pricing and investment decisions of the firm is even more surprising in light of the
strong emphasis that post-Keynesians (Galbraith 1967; Eichner 1976) place on the
interaction of price and investment decisions in their institutional analysis of
modern corporations.
Fifth, the transition from choosing the capital stock Kk = Yke /
ue to choosing invest-
ment according to Equation 11 has crucial implications for the assumed form of expec-
tation formation, as a combination of the current utilization rate and the secular growth
rate replace the expected utilization rate. It is implicitly assumed that all information
regarding the formation of the expectations comes from the present (or from the past
in adaptive specifications of expectations) and are in this sense purely backward
looking. Model agents do not form beliefs about economic relationships that they
then use to make endogenous guesses about expected variables. Firms only change
their investment behavior in response to changes in realized utilization, assumed to
approximate expected utilization. Even if firms believe that their sales in the next
period will be higher, they will not adjust investment for a given current utilization
rate. This type of expectation conflicts with Keynes (1936, p. 152): ‘The essence of
this convention … lies in assuming that the existing state of affairs will continue indefi-
nitely, except in so far as we have specific reasons to expect a change.’ This is a clear
statement of forward-looking, but not necessarily rational, expectations. If there are
reasons to expect a change in the state of affairs, such as a tax cut, a fiscal expansion
or monetary policy intervention, this will affect current economic behavior. An econ-
omic model in this spirit should be able to characterize economic behavior
endogenously.16

with f (0) = 0 and f ′ . 0. This interpretation is inconsistent with the post-Keynesian justification of desired excess
capacity based on a growth–profit trade-off.
16
The empirical evidence is overwhelming that consumption is a choice that to a considerable extent takes into account
expectations regarding future income flows (Parker 1999; Souleles 2002; Johnson et al. 2006; Blundell et al. 2008; Shapiro
and Slemrod 2009; Jappelli and Pistaferri 2010). Whether income shocks are anticipated or not and whether they are
perceived as temporary or permanent affects their impact on consumption enormously. This is not to say that this evi-
dence supports the permanent income hypothesis—quite the contrary. Yet, it is sufficient to claim that the assumption of
backward-looking expectations prevalent in post-Keynesian models omits behavioral aspects that are crucial for the
evaluation of monetary and fiscal policy effects.
 REVIEW OF POLITICAL ECONOMY 15

3.5.3 Financial structure

Decisions about the demand for new bank loans (Ḋk ), the profit distribution policy (Pdk ),
and the financial structure (lk ; Dk /Kk ) are equivalent.17 Hein (2008, ch. 13.3) and Hein
and Stockhammer (2010) pin down the firm’s profit-distribution policy by assuming
Pdk = 0. Then the shortage of profits to finance investment,Ḋk = Ik − Pk , determines
the demand for loans. The debt–capital ratio (lk = Dk /Kk ) will be determined endogen-
ously. Rationales for this behavioral assumption can be found in Keynes (1936, p. 144),
Kalecki (1971, pp. 105–109), Minsky (1976), and Fazzari et al. (1988). They all argue
that internal finance is preferred over debt finance due to additional costs of the latter
arising from information asymmetries.
Under the postulated profit-distribution policy, investment determines the external
finance needed for a given amount of profit. If financial structure mattered to the firm,
as the rationale above implies, then consistency of the microstory requires that decisions
about profit-distribution policy and investment are treated as interdependent. This is not
the case under the behavioral relations Pdk = 0 and Equation 11.18
The same criticism holds if one chooses to replace Pdk = 0 with the assumption that the
firm distributes a fixed share (1 − g) of their profits, implying a demand for loans of the
firm Ḋk = Ik − gPk (Lavoie and Godley 2001; Sasaki and Fujita 2012). A preference for
internal over external funds and the shareholder value in corporate finance (Stockhammer
2005–06) justifies this assumption. According to this rationale, a rise in the relative power
of rentiers vis-à-vis firms puts upward pressure on distributed profits. Hence, the greater
the rentiers’ influence, the higher Pdk and lk for given investment expenses. Therefore, g
may be interpreted as a compromise between reducing the cost of finance and increasing
the distributed profits. Again, investment affects the need for external finance but its
rationale does not reflect that. Moreover, the shareholder value rationale should have
implications not only for the profit-distribution policy but also for investment and
pricing decisions, things ignored in the behavioral equations above.

3.6 Aggregation
We also need to address the question of aggregation and expectation formation. Similar
to new-Keynesian Dynamic Stochastic General Equilibrium models, post-Keynesian
models typically make strong assumptions regarding agent homogeneity and
expectations.
Behavioral relations have to be aggregated. Each laborer, rentier, and firm behaves
in exactly the same way once we assume that the shocks of the animal spirits in
Equation 11, 1k , are equal across all firms, k. Our agents become representative;
average individual behavior is equal to the average aggregate behavior. Note the signifi-
cance of the assumption of homogeneous, representative agents in the post-Keynesian
framework. The common practice of post-Keynesian models to postulate a behavioral
17
Investment will be financed by retained earnings and new bank loans, Ik = Prk + Ḋk , where Prk ; Pk − Pdk denotes
retained earnings, with Pk being total profits. For given Pk and Ik , the profit distribution decision Pdk implies the
demand for new bank loans Ḋk and vice versa since Ḋk = Ik − (Pk − Pdk ).
18
Sasaki and Fujita (2012) criticize the assumption of zero distributed profits as implausible. The suggested retention policy
requires the interest rate to be positive since there would be no rentier income otherwise and, hence, no household
saving. Then Pk = Ik and no bond market would exist. The saving decision would be identical to the investment
decision.
16 C. SCHODER

relation on the macro level, and provide a verbal foundation of the hypothesis put
forward on the micro level, builds on the assumption that agents are homogeneous
in behavior.19 Thus, the popular view, expressed by Shaikh (2016, ch. 3), that orthodox
and heterodox economics differ along the lines of agent heterogeneity, does not hold in
general.

4. Concluding remarks
This article critically reviews the post-Keynesian approach to microfoundations—the con-
vention of putting behavioral relations on more or less verbal foundations. It focused on a
widely accepted neo-Kaleckian model with a small number of simple behavioral relations.
This makes it easy to provide consistent rationales. However, the article argues that the
rationale approach to microfoundation invites inconsistencies and nontransparencies
along many dimensions.
In one influential rationale of the labor supply, laborers seek to maintain a desired con-
sumption level that is affected by the consumption of a reference group and choose their
labor supply at a given real wage. According to this rationale, the labor supply should
depend on rentier consumption; however, it is assumed to be constant.
The rationale for relating consumption to income and wealth builds on fundamental
uncertainty and a hierarchy of needs. Yet interpreting a positive wealth–income ratio as
a convention, and the speed of adjustment attempting to approach the target, implies
that the parameters of the consumption function are endogenous.
Rationales for a positive markup build on Kalecki’s (1971, p. 168) degree of monopoly
or Kaldor’s (1985, pp. 50–51) profit–growth trade-off. These rationales refer to concepts
such as market share, market power, and finance frontiers that are not part of the post-
Keynesian macro model. If they were included in extensions of the baseline model, the
markup would need to be endogenous. However, the pricing rule follows lethargic behav-
ior in the sense that there is no feedback from the economy to the behavioral assumption.
For investment, firms seek a utilization rate that trades off growth and the cost of idle
capacity for given sales expectations. Fundamental uncertainty is then used to explain why
the capital stock does not adjust immediately to its desired level for given sales expec-
tations. This article identified five problems with this rationale for the neo-Kaleckian
investment relation.
Regarding the financial structure, post-Keynesians assume that firms prefer internal
funds over external funds. Since financial structure matters to the firm, and investment
affects the need for external funds, profit-distribution policy and investment decisions
should be treated as interdependent; yet this is not the case.
To overcome these shortcomings, the microstructure of post-Keynesian models should
be made transparent and consistent. Lavoie (1992, 2014) could be a starting point here. It
might be useful to distinguish two types of choice associated with nonlethargic, goal-
oriented or feedback-sensitive behavior—passive choice and active choice.
The concept of passive choice stresses the evolutionary character of behavioral rules.
Agents move through time with a trembling hand of choice and stay with the rule that
19
For the Kaleckian pricing theory, Steedman (1992) shows that aggregation requires the assumption of vertically inte-
grated industries, which effectively eliminates firm heterogeneity.
 REVIEW OF POLITICAL ECONOMY 17

yields the highest payoff locally. They do not optimize since they do not know the return
function globally and do not necessarily know the payoff of their choices a priori. This
evolutionary microfoundation does not require forward-looking behavior, but allows
for it. Active choice requires assuming that agents knows the full payoff function a
priori. Then purposeful behavior will induce the agent to maximize the payoff function.
This may be done period-by-period or intertemporally. Active choice is consistent with
a weak interpretation of fundamental uncertainty that excludes rational expectations but
allows for finding the optimal rule of behavior a priori by solving an optimization
problem for given expectations.
Moving away from backward-looking expectations without falling into the trap of
rational expectations or rational learning is another challenge. According to Branch
(2006), one way to move beyond rational expectations is to assume that our perception
of how the economy evolves over time is mis-specified and agents are unable to detect
this. Hommes and Zhu (2014) introduce a behavioral learning equilibrium. Agents are
assumed to follow a simple mis-specified forecasting model such as a first-order univariate
or multivariate auto-regressive process whose parameters are learned adaptively over time
using collected data.

Disclosure statement
No potential conflict of interest was reported by the author.

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