Deze samenvatting is gebaseerd op het studiejaar 2013-2014.

Chapter 1: Why should we study contemporary economics?

Many researchers tried to define economics. Possibly, the English economist Lionel Robbins proposed the most famous example of such a definition. According to Robbins, economics was the study of human behaviour as a relationship between given ends and scarce means that have alternative uses. Sixty year earlier Alfred Marshall had written that economics was the study of men “in the ordinary business of life”. Both these definitions are very abstract and obscure. A more informative definition would be that economics is the study of the functioning of economic life in society, while adding some illustrations of central issues that economists are concerned with.

The term economics has been used in English as a name for the subject since the 1890s. Before then, the name commonly used for it was political economy. This name reflected the relation between the study of economics and the political life and institutions of society.

It is undeniable that economics has many of the features of a cumulative science. We can think of some reasons why we should get to know the history of economics.

1. It is fun. The opinions of dead men may be fascinating to study even if one believes them to be wrong;

2. Some knowledge of the history of thought should form part of the liberal education of an economist;

3. If you know something about the history of economics this will contribute to a better understanding of the fact that the discipline of economics is in a permanent process of change and development, thereby leading to a better understanding of the nature of economic research.

There are many ways in which we could present the history of economic thought. We could analyse the changing nature of economic theory in conjunction with the social and economic development of society. But, on the other hand, we could emphasize economic thinking as part of the main currents of philosophical and political ideas. Another alternative is to emphasize the internal dynamics of the science where new insights and results emerge as a consequence of the economist’s awareness of the shortcomings of the present state of the subject. In the past people commonly judged the thought of previous generations if economists from what one considered to be their own preconditions without relating them to modern theory. This approach can easily lead to relativism: all theories become correct and valuable relative to the context in which the authors worked and lived. This approach could come to imply a complete denial of the cumulative nature of economics, and, consequently, of the possibility of progress in economics.

An economic theory is a set of hypotheses about the functioning of parts or the whole of the economic system. It may concern a limited set of questions or it may be a more comprehensive analysis. Theoretical research aims to improve current theories in terms of generality and logical standards. Furthermore, it wans to develop new theories that either concern novel aspects of economic life or types of economic activity that have so far escaped the attention of theorists. The history of economic thought has traditionally been a history of economic theories. From one point of view, the history of economic thought is a field of specialization within economics in the same way as are international economics, public finance, or labour economics.

Chapter 2: What about economics before Adam Smith?

Ancient times

Some elementary economic theories have been known and generally accepted for centuries, and we can find expressions of them in some of the oldest written sources that we possess, for example in the bible.

The Scholastics

The group of thinkers known as the scholastics, or schoolmen, were mostly priests and teachers at medieval universities from the thirteenth century onward. Their approach to the study of the market economy was from the beginning an ethical one. Among other things, the task of the scholastics was to provide guidance regarding the determination of the just price. You should keep in mind that at that time, many transactions took place between individual sellers and buyers who operated in relative isolation from other economic agents. Under these conditions it was possible for one of the parties to a transaction to exploit the other through a stringer bargaining position or better information. The scholastics found it necessary to acquire empirical knowledge of how transaction actually occurred and how the markets functioned. Their studies in this area led them to the view that the just price was ‘the natural price’. Possibly the most important contribution of the scholastics is the idea that economic life obeys certain laws that can be studied by scientific methods.

Mercantilism

Mercantilism was a political ideology rather tan a theoretical system, and the term may easily give a misleading impression of general agreement among a large group of writers on economics who in many respects had relatively little in common. Nevertheless, they shared some fundamental convictions that justify the common view of them as a particular school of thought. Above all, mercantilism was a set of economic policy prescriptions for rulers whose aim was to promote their country’s interests, its wealth, and power relative to other nations. The time had not yet come when interest of the country were to be identified with those of the people or the general public. The production of all goods ought primarily to take place, when at all possible, in the country itself. This was a crucial element of mercantilist thinking. The ideology of mercantilism was not erected on a unified theoretical basis. One can identify a variety of views about the functioning of the economic system.

Richard Cantillon

Cantillon wrote Essai sur la nature du commerce en général (1755), which contains several important contributions to economic theory.

• He develops a theory about the determination of relative prices

• He tries to explain the distribution of income for which he developed a theoretical framework for analysis of the economic circulation in the economy. In this framework the economy’s aggregate demand is always equal to the sum of incomes.

Many historians have emphasized that Cantillon can be said to have been the first to formulate a general equilibrium model of the economy. In modern technology we might say that he had developed an early version of an input-output model.

He distinguished between short- and long-term effects of changes in the stock of money, and he studied the relationship between the domestic money market, the balance of payments, and the rates of exchange. Cantillon’s general attitude to economic issues was mercantilist: a successful economic policy was one that led to a large domestic stock of silver and gold.

David Hume (1711-1776)

His most important works are A Treatise of Human Nature (1741-42) and Political Discourses (1752). Hume was the first to provide a clear and simple answer to the question “what is the effect of changes in the stock of money on the real economy?”, which he answered with “None!”. Prices, including the prices of the factors of production, such as wages, will be proportional to the stock of money: the larger the quantity of money in relation to the volume of transactions, the higher prices will be. In the short run the relationship between prices and the quantity of money is more complex, since it takes time before all prices fully adjust to a change in the stock of money.

Francois Quesnay (1694-1774) & The Physiocrats

Quesnay’s first contribution to the literature of economics appeared in the form of an article in Diderot’s famous Encyclopédie (1756). His later fame rests entirely on his Tableau Economique (1759), a sort of tabular construction showing the flows of commodities and incomes in the economy. It is related to the earlier model of Cantillon, but it is more detailed, and Quesnay also made an attempt to estimate the coefficients in the model on basis of empirical knowledge of the French economy. With a little good we may thus regard Quesnay as a forerunner both of modern national accounting and input-output analysis and as an early econometrician. According to Quesnay, agriculture was the main foundation of economic wealth. Consequently, a policy that was good for agriculture was good for France. He also said that the best economic system that the government could promote was free competition and free trade – ‘laissez faire, laisser passer’. He became the centre of an enthusiastic group of followers: The Physiocrats – a ‘school’ of economic thought.

Anne Robert Jacques Turgot (1727-1781)

Turgot is usually considered to have been a member of the Physiocratic ‘school’, and at any rate he was in deep sympathy with the liberal economic attitudes of the Physiocrats. His ideas about economic reform, which went in the direction of deregulation and liberalisation of economic life, did not achieve sufficient political acceptance. His Réflexions sur la formation et la distribution des richesses (1766) is said to have originated as a sort of roadmap for two Chinese students, Ko and Yong, who had come to France to study its economy and society. In parts it builds on Physiocratic ideas, but it also contains parts that are truly original. These original elements concern the analysis of investment and production, where Turgot moved beyond the basically static analysis in the work of Quesnay and the Physiocrats. In the Tableau it had been assumed that input capital per unit of land was constant. Turgot assumed that it was variable. On the question “what is the optimal use of capital in agriculture?” Turgot argues that the greatest surplus is attained when the value of production minus the interest on capital is as large as possible. This means that the use of capital should be increased as long as the marginal productivity is greater than the rate of interest.

Chapter 3: Adam Smith and his Wealth of Nations.

Adam Smith’s first book, for which for a long time he was chiefly known, was the philosophical treatise The theory of Moral Sentiments (1759), in which he discusses the foundations of man’s moral attitudes. Later writers have tended to see a contradiction between his first work and the later work The Wealth of Nations. The first book advanced view of man as a basically moral and altruistic being, while the second emphasizes self-interest as the driving force behind human action. But there is little reason to believe that Smith changes his views on moral and social questions.

1. It is possible both to hold the view that man is a moral being and that in many areas of his life he is motivated by the pursuit of self-interest;

2. Smith was apparently unaware of any such contradiction, because he published two new editions of The theory of Moral Sentiments after The Wealth of Nations had come out.

A central concern for Adam Smith in An inquiry into the Nature and Causes of the Wealth of Nations is to argue against the mercantilist view of economic policy and in favour of free trade and free markets. The book is divided into five ‘books’.

Adam Smith’s price theory

A problematic distinction that Smith introduced at an early stage of his theoretical discussion (book I, Chapter IV) was between value in use and value in exchange. Water is more useful than diamonds, but diamonds are more expensive; the exchange value of water, which is low compared to diamonds, does not reflect its high value I use. This alleged paradox he did not manage to solve, but he stated that his analysis would be limited to the study of exchange value.

The core element in the theory of price held by the classical economists (economists from Adam Smith to John Stuart Mill) is known as the labour theory of value: the relative prices of commodities are determined by the relative amounts of labour needed to produce them. In a relatively simple society the value of produce is distributed among the three components of cost, namely labour capital, and land. This perspective extends the theory of price formation from the simple labour theory of value to a more general cost-of-production theory. According to Smith, in any society wages, profits, and rent all tend toward their respective normal levels, and these normal levels are what determine the natural price – in later chapters of his book he discusses more in detail the normal levels of the cost components. In his theory Smith uses the normal level of cost as a causal explanation of price. Smith did not have what we now refer to as a general equilibrium perspective on price determination. In that perspective it makes no sense to say that product prices are determined by factor prices; instead, product and factor prices are mutually dependent on each other.

In the introductory chapter of The Wealth of Nations we find a famous analysis of the division of labour in society. The starting point for the discussion is the example of the pin factory: when the production of pins has been broken down into ‘about eighteen’ separate operations, with each worker specializing in just one or a few of them, then the pin factory can produce much more pins in a day than that could be produced by a single worker without specialization and division of labour. This implies that the unit cost of production is not only determined by technological relationship.

• It obviously depends on the organization of labour, which depends on technological possibilities

• It depends on the size of the market, in other words it depends on the demand; commodity prices are not only technologically determined but also depend on factors on the demand side of the market

The further society has advanced with respect to the division of labour, the lower prices will be. This is especially true for manufacturing goods.

Smith makes a distinction between the market price and the natural price (book I, chapter VII). The natural price corresponds to the normal level of the three components of cost (wages, profits, and rent). The market price is the actual price that prevails in the market at a given moment of time, and this can differ from the natural price both in the upward and downward direction. The market price is determined by the relationship between the quantity that is actually brought to the market and by the demand of those are willing to pay the normal price. This is called the effectual demand. When the supply is greater than the effectual demand, the market price will fall to some level below the natural price. Although, the natural price is the central level toward which the market price will continually gravitate. According to Smith, price fluctuations will be greater in the markets for agricultural commodities than in manufactured goods markets. The reason for this is that the variations in output, and thereby in the supply of goods on the market, are larger in agriculture, which is subject to frequent changes in production conditions through variations in the weather.

The returns to the factors of production

The natural or long-run prices of commodities are those that correspond to the natural or long-run level of the prices or returns to the three factors of production – labour, capital, and land. We could ask what are the long determinants of the prices of the factors of production?

The level of wages will be determined by the employment contracts. Workers and employers have conflicting interests: workers desire high wages, whereas employers want them to be as low as possible. In the contract negotiations the employers tend to have more bargaining power:

• There are fewer employers than workers, so that it is easier for employers to agree between themselves to keep wages low than it is for workers to combine to push wages up. In that time wage unions did not exist and were even forbidden, while there were no laws that prevented employers to cooperate;

• Another argument Smith uses is that when a conflict arises, the employers can hold out much longer than the workers.

However, wages are not only determined by the bargaining power of the two parties:

• The wage must be high enough for the worker to survive on it;

• The wage must be high enough for the worker to raise a family

In a later chapter Smith points out that the treatment of labour and wages as homogeneous is a reality simplification. In reality, wages will reflect the particular circumstances pertaining to different professions. Also, Smith mentions several causes of wage inequality, of which one is the ease or hardship of employment. Furthermore, he argues that wages will vary with how difficult and expensive it is to learn the profession, with the constancy or inconstancy of employment, and with the amount of trust placed in the worker. Finally, he states that the probability of succeeding in one’s profession is another cause of wage inequality. Adam Smith’s general theory of the wage structure is that the wages in different professions reflect noneconomic advantages and disadvantages. We call this theory the theory of compensating wage differentials.

The rewards for the use of capital are also variable. However, the variation will be much smaller than in the case of wages. The most important determinant of the variation in the rate of return on capital is the difference in risk. An investment in capital abroad is much more riskier, and, consequently, the expected return on foreign investment must be higher. Part of the return must also be seen as compensation to the owner for the work he has with the management and supervision of his business. This compensation must be higher for a merchant who serves a small market than for one who operates on a larger scale.

A third component of the natural price of a commodity is rent, which is discussed in book I, chapter XI. Rent determines prices in a way that is fundamentally different from wages and the return on capital (profit). Smith states that high profits and wages are causes of high commodity prices, whereas high rents are effects of high prices.

The concept of the invisible hand

The idea of the invisible hand is only mentioned once in The Wealth of Nations, which is a book of nine hundred pages. It is mentioned in book IV, chapter II. A popular summary interpretation of this statement is what is best for the individual is also best for society, and that the invisible hand ensures this is the system of free competition. One can argue of this is a ‘correct’ interpretation. It is not always the worse for society that the individual pursues his self-interest, but when he does so, it happens frequently that he also acts in the interest of society. There is an admission that the individual and social interest may be in conflict.

A couple of pages before the passage of the invisible hand Smith has a different formulation of the same line of thought – without the use of the famous metaphor. Then, he speaks of own advantage. The first aspect of his own advantage is that a man of business has less control over the use of his resources if he is not present where the production activity takes place. Thus, he will prefer investing at home above abroad even if the foreign rate of return on capital were higher. Given the difference between the required rate of profit abroad and at home, the second aspect of own advantage is that capital will be invested in such a manner that its total rate of return will be as large as possible. It is self-interest that constitutes the invisible hand, and the invisible hand works in two ways that are both beneficial to society. One achieves a right balance between domestic and foreign investment, and the composition of domestic investment is such that it yields the greatest possible return on the nation’s capital.

The invisible hand in relation to the market economy

Producers think primarily of their own interest and not of the welfare of their customers, but it is their self-interest that provides us with the goods and services that we demand. A much cited formulation on this is: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest” (Smith, 1776 (ed. 1976), p.27).

Perfect or free competition?

Smith’s book does not contain any systematic discussion of alternative concepts of competition. Modern references to the invisible hand tend to relate Smith’s insights to modern theories of the connection between economic efficiency and market equilibrium under perfect competition. When one reads Smith’s The Wealth of Nations, it becomes clear that competition first and foremost implies the absence of monopoly, and that it is this which ensures that prices tend towards there natural levels. The reason is that a price that lies above this level will lead to the entry of new firms and a downward pressure on the price. We could also argue this the other way around. The degree of competition increases with the number of sellers.

It has been a common view that Smith was an extreme market liberalist who believed that it was in the interest of society to leave everything to the free play of the market forces. This opinion is wrong. The economic framework of free competition experiences always the threat to be destroyed by the market actors themselves. This demonstrates that the self-interest of economic agents induces them to prevent the invisible hand to work for the interest of society.

The interest of the public

Smith states that the individual acts in the interest of society, but he does not actually define what that interest is. We could say that it is the same as the annual revenue of society. Smith’s line of thought mat have been that the maximization of the national income would provide the population as a whole with the largest possible amount of resources for consumption, and that this was as far as one could go in terms of normative statements without invoking ethical judgements. We do not know for sure if the annual revenue of society, which Smith speaks of, is equal to national income, or that it is to be understood as something wider than just national income, at least in its modern sense, such as social welfare.

According to modern economics the strength of the market mechanism is that under suitable condition it leads to an efficient use of society’s resources. On the other hand, it is not likely to believe the resulting distribution of income and resources between individuals ensures economic justice. Most probably, Adam Smith saw this in the same way. Smith was aware of the fact that the market could generate inequalities that were unacceptable from an economic justice point of view. A concern for fairness might motivate public intervention in markets. Competition was good for economic efficiency, but the market alone could not achieve a just distribution of resources.

International trade

Smith’s view on international trade is an important aspect of the system of free markets, but the argument in favour of free trade acquires a special significance in The Wealth of Nations, since it is sharp criticism of mercantilism. Smith points out that mercantilist trade policies prevent the market system from functioning efficiently. In the case of restrictions on imports, by imposing a high tariff, the government frequently creates a monopoly for domestic producers. This will be to the advantage of the domestic producers but not to the country as a whole.

The state and the market

Smith was advocate of the view that the public sector should be as small as possible. A minimal, or ‘night watch state’ would be the universally best system for the allocation of resources. The state has three functions:

1. It is the state’s main task to protect society against violence and invasion from other societies.

2. The state ought to protect each single member of society against injustice and oppression from other members of it.

3. Erecting and maintaining certain public works and institutions, which can never be for the interest of any individual, or small number of individuals, to erect and maintain.

Adam Smith supplies arguments why the state should refrain from interfering with free competition. He also puts forward the positive case for the state as an important sector in an otherwise market-dominated economy.

Economic growth

The analysis of economic benefits of a system of free competition and free international trade and of a well-functioning public sector can be read as analyses of an economic system that provides a framework for economic growth. The invisible hand of the market directs resources to the areas where they yield the highest return. At any time, ‘the system of perfect liberty’ will ensure the best possible use of resources.

What are the factors that cause the amount of productive resources to increase? That question answers Smith in book II, chapter III. There, he emphasizes the role of population. Population growth is of great importance for economic development because it implies both more workers and larger markets. The more workers increase the productive capacity of the economy. The larger markets and more workers will lead to more possibilities for the division of labour. The link between population, market size and work specialization is an important explanation of the growth of productivity. Further, the individual saving will lead to an increase of capital in the economy, and together with the growth of population the accumulation of capital implies more division of labour, improved productivity, and increasing prosperity. In his view, capital accumulation was a central source of growth in the wealth of nations.

Chapter 4: The classical school: Malthus and Ricardo

While Adam Smith is the first of the leading classical economist, it has been common to see John Stuart Mill as the last. For those classical economist based in London or its vicinity, their common meeting place was the Political Economy Club, founded in 1821. Thomas Robert Malthus and David Ricardo are two of the greatest names in the classical school, and they were the dominating characters in the community of economists at the beginning of the nineteenth century.

Thomas Robert Malthus (1766-1834), the theory op population

Malthus was best known for his theory on population growth, which was first presented in his book An essay on the principle of population (1798). It was an important source for Charles Darwin’s theory of evolution, and it had influence on the thinking of several generation regarding the population problem and related issues, particularly poverty and birth control. It came out six editions during Malthus’ lifetime. The most substantial revision occurred with the publication of the second edition. Therefore, the first edition is often referred to as the First Essay while second and later editions are known as the Second Essay. He partly wrote the book in response to William Godwin’s book Enquiry concerning Political Justice (1793) which had a utopian vision of the future. He claimed that in the human society of the future, war and crime would cease to exist, and, therefore, there would be no need for law enforcement. Disease, anguish, melancholy, and resentment would vanish, and each person would strive to promote the common good. The father of T. Robert Malthus was enthusiastic about Godwin’s book, while the son was unable to share this optimism. His main idea was that the tension between the population growth and the food production would set strict limits to how far human progress could be carried.

The first edition of Malthus’ Essay begins with two basic postulates:

1. Man cannot live without food;

2. The passion between sexes is necessary and will remain nearly in its present state.

Godwin made the assumption that the ‘passion between sexes’ would decline with increasing wealth. Malthus did not share this belief. According to Malthus, a population which is not faced with any constraints on the availability of resources will have a tendency to grow as a geometric series of the form 1, 2, 4, 8, 16, … The theoretical foundation for the assumption of geometric growth can be derived from biology. He also provides empirical justification of the hypothesis by citing the development in the United States where in fact it had turned out that population had doubled every twenty-five years. The production of food only grows as an arithmetic series, that is, in the form of 1, 2, 3, 4, 5, … In the theory of Malthus, an independent development of population and food production is impossible. The numbers 1, 2, 3, 4, 5, … must be considered as describing the development of production over time with a growing population. In a modern formulation the food production hypothesis may be interpreted as an assumption that there are decreasing returns to scale in agriculture.

The core of Malthus’s theory is that there exists a permanent tension between the availability of food and the size of the population. The natural growth rate of population must necessarily kept down to that of the lower rate of growth of food supply. The mechanisms that hold down the rate of population so as to keep it aligned with development of foods production were called positive and preventive checks, which Malthus also divided into ‘misery and vice’. Famine was the example of misery while birth control was the primary example of sin. In the long run, per capita food supply would be constant. The mechanisms would ensure this were on the one hand decreasing returns in agriculture, and, on the other hand, an indefinitely elastic supply of labour at the subsistence wage – which was defined as the level of income that was just sufficient for the reproduction of the working class. If wages were higher than the subsistence wage the number of children and thereby the population size would increase which would put downward pressure on wages, moving them back to the subsistence wage.

In the second and later editions Malthus admitted there were other checks on population than misery and vice. He introduced the self-control – ‘moral restraint’ – as a further cause of reduced population growth. The best form of assistance to the poor, according to Malthus, was a social and economic policy that stimulated people to have fewer children.

Economic Policy

Another area where Malthus’s participation was the debate about free trade. The issue arose particularly in connection with the so-called Corn Laws, which were a central theme in the economic policy debates in England in the early nineteenth centuries. The primary purpose of the Corn Laws was to protect British agriculture by allowing for prohibition on imports when the price of wheat fell below a certain level. Consequently, that level became the minimum price of wheat. Malthus was against the abolishment of the Corn Laws, which was against the principle of free trade. The Laws could be justified by the concern for national security, for it was important that Britain was self-sufficient with corn in the case of war.

Malthus was also a general economist with broad interest: his other main work was Principle of Political Economy Considered with a View to their Practical Application (1820). In this book, his belief was that aggregate demand could become too low to secure full employment. It was based on the assumption about population and wages: wages would tend toward the minimum subsistence level. Aggregate demand in society could tend to be too low to absorb the aggregate supply, and a natural consequence for this would be unemployment.

David Ricardo (1772 – 1823)

Ricardo’s career as a writer on economics began with the publication of the pamphlet The High Price of Bullion, a Proof of the Depreciation of Bank Notes (1810). Its argument was that the high price of gold was caused by a pronounced increase in the circulation of bank notes, thereby establishing Ricardo as an early spokesman for the quantity theory of money. The pamphlet established Ricardo as an authority on financial and monetary questions. Gradually, he became on of the central participants in the Political Economy Club. He wrote The principles of Political Economy and Taxation in 1817. Many writers have maintained that Ricardo’s most important contribution to the development of economics lies in his establishment of a certain style of theoretical research that had a strong influence on his successors. Unlike Smith, Ricardo reasons more in theoretical models. Ricardo’s principles can roughly divided into three parts. The first part discusses the foundations of the theories of price formation and income distribution. The second part is concerned with issues of taxation theory and policy, while the third part is a collection of chapters on selected topics that are only loosely interconnected.

Distribution & Price Theory

Like Adam Smith before him, Ricardo thought of labour, capital, and land as the three basic factors of production. But his theory of relative prices took the form of a clearly formulated labour theory of value similar to what we find in Smith’s work. In Ricardo's opinion, Smith had not clarified how there can be three factors of production and yet be the case that only the use of one of them explains relative prices. The theory chapters of the Principles can be read as an attempt to explain how these propositions fit together. Ricardo first confronts the view that a commodity production needs more inputs of factors of production than just labour; therefore, it cannot be the case that the use of labour alone determines value. The use of capital can be recalculated in terms of labour, so that the relative labour contents of commodities also takes into account al indirect use via the input of capital goods. When extended along these lines, the use of material factors of production does not create any problems for the labour theory of value; capital can be dissolved into units of labour.

Another theoretical approach to the analysis of capital, which represents one of his most important theoretical innovations, is that the process of production requires different amounts of time in different industries. The capital – of which Ricardo mainly thought as prepaid wages – will be ted up in the production process for unequal lengths of time, and the interest cost that this involves must be reflected in prices. If the direct wage costs are the same in these industries, the implication is that capital-intensive goods become relatively more expensive than would follow from the simple version of the theory.

Ricardo emphasizes that the value or price theory is a theory of relative prices. He also discusses the question of whether the theory can say anything about absolute prices. His criterion for a constant measure of value is that there must be a commodity whose labour content is constant, since such a commodity would be ideal for expressing all other prices. But such a commodity, he concludes, does not exist.

Theory of Rent

Ricardo developed a theory of rent: a farmer who rents his farmland from a landowner will have to pay him a periodic sum for the use of land. Land varies in terms of quality and productivity. As population increases, and, consequently, consumption of food increases, farmers will use land of decreasing quality. The land that ahs the poorest quality, cost of production (in terms of labour and capital) will be equal to sales revenue, and therefore rent will be equal to zero. Rent will increase with the quality of land. Rent is not an element of the cost of production; therefore, causation goes from the price of corn (food) to the rent of land, not the other way around. The price of corn most be determined by the cost of production on the farm with the highest cost, that is, by the farm ‘on the margin of cultivation’. Ricardo did not analyse the cost conditions on individual farms; it is for agriculture as a whole that competition leads to equality between price and cost on the marginal land.

Long-run Development & Stationary State

When population and workforce increase, the demand for agricultural goods (corn) increases too. For this demand to be satisfied, less-productive land must be brought into cultivation. This leads to an increase of rent on the more productive land and a larger share of rent in national income. With a decreasing rate of profit, the incentive to invest will weaken and gradually fall to the level where further accumulation of capital comes to halt. Then, real growth of the economy comes to an end and we arrive at the stationary state. This is not an inevitable process, because technical progress might slow the process. However, scientific and technical innovation could only slow down the process toward a stationary state; it cannot lead to any fundamental change in it. Another factor, which can delay the process, is the abolition of restrictions on food imports and adoptions of a regime of free trade.

International Trade Theory

The most important contribution that Ricardo made was that about free trade: the comparative advantage. Foreign trade does make a contribution to output or the amount of value, but its contribution is more individual; it encourage specialization and the international division of labour and this leads to a more efficient use of resources in every single country. The factors of production are assumed to be immobile between countries while finished goods are assumed to be perfectly mobile. This assumptions are used to demonstrate the benefits of international specialization: when each country specializes in production and exports part of its output, all countries can exploit their productive advantage in the international exchange of commodities.

Taxation theory & On Machinery

Further, a large part of Ricardo’s Principles is concerned with taxation. A he discusses the most important types of taxes, but his main interest is the incidence of taxes. Besides, at the appearance of the third edition of the book in 1821 Ricardo had written an entirely new chapter with the title On Machinery. In this chapter he discusses whether the industrial revolution and the introduction of modern technology (‘machinery’) was a development that benefitted all classes of society, paying special attention to the working class. His original conviction had been that since the introduction of machinery it became possible to produce at lower cost and sell at lower prices, resulting in larger volume of production and greater availability of goods for all classes of society. In his new chapter het argues that this old line of reasoning is not entirely correct. His new insight is that the demand for labour will fall because employers will substitute machinery for human labour. In his old story his line of reasoning had been that the labour was replaced by machinery in some industries, but that would have been absorbed by other industries. Thus, his old line of reasoning was that the demand for labour would be constant. According to Ricardo, new technology does not be against the interest of the working class, it could in fact come to their benefit, but this could only happen if the increased income of the landowners and capitalists were so substantial that their increased demand for consumption goods succeeded in creating new employment for the workers that had been laid off earlier.

Chapter 5: John Stuart Mill

John Stuart Mill (1806-1873) was an influential theoretical economist. His work can be seen as the definitive statement of the classical tradition from Smith and Ricardo, but in some respects it also foreshadows the great change in economic theory that were to occur in the two decades after his death. His main work is Principles of Political Economy (1848) which came out in seven editions during his lifetime.

Questions of Method

Auguste Comte (1789-1857) had important influence on Mill’s thinking. Comte argues that all social phenomena must be studies in a broad context, and that all social sciences, including economics and history, ought to be unified in a single science of man, which he called ‘sociology’. Mill was in some sympathy with Comte’s views, but in his opinion economic and social phenomena were so complex, that they could not be understood without a theoretical approach that made it possible to understand the interplay between them and to identify causes and effects. But, one ought to keep in mind that in many cases economic problems had to be considered in a broader context of social science.

Price Theory

Smith and Ricardo pay much more attention to the supply side than the demand side. They made frequent references to demand, but mostly as a phenomenon that is determined by factors for which their theory does not offer any real explanation. Mill realized this was an important unsolved problem in economic theory. He wrote a paper on it and for the first time in literature, we encounter the idea of demand and supply as functions of price, and market equilibrium as a situation where prices had adjusted to a level where there is equality between them. We can even see beginnings of general economic equilibrium; since he realizes that in each country there is a connection between demand and supply in international trade. Mill has made three important contributions to the theory of value / price theory.

1. He solves Ricardo's unsettled problem of price formation in international trade by bringing demand conditions into the analysis. He realizes that (relative) prices adjust to the level where the value of export is equal to import. The solution takes a form of a theoretical model that gives a logically consistent framework for the analysis of price formation.

2. His insists that the solution to the problem of international price formation is a special case of a more general theory, namely, that the price of a commodity tends to adjust to the level where supply equals demand.

3. This third contribution has to do with the concept of ‘reciprocal demand, which shows that Mill had a perspective on price formation that went beyond the case of equality between supply and demand for a single commodity. ‘Reciprocal demand’ remains a theoretical concept in the international trade theory and is now associated with the geometrical construction we call ‘offer curves’, invented by Alfred Marshall several decades later.

Mill did not draw any diagrams and used no mathematics, but the degree of precision in his literary exposition in remarkably high.

According to Mill, the fundamental principle of price formation is the tendency of the market mechanism to establish equality between demand and supply. In other respects, he drew the same line between the short and the long run as the economists before him had done. In the long run prices tend to converge to the ‘natural values’ of commodities. For some commodities this may be simply reflection of scarcity, but for most commodities it will be true that their long-run exchange values reflect relative costs of production.

In this respect, Mills’ thoughts are in line with those of Smith and Ricardo. But there are some differences; he had modified the theory of the earlier classical economists. He says that the ‘natural values’ corresponds to the unit cost of the most costly part of production. Here he comes close to the concept of marginal cost.

Wages & Labour

In his discussion of labour and wages, Mill pays close attention to the contributions that different types of labour make to the economic activity in society. He puts great weight on the distinction between productive and unproductive labour. He argues that this distinction is not easy to make, but his point of departure is a definition of production as an activity that produces material wealth. That part of the labour force that produces material wealth is productive, the other part is unproductive. Examples of unproductive labour are teachers, doctors, military, actors et cetera. Unproductive labour is also as a rule useful, but the characteristic feature of productive labour is its positive contribution to material wealth and economic growth. Capital accumulation is associated with productive labour, and, therefore, having a large share of the labour force employed in productive work is important for economic growth. Later he states that he will interpret the concept of production in a broad sense, so that labour that is aimed at teaching others the skills necessary to produce material goods will be classified as productive. With this interpretation little remains of the whole distinction between productive and unproductive labour and becomes of little value. Mills respect for tradition is so great that he refrains from rewriting this part of economic theory. But on the other hand, he broke with other classical theory: the wage fund.

The idea behind the wage fund was that wages of workers are prepaid by the employers, or capitalists. Therefore, employers must build up capital (called circulating capital) in order to fund the wage payments to workers. It is the size of this capital for the economy as a whole that constitutes total wage income in the economy, and this is called the ‘wage fund’. Mill rejected this theory. The reason he gave was that the hypothesis of the constancy of the wage fund had implications that were consistent with observations of the actual functioning of the economy. Of special significance was the implication that trade unions were unable to influence wages. Mill did not offer an alternative theory.

Unemployment & Economic fluctuations

A study of economic fluctuations and unemployment was not a central part of the theory of classical economists. These were just frictional problems of good and bad times, which did not need to explain further. Mill discusses the issue “Can there be an oversupply of commodities generally?” Hereby he supports Say’s Law: ‘supply creates its own demand’. Mill’s stand on the question of overproduction as a cause of economic crisis was ambivalent. One the one hand, he gives a strong theoretical defence of Say’s Law. However, on the other hand, he suggests an interpretation of it that acknowledges the existence of crisis and overproduction without making it necessary to reject the law.

Long-Run Development & Stationary State

Mill also discusses the driving forces behind economic growth – the progressive society, as he calls it. The causes are in his view developments in science, technology, and economic organization. Natural science has improved are insight about physical processes, while the distance in time between scientific breakthroughs and commercial exploitation becomes progressively shorter. At the same time, the social conditions for engaging in economic activity are getting steadily better. The reasons for this are:

1. Society is more than before based on law and order, and common people are to a lesser degree exposed to arbitrary decisions by those in power.

2. There has been a significant improvement in the conditions for organized economic cooperation.

There is reason to believe that economic growth will turn out to be beneficial for all classes of society, but the working class can be prevented from getting a share in it. The growth of material welfare cannot go on indefinitely: as society continues to accumulate capital, the rat of return on new capital will fall. In the long run, therefore, society will approach the stationary state. This vision was in line with the view of earlier classical economists. Mill’s ideology was not one of steady material progress but rather of stronger emphasis of nonmaterial values.

Socialism and the future

Mill was critical toward those who argued that a better life for the poor was to be achieved by the upper classes taking more responsibility for them. He was also a social reformer, and he was not without sympathy for some socialist ideas. But in his opinion, socialists had quite confused and erroneous views on the real effects of competition. They tended to forget that where there is no competition, there is monopoly, and this is definitely not in the interest of the working class. Mill remained a liberal, but his economic liberalism was joined with the conviction that a policy of economic reform was necessary for the promotion of social justice.

Public Sector

Principles contains also a broad discussion of the public sector. Mill begins by considering the limits and duties of the government. The state has some necessary tasks and some that are optimal. He points out that there are a number of tasks that are easily overlooked but that can only be carried out satisfactorily by the state, besides those tasks of protecting the country against foreign enemies and creating a safe domestic environment for property and life. For instance, the regulation of the right to issue money, and the standardization of weights and measures. Also the regulation of the limits to private property is part of the necessary task of government and this is closely associated with the very idea of civilized society. On the other hand, protectionism is an example of a poorly justified state, which is harmful for society as a whole. It might yield benefits in the short run but it is a harmful policy in the long run. Protectionism leads to a less efficient use of the economy’s resources. A lighthouse system is an example of a justified government activity: it is practically impossible to collect individual payment from the vessels that benefit from the lighthouse. Thus, while the production and use of goods and services as a rule should be left to the market, there are a number of tasks that require government intervention because the market is unfit to solve them.

Utilitarianism

The economic writings cannot be sharply separated from Mill’s work in philosophy. He continued in the tradition of Jeremy Bentham. In his book Utilitarianism (1863) he maintains that the fundamental moral principle is the promotion of utility, which he also interprets as happiness. He promotes the sum of utility in society ought to be the moral guideline both in the life of the individual and for public policy. When modern economists refer to the maximization of the sum of individual utility functions as the utilitarian principle, this is a simplified version of Mill’s utilitarianism.

Both as man and as scientist Mill was a complex personality. He was a market liberalist, social reformer, elitist, and spokesman for democracy and freedom. His death (1873) coincides more or less with the marginalist revolution in economic theory (chapter 8 and 9). Therefore, one might believe that the classical school ended with him. But this is not true. His book continued for several years to hold its position as the leading textbook.

Chapter 6: Karl Marx as an economist

Karl Marx (1818-1883) was a difficult person who did not associate easily with other people. When he moved to Paris he met Friedrich Engels who was of decisive importance for Marx, his writings and the whole communist movement. Engels was an extrovert and good-humoured person, unlike Marx. The first published result of the Marx-Engels collaboration appeared in the revolutionary year 1848 in the form of the small book Manifest der kommunistischen Partei. The Manifesto contains the beginnings of a more fundamental political and economic analysis and critique of the capitalist system, which were later to be expanded and elaborated in Marx’s main work Das Kapital. Marx’s economic analysis are sometimes embedded in complex philosophical discussions and his terminology and conceptual apparatus are in part very different from that used by his classical predecessors as well as that of later generations of economists.

Communist Manifesto

According to Engels and Marx, the bourgeoisie is the ruling class in society. It has come to occupy its positions of power by means of an economic and social revolution that led to the ruin of the feudal society. Early in the book it is emphasized that the victory of the bourgeoisie has led to an unprecedented economic growth, but at the same time to man’s ‘alienation’. Alienation implies that ‘the work of the proletarians has lost all individual character, and, therefore, all charm for the workman. He becomes an appendage of the machine, and it is only the most simple, most monotonous, and most easily acquired knack, that is required of him.’

The basic cause of economic and social development is the growth of the productive forces. These are determined by technology and natural resources, and these are in turn dependent on factors outside the economic system. Further, they are also affected by human activities. Any level of the productive forces requires a corresponding mode of production – a certain organization of production based on a set of property rights and institutions that in turn determine the distribution of income and power. It corresponds with the modern concept of economic system. As productive forces develop, tension arises between the productive forces and mode of production, since the ideological superstructure prevents a flexible adjustment between the two. The ideological superstructure, among other things, consists of the structure of government, the legal system, literature, art and science. Sooner or later it will ends in a revolution that establishes a new mode of production and ideological superstructure, which with time will lead to new tension.

In the view of Marx and Engels it was the tension or contradiction between the mode of production and the productive forces that about one hundred years previously had led to the fall of the feudal society and the rise of the bourgeoisie. Their analysis was that they were close to a new revolution, consisting in the revolt of the proletariat against the bourgeoisie. Regarding the more specific political features of the future rule of the proletariat and the communists, Marx and Engels wrote down a program consisting of then point, of which the main elements were:

• Government expropriation of all land

• Strong progressive tax system

• Abolition of rights of inheritance

• Nationalization of credit, transport, manufacturing, and agriculture.

When the revolution comes to halt a new society will be established that is characterized by economic and social harmony. This is a typical expression of utopian thinking. Which is strange, since Engels and Marx criticised other utopian thinkers. The Marxist utopia was according to originators based on a scientific analysis of the dialectics of history, showing how the proletariat’s rise to power would inevitably lead to the ideal communist society.

A central idea in the Manifesto is the theory of all-important role of the productive forces for the development of society; at least up to the time of the revolution of the proletariat. This idea is often referred to as historical materialism, and because it tends to be associated with Marx his view of history and society has often been characterized as Marxist. A notable feature of the argument in the Manifesto is the tension between on the one hand the thesis of the victory of the proletariat over the bourgeoisie as a case of historical inevitability and on the other hand the authors’ appeal to the same proletariat to form a political alliance on the basis of the program of the Communist Party.

Capital

The book Das Kapital contains an analysis of the functioning of a market economy that is based on the institutions of private property, and in fact the use of the term capitalism to describe such a system originated with Marx.

Capitalism and surplus value

Marx attempted to describe the difference between capitalism and the economic system of the traditional feudal society in terms of two alternative representations of economic circulation. A representative agent of the traditional society is the artisan, who initially has a stock of finished goods, C, which he exchanges for money, M, which in turn he uses to buy goods for his own consumption. The economic circulation of society is therefore C – M – C. in the capitalist society the capitalists starts out with money that they use to purchase goods, which in turn they sell for more money; the circulation M – C – M’. Hereby, ΔM = M’ – M, which is profit, or as Marx calls it, the surplus value of capitalists. The surplus value forms the basis for capital accumulation and economic growth.

Marx’s labour theory of value

Marx took labour theory of value, especially in the form given it by Ricardo, as the point of departure for his own price theory. Like Ricardo, he also took account of the indirect use of labour through a kind of reasoning that shows – to use modern notion – an input-output perspective on the economy as a whole: in order to calculate the labour content of a particular commodity, we must take into account not only the amount of work that goes to produce the commodity itself but also the work required to produce the other inputs in the production process. In the end all commodities will be produced by labour and the amount of labour which is required to produce an additional unit of a commodity is the value of a commodity in terms of labour. Marx uses a more abstract justification of the labour theory of value than the ones used in Smith and Ricardo. Use value is defined as the socially necessary time required for production, including indirect time used for the production of the non-labour inputs. The indirect time use reflects the labour input of the past. The socially necessary labour is an average for the commodity in question. Marx did assume that surplus value was a constant fraction of labour costs, uniform across industries. This constant was the result of competition between producers who always strive to maximize value. Therefore, commodity prices are equal to relative labour costs, even if they were a component of surplus value in all prices.

In volume 3 of Capital, Marx adopted a more subtle approach to price theory. The central concept was the ‘organic composition of capital’. The total capital used in production is equal to c + v, where c is cost of fixed capital and v is wages. The organic composition of capital is q = c / (c + v). Where q is a measure of the capital intensity of production, which lies between 0 and 1 and must be assumed to vary across industries. Competition between capitalists leads to a rate of surplus value that stands in a constant ratio to capital. The relative prices or exchange values are only equal to relative labour costs when the organic composition is the same in all industries.

Economic growth

The theory about economic growth can be considered as a sketch of a model of economic expansion in a society with two sectors of production. One sector produces consumption goods, while the other produces investment goods. Part of total income in society goes is saved. The income of the capitalists is the only source of saving in the economy. Workers consume the whole of their income, while part of the profit / surplus value in each of the two sectors is saved. Equilibrium requires saving = value of output of investment goods. These assumptions provide the elements of a theory of growth: investment leads to an increase in capital stock and thereby to increased production and higher income for the capitalists, who increase then their saving, making room for additional investment. It can be interpret as a model of balanced growth in which the long-run rate of growth in the economy is constant. This is definitely not what Marx had in mind.

Breakdown of capitalism

Marx assumed that capital income or profit only depends on the input of labour. An increase of capital relative to labour will lead to a fall in the profit per unit of capital. Accumulating extra capital will not solve tis problem, because this only reinforces the tendency to a falling rate of profit. Marx hypothesizes that the capital producer is motivated by a desire for profit and accumulation as goals in themselves, not as a source of consumption and the satisfaction of needs. The consequences for workers of the accumulation of capital are twofold.

1. Each worker has more capital to work with, which makes the worker more productive, leading to a rise is wages

2. There will be an increasing concentration in industry. This will mean that demand falls. With an increasing population, the net result will be that the number of unemployed persons will rise, both in absolute and relative terms.

Marx reasons in line with Malthus: in the long run, the wage rate tends toward a level where it is sufficient to ensure the reproduction of the working class. But this level will, according to Marx, not be low enough to secure full employment.

The trend toward more accumulation of capita, a falling rate of profit, higher industrial concentration, and greater social misery will in the end lead to tensions between the productive forces and the mode of production that are so strong that the capitalist system will be unable to survive. This is more a prophetic version rather than a convincing economic theory. He does not provide convincing arguments why increased concentration involves more unemployment.

Friendship with Engels

The role of Engels in the development of Marxist economic theory is an interesting and controversial question. His importance as a provider of moral and economic support for Marx is indisputable. His role in the collaboration between the two seems to have varied over time. After Marx’s death, Engels’s literary and scientific contribution became of major importance, above all as the editor of the second and third volumes of Capital.

Chapter 8: Jevons and Menger

The nature of the marginalist revolution had the following three characteristic features of the new orientation in economic research:

1. A stronger emphasis on erecting economic analysis on the foundation of theories of behaviour for individual economic agents (firms and consumers)

2. Increased focus on the demand side of consumer goods markets and on the supply side of factor markets, accompanied by a critique of the classical labour theory of value. Marginal utility became a new a central concept of economic theory.

3. More reliance on mathematical formalization, above all through the use of differential calculus.

Both producers (firms) and consumers were regarded as agents who attempted to achieve the best possible outcome for themselves in the form of the highest possible profit for firm and utility for consumers.

William Stanley Jevons (1835-1882)

His book The Coal Question (1865) caused great stir by predicting England’s demise as an industrial nation through the depletion of its coal reserves. He related the problem to Malthus’s analysis of the population question. England’s economic development was bound up with exponential growth in industries that were dependent on coal as a source of energy, but the coal itself could no longer be extracted at the speed that this growth required. The lack of coal would therefore act as a brake on the country’s economic growth, and it was necessary to rethink its national strategy. The book The Theory of Political Economy has been regarded as his main work. However, Jevons was not only a theoretical economist. He made important contributions to empirical economies through his work on the construction of price indices, and on business cycles and labour economics. He also worked on logic and the philosophy of science, where his main contribution was The Principles of Science (1874).

Mathematical Method

According to Jevons in his Theory of Political Economy the science of economics must be reformulated by means of mathematics; the ideal model must be that of the natural sciences. Admittedly, there are those who maintain that an important difference between the natural and social sciences is that many social phenomena are difficult to quantify, but this objection is, in Jevons’s view, of little significance. There are great possibilities for the application of mathematics to relationships that are not usually thought of as being measurable in the conventional sense of the word. Jevons actual use of mathematical methods in Theory of Political Economy is not very impressive or extensive. He only had a limited mathematical training.

Marginal Utility theory

He indicates that utility is a property that a commodity possesses, and he uses quotes statements by Say and Bentham that support his view. But then he rounds off the discussion by saying that even if these quotations ‘perfectly’ express the meaning of the word as it is used in economics, one has to keep in mind that it is the judgement and attitudes of the individual that is the real criterion of what is or is not useful. Therefore, utility is subjective and not an intrinsic quality of commodities.

He makes a distinction between total utility and marginal utility – the final degree of utility. He hypothesizes that marginal utility is a decreasing function of the quantity consumed. This is interesting because earlier he stressed that utility is not an intrinsic quality of commodities. The declared aim of Jevons’s utility theory is to explain the determination of prices.

Demand and prices

With the work of Jevons the consumer side of markets comes to occupy a much more prominent place in price theory. The theory of the demand for consumer goods is related to a theory of consumer decisions, and Jevons emphasizes strongly the importance of marginal utility for the understanding of prices. His ambition was clearly to develop a general price theory, but whether he achieved it remains at best an open question. He had no clear understanding of how to formulate a general equilibrium theory in which supply and demand are determined by prices, while prices, in turn, are determined by the condition that supply must equal demand in all markets. Therefore, Jevons cannot be said to have been successful in constructing a general equilibrium model in the modern sense.

Jevons’s most ambitious attempt at mathematical economic model building is his model of market equilibrium in an exchange economy, where there are two consumers (trading bodies) who trade in two commodities (corn and beef) and where the total supply of each of the two commodities is given. He shows, without giving the details of the mathematical derivation, that the rate of exchange in quantity terms – the ratio between the numbers of units of corn an beef exchange in the market – must be equal to the ratio of marginal utilities for consumer A, and also to the corresponding ratio for consumer B. The analysis is impressive and the result is formally correct, but when we take account of his strong programmatic statement about the purpose of utility theory, it also contains some paradoxical features.

• The model has no prices in it, although the purpose of the theory is said to be the explanation of prices; it determines quantities, not prices.

• The model is limited to a situation of pure exchange where there is no production. Therefore, it cannot tell us anything about the role of production costs in the explanation of prices. At this point, Jevons makes it easy for himself in relation to his criticism of the classical economists, for when the costs of production are not included in the model their importance for the formation of prices is obviously zero.

The shortcoming of the model forces us to conclude that he was rather far from the realization of his ambition to construct a complete theory of the formation of prices.

Sunspot Theory

Jevons was also a pioneer of empirical economics. One of his achievements in this field was a study of the long-run development of the price level that is remarkable both for the systematic and thorough collection of data and for the originality of the design of price indices.

Jevons’s conclusion of the causes of fluctuations in the business cycle was that it must be sought in factors outside the economic system as such – that is, exogenous factors. He tested the hypothesis that the periodic changes of economic activity could be traced to the periodicity of the sunspots. Sunspots are areas of the sun with especially strong magnetic fields; the more numerous and larger the sunspots are, the colder is the earth’s climate. The idea of seeking the causes of the business cycle in the exogenous factors is obviously an interesting one from a theoretical point of view, and the systematic – although imperfect – statistical test was clearly an innovative contribution to empirical economics.

Carl Menger (1840-1921)

Part of Menger’s task as an economic analyst was to follow and analyse price movements in particular commodity markets, and he was struck with how little help he had in this work from established price theory that was founded on the labour theory of value. His attempt to work out an alternative theory resulted in his most famous book Grundsätze der Volkswirtschaftslehre (Principles of Economics, 1871; 1950)

The theory of value

His ambition in the Grundsätze is to develop a general theory of value that is capable of explaining all prices, both commodity and factor prices, on the basis of the same principle. He found this principle that in something that is similar, but not quite the same, as the hypothesis of diminishing marginal utility. If a limited number of units of a commodity can be used for different purposes, they will be allocated among these in such a way that every need that is satisfied is more important than any need that is not satisfied. The value of a satisfied need can be measures by the loss it would entail if a unit of the commodity had been removes. Menger puts forward the hypothesis that the subjective value of a unit of a good decreases the more one consumes of it. This corresponds to Gossen’s first law, but the formal analysis is limited to a numerical example. While Menger can be said to have rediscovered Gossen’s first law, he did not manage to formulate the second law, describing the consumer’s optimal allocation of his income between alternative uses. The closest Jevons came to Gossen’s second law was in the analysis of optimal allocation of the same good to the satisfaction of several needs. Menger considers exactly the same problem. Menger, like Jevons, failed to solve the more general problem of the allocation of different goods with the objective of obtaining maximum utility or satisfaction of needs.

Menger applied his price theory not only to consumer goods (goods of the first order) but also to factors of production (goods of a higher order). Prices of the factors of production were derived from the prices of the goods of the first order that they helped to produce. The value or price of a factor of production is determined by the reduction in the value of the finished good that would result if the supply of the factor of production were to be reduced by one unit, given that the other factors of production were optimally reallocated. This result is an early version of the marginal productivity theory of the prices of factors of production.

Methodenstreit

Menger is not of the same stature as the other leading figures in the marginalist breakthrough, Jevons and Walras.

• He was seen as the pioneer in launching the new theories in the German-speaking world

• After his death his claim to be considered one of the founders of the new theory was strongly advanced by one of his prominent successors in Austrian economics, Eugen Böhm-Bawerk.

• There emerged in the German-speaking academic world a major controversy about the right approaches to economics, and in this controversy Menger became to appear as more of a pure theorist than he really was.

Menger’s opponents in the so-called Methodenstreit were adherents of what is known as the German historical school, of which Wilhelm Roscher was the founder.

In Menger’s book Untersuchungen über die Methode der Sozialwissenschaften und der politischen Ökonomie insbesondere (1883) he argued that a crucial weakness of the research strategy of the historical school was that, in contrast to his own approach, it did not base its analysis on individual behaviour. The researcher Gustav Schmoller replied to Menger in the form of a very critical review of his book, which in turn provoked Menger into a further attack. The end result of the Methodenstreit was that both parties in the debate felt forced to take up positions that were more extreme than they may first have intended. At the same time it led to a long-lasting conflict concerning research methods between German and Austrian economists who supported Schmoller and Menger, respectively. In our perspective it is obvious difficult to argue that economics as a science should either be theoretical and deductive or empirical and inductive.

Ernst Engel (1821-1896)

Engel is a researcher whom it may be natural to classify under the historical school, but who took no part in the Methodenstreit. His place in the history of economic thought is due to his empirical studies, especially his discovery of what later became known as Engel’s Law. He putted forward the hypothesis that there existed an empirical law regarding the composition of consumption, both at the individual level and the national level: the expenditure on food as a percentage of income falls as income increases. The elasticity of food is thus less than one. In another paper Engel presented empirical estimates of what he referred to as the value of man. For different socioeconomic groups he calculated the expenditure of training a boy to practice his father’s profession, demonstrating that this expenditure increased with the father’s income and decreased with family size.

The Austrian School: Eugen von Böhm-Bawerk and Friederich von Wieser

Von Böhm-Bawerk and Von Wieser were the two best-known followers of Menger. Von Böhm-Bawerk was educated in law and political science, but due to the influence of Menger he became interested in economics. His name is mainly associated with his theory of capital and interest as it was laid out in his book Kapital and Kapitalzins, which was published in two parts. One of the questions that he raised in this book was why the rate of interest is positive. He gave three reasons for it:

1. Individuals expect in general that more resources will be available for consumption in the future;

2. People’s systematic tendency to underestimate future needs, which Von Böhm-Bawerk claimed to be an undisputable psychological fact.

Both these reasons imply that consumers must be compensated for transferring resources into the future

3. The advantages of ‘roundabout production: there must be some factor that causes producers to stop the process of time extension, or, in other words, to choose a period of production of finite length.

This factor is just the positive rate of interest. The lower the rate of interest, the longer the period of production that will be chosen by producers, and the more resources will be tied up in the production process.

As a theorist Wieser is chiefly remembered for two reasons:

1. He was the inventor of the term marginal utility

2. His theory of the relationship between commodity and factor prices.

Chapter 10: Alfred Marshall

Marshall is an economist who belongs to the second generation of marginalists. Marshall gave the new theories of Jevons, Menger and Walras a form that made them more accessible both to professional economists and others, and more useful as practical tools for applied economic analysis. His most important and known book is the Principles of Economics (1890), which appeared in eight editions, and a large part of Marshall’s time was spent in revising and extending it, particularly by adding an increasing number of appendices.

Style & ambitions

Marshall took a long time to publish his ideas. An explanation could be Marshall’s high demands on the standard of his published work. Another explanation lies in his sensitivity to criticism; he was especially keen not to publish anything that could hurt or provoke others.

According to Marshall, mathematics could be helpful, but only for the theorist’s private use. If his mathematical analysis led to new economic insights he should be able to express them in ‘plain English’, and when that had been achieved the mathematics could be ‘burned’. If, on the other hand, it turned out to be impossible to express the results of mathematical analysis in plain language, it was necessarily of little interest and value to the public to which it was addressed. When writing the Principles, Marshall took his own advice by relegating all formal analysis to footnotes and a separate mathematical appendix.

The Principles are divided into six main parts, or ‘books’. Of these it is book 5 that has received most attention by later economists, because it is there that Marshall establishes the theoretical framework for partial equilibrium analysis that was to have such an important influence on the development of economics.

Demand & Supply

Partial equilibrium theory – the analysis of price formation in a single market – is forged into an operational tool of analysis that can be used to analyse a range of theoretical and applied problems. An important aspect of his price theory was also that it provided an integrated view of the relationship between the classical approach and the new view that was associated with the marginalist breakthrough. The classical price theory was a cost-of-production theory. However, they made an exception for goods that existed in fixed quantities; in such cases price would be determined by scarcity. This dichotomy was unsatisfactory because it did not establish a general theory of price formation. Marshall’s contribution was the now well-known supply and demand diagram, where an upward sloping supply curve and a downward-sloping demand curve were drawn in the same diagram and where equilibrium is represented by the point of intersection between the two curves – ‘the Marshallian cross’ as it has been called. He gives demand and supply equivalent roles in the process of price formation and emphasizes that none of them can have priority over the other. A central an important implication of Marshall’s approach is that the relative importance of demand and supply as determinants of prices depends on the time perspective of the analysis and not only, as the classics had maintained, on the nature of the commodity. He illustrated his discussion by an example taken from the fishing industry. His conclusion was that in the short run a change in demand will lead to an increase in the price of fish. In the long run the conclusion may be a different one. The distinction between short- and long-run analysis may perhaps appear to be a rather trivial one, but Marshall made it into an important theoretical distinction by linking it to the scope for capacity adjustment.

General & partial equilibrium

Marshall laid the foundation for what we now call partial equilibrium theory. Marshall was aware that a weakness of the theory was that it might neglect causal factor that were important for the solution of a concrete problem. His main defence of the approach was that the human intellect had ‘limited powers’ so that it was necessary to simplify complex problems in order to understand and be able to solve them. But, one had to be aware of factors that were disregarded during the analysis but which ought ideally to have been included. This technique of analysis he characterized by means of the Latin term ceteris paribus – everything else equal.

Demand, Utility & Welfare

Marshall’s theory of consumer demand is based on marginal utility considerations, even if he shows little interest in utility theory as such. However, he makes good use of the concept, without a modest degree of formalization. He assumes that the marginal utility of each good is decreasing and that the consumer will choose his demand so that the marginal utility of consumption will choose his demand so that the marginal utility of consumption, measured in terms of money, is equal to the price. Because marginal utility is decreasing, an increasing in price must lead to a point of adjustment where marginal utility is higher than before and the amount of consumption is lower. The demand curve is accordingly a decreasing function of price. This line of reasoning is based on a simplified assumption. Marginal utility as measured in money must reflect not only the marginal utility of the goods but also the amount of income that the consumer has. When the price of a commodity falls, the purchasing power of money and real income of the consumer goes up, and this leads to a more complex relationship between price and demand. He considered this complication of less importance and made the assumption that marginal utility of income is constant. This assumption implies in economic terms approximately the same as the disregard for income effects. It seems clear that Marshall was on the track of the modern distinction between income and substitution effects of a price change. Marshall made this assumption not only as the foundation of the analysis of demand, but also for welfare considerations. The individual demand curve will correspond to his marginal utility of the commodity in question.

Marshall defined consumer surplus as the difference between the maximum amount that the consumer would have been willing to pay for some given quantity OH, and what he actually pays (figure 10.2). The consumer surplus is thus the area between the demand curve and the price line, and the value of a decrease in price becomes equal to the increase of consumer surplus.

The aggregate social surplus of a certain volume of production cannot be measured only by the consumer surplus. In addition one has to take into account the producer surplus – revenues minus the cost of production. The social surplus is equal to the area between the demand and the supply curves. This area is as large as possible when consumption (demand) and production (supply) are at the point of intersection. When the demand price is, for example, higher than the supply price – if the consumers’ marginal benefit is higher than marginal cost – one can increase the social surplus by increasing output and share the extra surplus in a way that makes either the buyer or seller or both better off.

Elasticities

Marshall introduced price elasticity of demand by pointing out the usefulness of having a measure of the sensitivity of demand to a change in the price. It is an important measure because it is independent of the units that we use in measuring quantity and price, thereby making it possible to compare the price sensitivity of demand across markets. In addition, one may also define the elasticity of supply, but in discussion of this concept Marshall is a bit more guarded. The reason for this caution is that the price elasticity of supply must be assumed to be very different in the short and long run, a complication that was of much less relevance for the elasticity of demand according to Marshall.

Externalities

Marshall was primarily interested in an explanation of why the long-run supply curve under perfect competition could be decreasing. His view was based on a conviction that an increase in demand frequently led to a lower price, and this could only be true if the supply curve was declining. But this result led to a problem: under perfect competition the supply curve of the individual firm must be equal to its marginal cost curve, and decreasing marginal cost is inconsistent with the assumption of perfect competition. Marshall’s solution to the problem was the introduction of the concept of ‘external economies’ as a term describing factors beyond the control of the individual producer, which led to lower cost for the firm. These factors are external to the firm, but internal to the branch/industry. The individual firm will always confront increasing marginal costs, but an increase in demand, that has as its immediate effect a higher price, will lead all firms in the branch to increase their output. This expansion of the industry could possibly lead to lower costs at the level of the individual firm. He also introduced ‘external economies’ to represent the opposite case where the long-run supply curve is increasing because industry expansion leads to increased costs for the individual firm. In Marshall’s sense, both negative and positive external effects imply that the market does not function efficiently, since each individual firm does not take account of the fact that changes in its own output volume will have an effect on the costs of other firms.

As an solution Marshall suggests that one ought to tax increasing cost industries and use the revenue to subsidize industries with decreasing costs. By subsidizing firms, stimulating them to increase their output, one is able to compensate for this lack of incentives. But, there re a number of qualifications as regards the tax’s practical implementation. The costs of collecting the taxes and distributing the subsidies may be considerable and could also involve attempts at fraud and corruption. Further, he points out that the desire to benefit from the subsidies could lead businessmen to transfer their attention away from the management of their firms and toward attempts to influence the public authorities in charge of the subsidies.

Income distribution & Factor markets

The point of departure for Marshall’s theory of wages is the analysis of the decisions of the profit-maximizing producer: How many workers should he hire? It is profitable to hire more workers as long as the value of the marginal productivity exceeds the wage rate, which the producer takes as determined in the market. Bringing demand and supply together, wages are determined by supply and demand in the labour market, and the ‘iron law of wages’ of the classical economists is no longer valid.

In a corresponding manner, Marshall presents a theory of the demand for capital, where profit maximization implies that the marginal productivity of capital will be equal to the rate of interest. In this way a theory of the demand for the factors of production is established.

Society & Economy

Marshall kept an open mind about the motivation of economic agents: it could be quite complex, going beyond the single-minded goal of profit maximization or the desire to obtain the highest possible individual standard of living, a minor modification of the maximization hypothesis was the emphasis that he put on family considerations, as in his discussion of parents’ investment in their children. But in addition he maintains that managers and other businessmen are also driven by motives that are socially conditioned. Foremost among these are social responsibility and the desire for recognition by others.

Marshall was a strong advocator of free markets: freedom of industry and competition led to an efficient use of resources. Furthermore, it made men become hardworking, conscientious, and prudent. This would have a long-run effect on economic development and growth.

Chapter 11: Edgeworth, Pareto and Pigou

The three characters of this chapter all attempted to tackle the problem of the real meaning of the concept of maximum satisfaction. But, they approached it in rather different ways.

Francis Y. Edgeworth (1845-1926)

Edgeworth published three books, the most important of which are New and Old Methods of Ethics (1877) and Mathematical Physics (1881).

‘Exact Utilitarianism’

Edge worth was a utilitarian: he maintained that total welfare in society should be measured by the sum of individual utilities. The individual person’s utility was identified with the satisfaction that resulted from his consumption and activities. He believed that earlier utilitarian thinks like Mill and Bentham had not defined their welfare objective in a way that led to any practical conclusions; they were unable to present a logical proof that their conclusions followed from their utilitarian assumptions. Edge worth suggested the approach that he called ‘exact utilitarianism’. He first considered the question of how individual utility depended on income, building on an analogy with the empirical insights that originated from the research of the German psychologist Gustav Fechner (1801-1887), whose central result was that the perception of sensual stimulus increases less than proportionally with the strength of the stimulus. From this Edge worth concluded that the marginal utility of income must be decreasing. He concluded that an equal distribution of income is best for society, since everybody has the same utility function. He also showed that for the case of inequality in working capacity he shows that the utilitarian principle under certain assumptions implies that those with the greatest capacity should do the most work. This raises the question: How do we know that utility is comparable between individuals? Comparability is an assumption that we need to make whether we assume that the relationship between utility and income is the same for different individuals or that it varies in some systematic way with their work capacity or psychological makeup. Edgeworth actually takes it as an axiom that happiness or utility is measurable and comparable between individuals and defends the assumption by reference to the results of psychological research.

The Equilibrium of Exchange

The theoretical contribution for which Edgeworth is best known in his analysis of market equilibrium in an exchange economy. The framework is an economy with two consumers and two goods that are fixed in supply, and where the two consumers own given shares of the supply. The problem is to characterize the equilibrium that will emerge when the two consumers are free to trade with each other. To solve this one must make some assumptions about the consumers’ preferences for the two goods, represented by utility functions.

Earlier writer had defined total utility (U) as the sum of the utility of x, u(x), plus the utility of y, v(y), so that:

U = u(x) + v(y)

This function is said to be additive. Edgeworth introduced a more general formulation where total utility is a function of the two quantities, but without any presumption that it could be written as a sum, so that:

U = U(x, y)

Edgeworth did not explain why the generalization was of economic interest. In the latter version of the marginal utility of each good will depend not only on the quantity consumed of that good, but also on the quantity consumer of the other good. The relationship is such that an increase in y would cause a reduction in the marginal utility of x, and vice versa. He did not define that the goods were substitutes or complements; this was done by two Austrian economists Rudolf Auspitz and Richard Lieben (1889).

Edgeworth’s other important contribution to utility theory was the concept of indifference curves. He drew these curves in the shape that is familiar to us today and showed that the convexity of the curves followed from the assumption that he made about the marginal utilities. Namely, that the marginal utility of each good was a decreasing function both of the quantity consumed of that good and of the other good. After this he turned to the analysis of equilibrium in an exchange economy. The final agreement between two consumers would have the property that it would not be possible to suggest a further exchange that would be to the advantage of both parties. But in an economy with a large numbers of agents the assumption of perfect competition can be given as a rigorous justification. Earlier, Cournot had arrived at a similar conclusion, but Edgeworth’s formulation was more general and theoretically deeper.

Edgeworth was not the first to draw the Edgeworth box diagram, but he provided so many of the elements required for its construction that it is not unreasonable that the diagram carries his name. But the first to draw the diagram, as we know it today, was Vilfredo Pareto.

Vilfredo Pareto (1848-1923)

He was convinced that general equilibrium theory was the most fruitful framework for the analysis of economic and social problems. His main works in economics are the two books Cours d’économie politique (1896;97) and Manuel d’économie politique (1909). It is the second book that contains most of his original contributions to economic theory, and it is to this that he owes his position in the history of thought. There is no sharp division between his work in sociology and economics, and his main work in sociology, Trattato di Sociologia Generale (1916). Pareto was Walras’s successor. Like his predecessor he was a strong believer in the benefits of the mathematical method of economic analysis, and he saw it as one of his central tasks to generalize and further develop Walras’s ideas.

Demand & Utility

Pareto set himself the task of arriving at a version of the theory of consumer behaviour that was as general as possible in the treatment of individual preferences. In this area, his work to a large extent ran parallel to that of Edgeworth. But Pareto managed to reach a deeper understanding of the real connection between the utility function and the indifference curves. The connection between consumption and utility numbers may be referred to as the utility function, but the function is just a representation of the preferences; the basic information about the structure of preferences lies in the system of indifference curves – the indifference map. This view was in contrast to Edgeworth’s way of looking at the problem. Pareto’s concept of utility is ordinal in contrast to that of Edgeworth, who saw it cardinal. Pareto derived the conditions for utility maximization for an individual consumer and carried out a mathematical analysis of what happened to the optimal choice of consumption goods when one of the prices changed while the remaining prices and income remained constant.

Optimality & Market Equilibrium

Pareto’s fame rests on his role as the originator of the modern theory of welfare economics. He developed the conditions for maximum welfare. In modern textbooks, the definition of Pareto optimality is usually written as the condition that it is impossible to increase the utility for one individual without decreasing the utility for somebody else.

Pareto states that his definition of an optimal use of resources could be used to characterize market equilibrium under perfect competition, and he discusses this property of the equilibrium very carefully. He begins with the case of pure exchange, introducing ‘Edgeworth’s box diagram,’ and goes on to generalize the analysis to an economy with production. He also argues that his definition of optimality is of interest for the analysis of alternative economic systems: in a socialist state that is concerned with the welfare of its citizens the ministry of production ought to organize production and factor use in accordance with the rules for optimal resource allocation implied by his analysis. Such a society would probably also rely on the market mechanism as an instrument for the allocation of resources, although only to a limited extent. However, in its planning activities for the nonmarket sector the ministry of production would have to rely on calculation prices, for without prices the ministry would grope in the dark as regards the planning of production. After having discussed a number of issues pertaining the choice between markets and socialism, Pareto concludes that the pure theory of economics does not give a truly decisive criterion for choosing between an organization of society based on private property and social organization. Pareto does not provide a systematic discussion of what these other characteristics of social systems really were. But several passages in the Manual indicate he was aware of it and of the problems that would arise in a socialist economy, in particular the weakening of incentives that would result when the individual’s income was allowed to become independent of his own effort. Also he argues that economic and political institution would have different political incentives that would be of major importance for the determination of the equilibrium of the economy.

Law of income distribution

Pareto is remembered for his hypothesis about the distribution of income, which was founded on empirical regularities rather than theoretical considerations and which he presented in his book Cours d’économie politique. Classical economists had been concerned about the functional distribution of income, that is, the distribution of income between the social classes (landowners, capitalists and workers) who owned the main categories of the factors of production. Pareto studied the personal distribution of income between the individuals in society, independent of the factor markets from which their income was derived. He found out that when income goes up by 1 percent the number of income earners who have at least this income falls by 1.5 percent. Mathematically presented by the equation

Log (N) = log (A) – a * log (y)

Here ‘N’ is the number of persons that have an income that is greater than or equal to ‘y’. ‘A’ is constant representing the size of population and ‘a’ is the constant that Pareto believed to be equal to 1.5. The average income of those whose income is greater than y always is equal to a/(a-1)*y.

The ‘law’ led to an increased interest in the study of income distribution, but it was also controversial:

• It had no foundation in economic theory, since it was not derived from an analysis of the functioning of the factor markets

• It was argued that the law could be used to support a socially reactionary viewpoint by which the distribution of income between rich and poor acquired the status of a natural law.

Arthur C. Pigou (1877-1959)

His general approach to economics was strongly influences by Marshall, and in much of his work he continued the tradition from his old teacher. He was an pioneer of modern welfare economics and wrote Economics of Welfare (1920).

Utilitarianism & Material Welfare

Pigou was a convinced utilitarian who thought it was obvious that redistribution in favour of low-income groups would increase the sum of utility in society and that there were no scientific foundations needed to prove it. Also, Pareto maintained that it was meaningless to compare the utility of different individuals, while Pigou argues that such a comparison leads to ‘evident’ results. But he makes an important reservation about the social benefits of the redistribution of income: a transfer of income between the rich and poor could conceivably reduce the total income of society and thereby weaken the economic basis for redistribution. High marginal tax rates of income tax might reduce work effort, so that a trade-off must be made between the concerns for economic efficiency and distributive justice.

Pareto’s main interest in the field of utility theory lay in a concept that could serve as a basis for the theory of consumer demand. Pigou, on the other hand, was interested in utility in the sense that the concept had been used by older utilitarian philosophers and which he used to denote material standard of living. The law of decreasing marginal utility is therefore not primarily related to the shape of indifference curves but to a proposition about the relationship between income and the standard of living, which Pigou believed could be empirically justified.

Market Failure & Efficiency

Pigou distinguishes social and private marginal net product. The marginal net product refers to the value of an extra unit of resources (labour, capital, etc.) that is made available for production. The net product is the increase in the total value of production that follows from the resource increase. A rational use of society’s resources implies that for each resource its marginal net product should be the same in all uses. This is a criterion of economic efficiency. If all the cost and benefit that follow from such an increase of resource use is taken into account by firms and consumers, private and social marginal net products are the same. Then the market mechanism operates efficiently and there is no need for public intervention.

The proposal to use taxation as an instrument of environmental policy is perhaps Pigou’s best-known contribution to economics, and in his honour they are often referred to as Pigouvian taxes. Whereas Pareto laid the foundations for theoretical welfare economics, Pigou showed how it could be used to derive guidelines for economic policy.

Public Economics

The Economics of Welfare was to a large extent devoted to the justification for political interventions in economic life, but it does not provide a systematic discussion of the instruments of economic policy. This was done in A Study in Public Finance (1928;1947). It contains analyses of public expenditure and taxation. Pigou makes the reader thinking about public expenditure in a way that focuses on the best use of society’s resources and the optimal distribution of tax revenue among the various branches of government.

In the case of externalities a tax can be used to correct for it. One has to think differently about the balance between the public and private sectors, for the efficiency loss of the tax increase has to be counted as part of the cost of public expenditure. In addition to the direct resource cost associated with the use of factors of production comes the indirect tax cost, which will act as a brake on the use of resources in the public sector. This tax cost is known as the marginal cost of public funds, MCF. Further, MB is the marginal benefit of public expenditure and MC its resource cost. If taxes had no adverse effects, optimal public expenditure should be characterized by condition MC = MB. With harmful or distortionary taxation it should be written as MB = MCF * MC, where MCF > 1.

Another contribution to public economics is the idea of the optimal tax system. According to Pigou, all feasible taxes involve harmful effects for the economy, since they lead to differences between the social and private net marginal product; taxes have incentive effects on labour supply, consumption and savings that are costly to society. But, taxes are needed to finance public expenditures. Ramsey showed that in order to make the total damage, or efficiency loss, from taxation as low as possible, the percentage reduction in consumption ought to be the same for all goods. This can be achieved by imposing the highest taxes on goods that are inelastic in demand or supply. In later editions of Pigou’s A Study of Public Finance he showed how a simplified version of Ramsey’s results could be derived from partial equilibrium analysis.

Public Policy & Unemployment

Pigou wrote several books on the causes of unemployment, most famous of which is Theory of Unemployment (1933). The fundamental causes of unemployment are to be found in imperfections of the market mechanism, particularly in the market for labour, that delay the adjustment of supply and demand.

Chapter 14: The great systems debate

The social alternative to an economy with free markets became increasingly prominent in public discourse, and many economists began to feel that current economic theory did not really provide the defenders of the market system with much support.

Ludwig von Mises (1881-1973)

Mises published an article that was destined to become of major importance for the debate. Mises was a student of Menger and Böhm-Bawerk and an enthusiastic spokesman for free markets as the system best suited for achieving both economic efficiency and individual freedom. He maintained that in a socialist economy based on central planning, rational economic calculation is impossible, because market-determined prices are absent. Planners will be unable to guide society’s resources to there most productive uses, since it is not possible to compare the value of factor inputs with the value of output.

Oskar Lange (1904-1965) & Abba Lerner (1905-1982)

Mises was not to become a central participant in the debate; his article was the spark that started it. The first writer to take up the challenge from Mises was the Polish economist Oskar Lange. In 1934 he presented a plan for a socialist economy that implied the socialization of all production apart from that which took place in small enterprises. The socialized production in the individual plants was to be coordinated by trusts, which, in turn, were to be supervised by a public bank, which would play the role of a central planning board. Lange had doubts whether the actual market economy could function in such a way as to satisfy the conditions for an optimal allocation of resources. He claimed that political attempts to gain control of monopolies and cartels were doomed to failure, since the large and powerful companies would easily come to have more political influence than the supervisory institutions that were set up to control them.

Under Lange’s system of market socialism firms would be owned by the state, and they would be instructed by their owner to maximize profit, just like firms in a market economy with private ownership. But, prices would be determined by the central planning bureau by trial and error to create equality between supply and demand.

Lange admitted that market socialism could have some imperfections. He stressed the danger associated with an increasing bureaucracy that could follow from detailed state regulation of industry. However, he pointed out that this could also be the case in market economies, which were dominated by large companies. Further, he realized that the lack of incentives could become a problem when managers were no longer guided in their decisions by a concern for private profit. However, the democratic control of managers could be exercised so that efficiency would be encouraged.

Lange was not the only economist who took an interest in the theory of market socialism in this period. Abba P. Lerner’s political convictions were a mixture of socialism and belief in the efficiency of the market mechanism. He was also convinced of the importance of private firms for ensuring the individual’s freedom regarding the choice of occupation. He published articles that elaborated the analysis of Lange’s system, and it is Lerner’s clarifications of the price adjustment mechanism under market socialism that has made it known as the Lange-Lerner mechanism.

Lerner wrote the first modern textbook of welfare economics: The Economics of Control (1944). He pointed out that there were three sets of conditions that would have to be satisfied for the allocation to be Pareto optimal:

1. Efficiency in consumption: it must be not possible to make one consumer better off without making one or more others worse off.

2. Efficiency in production: it must be not possible to increase the output of one commodity without reducing the output of one or more other commodities.

3. Efficiency in product mix: it must be not possible to alter the composition of production so as to make one consumer better of without making one or more others worse off.

These conditions would be satisfied both under perfect competition and under market socialism. The crucial condition was that all consumers and firms faced the same prices.

Friederich von Hayek (1899-1992)

Hayek became in the 1930s a prominent critic of the macroeconomic theories of John Maynard Keynes. Gradually, however, he became more interested in questions related to the choice among alternative economic systems, and in this area he became known as the foremost spokesman for Mises’s side in the systems debate, and as the strongest critic of Lange’s views. He believed that Mises’s views on prices and market paid insufficient attention to two important aspects of the market mechanism:

• Incentives: owners of private firms strive to maximize profits, since the profits accrue to themselves.

• Information: consumers’ knowledge of their preference and resources and firms’ insights in the technology of production are as a rule unavailable to outside observers like a state planning bureau. Prices transmit information to the individual economic agent, and this induces him to make socially rational decisions, even if his own information about the economy as a whole is severely limited.

Hayek stated that economists like Lange and Lerner had been misled by formal analytical models that completely disregarded the problem of information.

Why many economists in the 1950s and 1960s thought that it was obvious that Lange had won the debate was based on at least two arguments:

• Lange had based his arguments on existing economic theories

• The general planning optimism of the first couple of decades of the post-war period, which was derived both from the successes of wartime planning and from what was perceived as the great economic progress of the Soviet Union under its regime of central planning.

Hayek wrote The Road to Serfdom (1944) which represents a significant extension of the framework for discussion of alternative economic systems. The conditions for political and economic freedom are in reality closely connected, and restriction on it would follow from the extension of government control. He warned against the trend toward expansion of the public sector and central economic planning, and argued that this development would imply a weakening of political democracy. This was the road to serfdom.

Joseph Schumpeter (1883-1950)

The book Theorie der Wirtschaftlichen Entwicklung (1912), in which he presented his theories of the sources of economic growth, made him an internationally recognized economist. While he was a professor at Harvard University he published two major books, Business Cycles (1939) and Capitalism, Socialism, and Democracy (1942). His great work on the history of economic thought was incomplete at the time of his death but appeared as History of Economic Analysis (1954). Many maintained that Schumpeter is the founder of what is sometimes called evolutionary economics.

His contributions to the great systems debate are closely related to his view of the driving forces in the development of the market economy. The entrepreneur, the agent who introduces innovation in economic activity, plays the main role in this process. Innovations break through when the accumulation of inventions and discoveries has reached a critical mass. With a change of technology there will be opportunities for new products and new techniques of production; new firms and industries emerge while some of the old ones vanish. This is called creative destruction.

Schumpeter gives a theory of eventual victory of socialism which is based on Marx’s analysis of the development and decline of the capitalist system and the rise of the proletariat. The similarity appears above all in the broad sweep through economic, sociological, and political causes. But there are also a number of dissimilarities between the two perspectives. Marx predicted a development toward class war and revolution. On the other hand, Schumpeter foresaw a gradual development whereby bureaucratic socialism would come to take the place of capitalist system lacking in social legitimacy.

Even if Schumpeter's writing expresses a general scepticism toward bureaucratic decision process, whether they occur in the public or private sector, he takes the view that the problem of bureaucratization cannot be used as a point against either socialism or capitalism. He believed that a form of decentralized socialism of the Lange type would be feasible in practice. His main argument in favour of the system is that the solution of fundamental economic problem would in some respect actually be easier than in the market economy. Uncertainty based on the lack of knowledge about the behaviour of competitors would be eliminated under decentralized socialism, where the central planning agency, through its responsibility for determining prices, would take on the task of coordination decisions between companies. Other types of uncertainty would remain and would be basically the same as in a system of free markets.

Chapter 15: John Maynard Keynes (1883-1946)

During the 1930s there was a radical change, and the person who more than anyone else is associated with the theoretical orientation is the English economist John Maynard Keynes.

Life & Work

His book The Economic Consequences of the Peace (1919), which combined economic analysis with vivid and provocative descriptions of the negation process (of the Peace Conference in Versailles), caused great public attention and made him world famous. From 1911 to 1945 he was in charge of the Economic Journal, first together with Edgeworth and later as its sole editor. Keynes’s first real contribution to his field of research was the book A Tract on Monetary Reform (1923). But, a more ambitious work was his next major publication, A Treatise on Money (1930), which clearly aimed to give an original contribution to economic theory. However, his major work is The General Theory of Employment, Interest, and Money (1936). Toward the outbreak of World War II Keynes was more drawn in political life as an advisor to the British government. He made a number of significant contributions in several areas, but the most important was perhaps his efforts to establish the system of international exchange rate cooperation that became known as the Bretton Woods system.

General Theory

Popular views of what the General Theory is all about are often based on the political implications of the analysis, especially the recommendation that the government should try to stabilize employment by influencing aggregate demand. The policy tools to be used should primarily be changes in public expenditure and the level of taxation. If this view is historically correct is open to discussion.

The General Theory does provide a theoretical foundation for the recommendation of a more active government policy to ensure full employment, which had been a main concern of the author since the 1920s. When economists with a background in ‘classical theory’ (the representatives of the conventional view, such as Pigou) suggested increased public spending as a remedy for unemployment. By contrast, Keynes’s analysis led him to believe that the state had to undertake a more permanent responsibility for carrying out an economic policy that ensured full employment.

The central theoretical message of the book is that the price and wage mechanism does not function in a way that leads to full employment. When the economy is exposed to shocks, particularly in the form of demand failures, its quantities, not prices and wages that bear the brunt of adjustment to a new equilibrium.

Labour & Wages

Keynes begins his analysis by summarizing the classical economists’ view of the labour market (chapter 2). The classical theory of employment is based on two fundamental postulates:

1. Wage is equal to the marginal productivity of labour

2. Wage is equal to the marginal (dis)utility of labour at any given volume of employment.

Keynes defines equilibrium as a state where demand price of labour is equal to its supply price for all levels of output and employment. The labour market tends toward a competitive equilibrium. Employment can only be increased through organizational changes in the labour market that reduce frictional unemployment or through measures that either increase the marginal productivity of labour or decrease the marginal (dis)utility of labour – that is, increase labour demand or decrease supply.

Keynes has two objections to the classical view of unemployment:

1. The supply of labour depends both on the real and the nominal wage rate, that is, both on the purchasing power of wages and on money value. The nominal wage level is inflexible downward. An interesting justification for the assumption of nominal wage rigidity has to do with the workers’ comparison of their own wage with that of others. Therefore, a decrease of real wages that is due to increasing prices of consumer goods will get not so much resistance because it has the same effect on workers in all industries and professions.

2. Falling wages will lead to falling prices or at least to expectation of falling prices in the future. Therefore, there will be little effect on wages in the short run, so that one fails to achieve an increase in the demand for labour. The expectation of falling prices reduces the profitability of new investment so that the effects through this channel also fail to reduce unemployment.

The classics thought of wage rigidity as a feature that delayed the normal adjustment to equilibrium in the labour market, while Keynes considered it to be an equilibrium phenomenon. The contrast between Keynes and the classics becomes a matter of degree rather than of fundamental disagreement.

Demand & Employment

Since wages are not flexible downward the normal situation in the labour market will be one where the wage is too high to be consistent with full employment. With labour supply > labour demand, the demand for labour determined the actual amount of employment. The two components the demand for consumption and investment goods determine the demand for labour. Keynes had different ideas about the determinants of consumption and investment demand, and he formulated his ideas at the macroeconomic level: as theories of what determines aggregate consumption and investment goods demand. Aggregate income is the main determinant of aggregate demand and therefore of (un)employment. This is one of Keynes’s most important contributions to economics. Further, when income increases people’s consumption will also increase but by less than the increase in income. The ratio of the two increases is the marginal propensity to consume (0

With regard to investment, Keynes assumed that society’s capital stock could be taken as given. However, capital owners wish to increase capital stock as long as the expected yield on new investment is higher than the market rate of interest; investment demand is a decreasing function of the interest rate. While there is a stable relationship between consumption and national income, investment demand is characterized by fluctuation that stem from the fact that expectations about the future are constantly changing, being strongly influenced by speculative considerations.

Keynes also provided an theory of investment multiplier: an increase in investment of a certain amount will increase national income by that same amount plus the secondary increase in consumption (which, in turn, depends on the marginal propensity to consume) that is generated by the increase in income. Fluctuations in investment demand transmit themselves via their effects on consumption to fluctuations in income that are larger than those of investment. The income changes lead to changes in the demand for labour and therefore – because wages are rigid – to changes in employment. Full employment becomes the special case where the demand happens to coincide with the supply of labour, but the normal state of the market economy is one of less than full employment.

Money

The demand for money (the liquidity preference) depends on the rate of interest and real income. The interest rate represented the cost of holding financial assets in liquid form. In the Keynesian perspective, an expansionary monetary policy consists in an increase of the money supply by the central bank. For the general public to wish to hold the larger amount of money, the rate of interest must fall. This acts as a stimulus to investment and leads to increased output and employment.

There were two reasons that made Keynes believe that variations in money supply would be of little importance for macroeconomic stabilization.

• He considered investment to relatively intensive to variations in the rate of interest. If the effect is equal to zero, monetary policy would be unable to influence demand, and the only result would be a lower interest rate.

• When the interest rate became sufficiently low, an increase of the money supply would be no effect on investment demand.

Stabilization Policy

Keynes focus was on fiscal policy and an effective tool of stabilization policy. Fluctuations in private investment demand could be counteracted by variations of public expenditure in the opposite direction. As an alternative, private consumption demand could be stimulated by lower taxes which would have their own multiplier effects on national income. The ‘classics’ stated that an increase of public expenditure would push up the rate of interest and reduce private investment, possibly by so much that there would be no net effect of demand and employment. Keynes was more optimistic.

A controversial aspect of his analysis was that he not only emphasized the unpredictability of private investment; he also believed that private investment was on a long-run declining trend as a result of a decreasing rate of return on capital. Keynes was not an adversary of the market economy. The market system alone was incapable of achieving a state of full employment, the markets were in need of the help of the government to reach this state, but once reached, the markets could be left to do their work according to the classical recipe for an efficiently functioning economy.

The followers of Keynes: Keynesians

The first to suggest a more formal representation of Keynes’s theories was the English economist John R. Hicks in his article Mr Keynes and the Classics (1937). He proceeds to construct a mathematical model that aims to provide a compact summary of the General Theory and at the same time illuminate the relationship between Keynes and the ‘classical economists’. Hicks developed the model that became later known as the IS-LM diagram (figure 15.1). According to Hicks, the LM curve was almost vertical because money demand was independent of the interest rate. By contrast, Keynes’s view was that money demand was very sensate to changes in the interest rate; in fact, so sensitive that the LM as a special case – the liquidity trap – was practically horizontal for sufficiently low interest rates.

Another major proponent of Keynesian theory was Alvin Hansen (1887-1975) with his book A Guide to Keynes (1953), which did much to the spread of knowledge of Keynesian thinking in the US. Probably of even more importance was the fact that Paul Samuelson gave the new macroeconomic a prominent place in his textbook Economics: An Introductory Analysis (1948). He introduced the so-called 45° diagram (figure 15.2) that was designed to demonstrate how national income in the short run was determined by aggregate demand.

The diagram is a further simplification of Hicks’s model. The 45° diagram is a representation of the case where Hicks’s IS curve is vertical, so that the level of national income is determined exclusively by the condition of equality between planned saving and planned investment. It is remarkable that both simplifying versions neglected the analysis of the labour market that Keynes gave such prominent place in the General Theory.

Long-run development

The core of Keynes’s theory is related to the short run. However, Keynes also had a long run, more loosely sketched theory of the development of the market economy in chapter 16 of his book, based on two elements:

• As capital accumulates the marginal return on it will decline, and this weakens the private incentives to carry out new investment projects

• Decreasing average propensity to consume means that with a growing national income the share of saving goes up, leading to an increasing gap between saving and investment with a corresponding tendency to long-run permanent unemployment.

Other writings

He also wrote essays on Marshall, Malthus, Edgeworth, and Jevons in his Essays in Biography (1933) and further he wrote articles in Essay in Persuasion (1931). He contributed to the development of economic theory in more ways, which were more indirect. In his polemics against the Versailles Peace Treaty he had argued that large amount of war reparation that were imposed on Germany would have as a secondary effect that the terms of trade would turn against Germany, thereby placing a burden on the country’s economy that came in addition to the direct payments of reparation.

Chapter 16: Econometrics

In most books and articles that attempted to discuss the relationship between economic theory and real world observations, empirical data served simply as illustrations of the importance of the issues that were being discussed. There were no serious discussions of how economic theories could be systematically tested and little awareness of the problems that such tests would raise. It were later when birth was given to econometrics, the systematic application of mathematical and statistical methods to the study of economic relationships.

Early applications of statistics

The first studies of the pattern of consumption across income classes were motivated by a concern with social inequality. In the late eighteenth century budget data for poor families was collected with the aim of throwing light on their vulnerability to increases in the prices of food, clothing and fuel. In the latter half of the nineteenth century the analysis of budget date became more sophisticated: researches in the area were no longer content to construct tables that showed the variation of consumption outlays with income, but began to fit mathematical functions to their statistical data. This enabled them to compute what we would now call the income of Engel elasticity.

Another important area of application of statistical methods to economic problems was the study of the business cycle. While explanations of the cycle led an uneasy life on the outskirts of economic theory, empirical economists were well aware of the importance of the changes in economic life between good and bad times. Some economists felt that the primary task in the study of the business cycle lay not in the construction of formal theories but in the systematic and careful collection of data.

Many of the problems that arose in the early applications of statistical methods to economic data clearly called for a more systematic approach to the problems of how to combine mathematical and statistical methods in the study of actual economic data. One of the pioneers of this was Ragnar Frisch.

Ragnar Frisch (1895-1973)

Frish was firmly convinced of the necessity to adopt mathematical and statistical methods both in economic research and teaching. At the international level, this conviction led him in 1930 to become one of the founders – together with Joseph Schumpeter, Irving Fisher, and others – of the Econometric Society, and he became the first editor of its journal Econometrica.

Theory on Consumption & Production

In the theory of consumer demand Frisch was one of the first to develop an axiomatic foundation for utility theory that showed how the utility function could be derived from more elementary hypotheses about preferences and consistent choices. The type of function he preferred was cardinally measurable.

He wrote a book on ‘theory of production’. The book discusses the representation of production processes by means of production functions in great detail and derives the conditions for optimal production and factor use under a variety of market forms.

Dynamics & Business Cycles

Frisch made a distinction between static and dynamic economic theory in his article in 1929. At that time there were few examples of dynamic models in economic theory. The need for a more rigorous dynamic analysis was perhaps most pressing with respect to the explanation of the variations in aggregate economic activity of society.

Frisch most important contribution to business cycle theory rests on a single article, Propagation Problems and Impulse Problems in Dynamic Economics (1993). He constructs a macroeconomic model that describes the demand for money as a function of consumption and investment; consumption as a function of the quantity of money; and investment as a function of the growth of consumption (what later became known as the acceleration hypothesis) together with an equation that describes how new investment projects are spread over time. It is an early explanation of a macroeconomic theory that aimed to explain aggregate economic activity by means of a model with only a few variables and equations.

Econometrics

Frisch was the first to propose the use of the term econometrics to describe a research program that consisted in:

1. Mathematical formulations of economic theories;

2. Systematic tests of the theories using the methods of mathematical statistics.

In his view, the two components were closely interwoven. Statistical analysis of economic relationships was meaningless unless it was based on rigorous theoretical reasoning, that is, on a mathematically formulated theoretical model. Theory, he argues, also played an essential role for our ability to critically interpret empirical observations. This view emerges especially clearly in Frisch analysis of what later became known as the identification problem. For example, whether price-quantity combination data belongs to the supply or the demand curve. Frisch and some other econometricians developed statistical methods that were designed to identify each individual relationship (such as supply and demand) from data observations that simultaneously represented different relationships between the same set of variables – confluence analysis.

Economic Planning & National Accounting

Another area of interest of Frisch was the construction of a system of national accounts. This should be designed according to the rules of double bookkeeping, as these were used in a private company. It was important to construct a system that showed the interrelationships between the various sectors of the economy. This became known as the input-output analysis. However, in spite of Frisch’s contributions, the main honour goes to the Russian-born American economist Wassily Leontief (1906-1999), whose book The Structure of the American Economy (1941) became extremely influential in this field.

Frisch considered national accounting a necessary part of a much larger project, which was to establish an economic and political system based on economic planning. His view was that the national planning models that described the structure and functioning of the economy ought to be supplemented by a so-called macroeconomic preference function that was intended to represent the preferences of politicians regarding goals such as consumption, investment, income distribution, and employment.

Systems Debate

He never joined the great systems debate of the 1930s and 1940s. But he was an participant in the economic and political debate in Norway, often on the issue of socialism versus market economy. The main alternatives in terms of economic systems, he argued, are the unenlightened financialism in the Common Market and the ‘rule of social planning’. While the form term was characterized by the market economy, the latter was characterized by rational economic planning.

Keynes-Tinbergen Debate

The first to construct a model that could be used to give picture of the actual development of a real economy was the Dutch economist Jan Tinbergen (1903-1994). His first effort was an attempt to construct a numerical model of the Dutch economy that could be used as a foundation for anti-depression policies. It laid the foundation for the work on large numerical models of the economy, which at present play an important role for business cycle forecasts and public policy design in many countries. By feeding real economic data into his models, Tinbergen was able to show that they generated cyclical movements that corresponded well with empirical experience.

Given the novelty and complexity of Tinbergen’s approach, it was not surprising that his would should initially have been met with a good deal of criticism. The most famous of his critics was no less than John Maynard Keynes, who showed little appreciation of the nature of Tinbergen’s pioneering contribution, focusing instead on what he perceived as a lack of reflection on the logical foundations of his program of research.

Trygve Haavelmo’s contributions to econometrics

It was Haavelmo’s contributions to econometrics that laid the foundations for his Nobel Prize award. His main work in the field is the monograph The Probability Approach in Econometrics (1944). The focus of this work as well as a series of article from the 1940s is on fundamental methodological issues, and his most important message is that economic theory and the statistical estimation of theoretical relationships must be regarded in clos connection with each other.

• Statistical estimation must take account of the restrictions that theory places on the relations that one wishes to test;

• To be empirically useful the theory must be reformulated in the probabilistic terms, for it must allow for the fact that the theoretical relationship will not hold in an exact sense when we attempt to test them against data.

The test of an economic theory by the use of empirical data requires that one reflects on the relationship between the variables of the theory and the real-life data that we select to present them.

One important concept that Haavelmo introduces was that of autonomy. An economic relationship is said to be autonomous when its character is unaltered with changes in the other relationships that characterize the economy. Haavelmo also made important contributions to the understanding of the identification problem, where he extended the analysis of Frisch and others. Finally, he contributed a path breaking analysis of what became known as the problem of simultaneity. In an economic model consisting of a set of n equations between n variables Haavelmo showed that it leads to erroneous conclusions if we try to estimate one of the equations in isolation from the n – 1 other equations in the model. Ideally, therefore, one ought to estimate all equations in the model simultaneously.

Econometrics’ Progress

The emergence of the econometric approach has had a deep influence on theoretical and empirical economics.