The History of Economic Ideas:

1

• The History of Economic Ideas
• How Did We Get Here from There?
• Peter Fortune
• Ph.D. Harvard University
• www.econseminars.com

2
The Primary Reference for this Course IsBlaug,
Mark. Economic Theory in Retrospect,Fifth
Edition, Cambridge, England, 1997
3

• Major Economic Questions
• ? How Will Economic Decisions be Made?
• Tradition Tribes and Villages
• Command National or Regional
• Market The Needs and Wants of Consumers
• ? What Is the Source of Economic Surplus (The
• Wealth of Nations)?
• ? What Determines the Distribution of Wealth and
• Income?
• By Functional Shares (Labor, Capital,
  Land)
• By Wealth Holder or Income Recipient
  (Percentile)

4

• Major Economic Questions
• ? Production, Consumption, Pricing and Allocation
• What will be Produced, How Much, and For
  Whom?
• What Prices will be Attached and Who will
  Pay Them?
• How Will Factors of Production be
  Allocated across Firms
• and Consumers, and at what prices
• ? How Efficient is the Allocation of Resources
  and
• Production?
• Economic Efficiency vs. Engineering
  Efficiency
• Judging Economic Efficiency
• ? The Nature of Business Cycles (General
  Gluts)?
• Why Can General Gluts Occur?
• Monetary vs. Real Causes

5

• Major Economic Philosophies
• ? Mercantilism
• Jean-Baptiste Colbert, Richard
  Cantillon, John Lock, David Hume
• ? Physiocracy
• Francois Quesnay, Pont de Nemours,
  Mirabeau
• ? Capitalism I The Merits of a Market Economy
• Adam Smith, David Ricardo, John Stuart
  Mill, F.Y. Edgeworth,
• Alfred Marshall, F. A. Hayek, Milton
  Friedman
• ? Capitalism II The Pitfalls of a Market
  Economy
• Recession and Depression
• Thomas Malthus, John Maynard Keynes
• ? Socialism
• Karl Marx, Joseph Schumpeter, The
  Fabians

6
Economic Thinking Before Adam Smith
Mercantilism and Physiocracy
7
Jean-Claude ColbertandMercantilism
8

• ? Jean-Baptise Colbert (1619-1683)
• Finance Minister to Louis XIV (1665-1683)
• Louis XIV was extravagant and constantly
  at warneeded
• treasure
• Colbert believed that the source of
  national strength is money
• (specie)
• and that government must encourage
  specie inflows
• especially to the Kings coffers!

9

• ? Colberts Policies
• Tariffs on imported goods to discourage
  imports and generate
• tax revenue
• Internal improvements (bridges, roads,
  canals) to promote
• exports
• Regulation of French product
  characteristics to promote brand
• identity
• Tax reform to get the rich to pay their
  taxes and to lessen the
• burden on the poor
• Subsidies to French agriculture and cloth
  to encourage exports
• and discourage imports
• Formation of French colonies to create
  gains from trade

10
Critics of Mercantilism
11

• ? Richard Cantillon (1680-1734)
• Irishman with Spanish name writing in
  French--little is known
• about him
• A speculator in John Laws enterprises
• Charged with murder
• Wrote A Treatise on the Nature of General
  Commerce his
• only known work
• The treatise outlined the first general
  equilibrium model of an
• economy (two sectors trade and
  agriculture) with both prices
• and quantities determined

12

• ? Cantillons Ideas
• Influenced the Physiocrats by proposing a
  land theory of
• value--only land adds to value
• Proposed that inflows of money created
  increases in prices
• (inflation), not more trade
• and that mercantilist policies to create
  a trade surplus were
• self-defeating
• laid the foundations for David Humes
  Price-Specie Flow
• Mechanism
• and for the Quantity Theory of Money

13

• ? David Hume (1711-1776)
• Scottish Philosopher and Friend of Adam
  Smith
• Influenced by English empiricists John
  Locke and Bishop
• Berkeley. Hume believed that only
  concepts which were
• observable had meaning.
• Argued that morals arise from the utility
  they createmoral
• rules exist because we all benefit
  Influenced Smiths
• Theory of Moral Sentiments (1759)
• Died in 1776 -- the year The Wealth of
  Nations was
• published

14

• ? David Humes Price-Specie Flow Mechanism
• Proposed that in a specie money system
  (fixed exchange
• rates) there is an automatic
• mechanism in which specie flows between
  countries create
• inflation in the long run
• When the domestic currency weakens enough
  so that
• foreign currency price goes
• above the gold export point, gold is
  sent abroad and
• domestic prices fall while foreign prices
  rise
• When the domestic currency strengthens
  enough so that
• foreign currency price goes below the
  gold import point
• gold is sent from abroad and domestic
  prices rise while
• foreign prices fall
• Thus, policies to induce importation gold
  ultimately only
• change prices levels in domestic and
  foreign currencies
• gold flows do not increase real
  purchasing power

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• ? Hume on Money and Inflation
• Hume formalized the money-price level
  link as the
• Equation of Exchange (MVPT)
• Is this a tautology? If V?PT/M then
  MVPT reduces to
• PTPT! Gibberish!!, But when
  supplemented by theories of
• M, V, P and/or T it is valid.
• A common theory of V was
• ? V is not identically equal to PT It
  is only so in an
• economic equilibrium.
• ? Velocity is determined by the
  synchronization between
• receipts and expenditures
• The quantity theory assumes M is a
  Medium of
• Exchange, not a Store of Value.
• The Implication is that in a fully
  employed economy the
• price level is proportional to the money
  supply

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Francois QuesneyandPhysiocracy
18

• ? Francois Quesnay (1694-1774)
• French Physician ennobled by Louis XV as
  his thinker
• With Jean Gournay formed the French
  Economistes, called
• the Physiocrates
• The Physiocrats became the leading
  economic thinkers of
• France
• Wrote the Tableau Economique, considered
  by many the
• first great economic analysis

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• ? The Tableau Economique (1758)
• Land is the only source of economic
  surplus (wealth)
• Labor and capital only earn what is
  needed to maintain
• them so their earnings only replace the
  value used up in
• the act of production
• Land is a free gift from God and does not
  need to be
• maintained. Landlord receipts in excess
  of payments to
• labor and capital are the only source
  national wealth
• This was demonstrated by a table of
  receipts and
• expenditures for workers, landlords and
  capitalists (the
• Economic Table)
• Made a distinction between productive
  labor(labor in
• agriculture, the source of excess
  value) and unproductive
• labor (labor in industry and trade).
  Smith would make the
• same distinction but with different
  definitions.
• The only measure of economic health is
  the income of
• landlords

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• A Summary of Pre-Smithian Ideas
• ? A theory of the price level had emerged from
  Cantillon and Hume
• ? Economists had struggled with the Issue of what
  is the net value
• of economic activity The Mercantilists
  looked to gold and silver,
• the Physiocrats to agricultural output
• ?The triumvirate of players--land, labor, and
  capital--had been
• formed
• ? A subsistence theory of wages had been
  introduced
• ? A discussion about when income was necessary
  and when
• it was value added had been opened by the
  distinction
• between productive and unproductive labor
• ? Economic activity was heavily regulated with
  the goal of
• promoting National Welfare

21
The Advent Of Economic Science Smith, Ricardo,
Malthus and Marx
22
Adam Smith
23

• The Birth of Capitalism Adam Smith
• ? Adam Smith (1723-1790)
• Scottish moral philosopher, wrote The
  Theory of Moral
• Sentiments (1759) Why are we
  self-interested yet not at
• each others throats? Answer the capacity
  for empathy
• Adhered to Humes view that morality came
  from our
• experience and psychology, not from innate
  principles or
• from reason, but rejected Humes notion
  that utility is
• source of moral sentiments
• Published An Enquiry into the Nature and
  Causes of the
• Wealth of Nations in 1776. Applied his
  view of moral
• sentiments to economic matters
  self-interest motivates
• people to make economic decisions that, as
  if guided by
• an invisible hand,

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• ? Smiths Economic Philosophy
• Self Interest (with moral sentiments)
  combined with
• individual freedom is the source of
  economic wealth
• The mechanism is that self-interested
  responses to prices
• and opportunities leads to improved
  production and
• consumption decisions
• In the long run, free entry and exit
  leads to zero profits for
• firms (economic profits) while wages
  stay at the
• subsistence level
• Regulation of economic decisions (as in
  Mercantilism)
• reduces the general welfare by thwarting
  incentives and
• preventing free choices benefit all.
• There is no inherent economic conflict
  between labor,
• capital, and land all benefit from the
  free choices made
• by others

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• ? The Dynamics of Capitalism
• The fundamental driving force in capitalist
  accumulation The
• capitalist automatically saves his profits
  and thus induces
• economic growth
• Economic growth encourages a division of
  labor creating
• increases in productivity which add to
  profits and to further
• capital accumulation (the pin factory
  example)
• In the short run, capitalist accumulation
  leads to increases in
• wages and decreases in the profit rate as
  capitalists compete
• for markets.Also, increased wages induce
  population growth
• which--with a lag of many years--adds to
  the labor force and
• reduces wage rates back to original
  subsistence level
• In the long run, free entry and exit into
  production and trade
• leads to zero economic profits for firms
  while wages stay
• at the subsistence level. Wage and profit
  rates are at
• their natural levels but output and
  population have grown

26

• ? International Trade
• International trade is different from
  domestic interregional
• trade because capital and labor are
  domestically mobile,
• but internationally fixed
• Absolute advantage directs trade
  Countries produce and
• trade those goods which they can produce
  more cheaply
• than others
• Free trade benefits all--world production
  and domestic
• welfare are maximized by encouraging
  purchase of low-
• priced imports and sale of high priced
  exports

27

• ? Smiths Theory of Value
• Value in Exchange (relative price) vs
  Value in Use (total
• utility) The Water-Diamonds Paradox
• Long Run Value in Exchange Natural
  Price is Supply
• Determined (Constant Costs)
• Natural Price is set by cost of
  production wagesprofits
• (rent?)
• In the Short Run value in exchange is
  determined by
• Demand and Supply
• Resources shift between industries when
  LR value differs
• from SR value

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Value in Exchange vs. Value in Use The
Example of Free Water
D
Price per Gallon
Value in Use
S
0
S
Gallons Consumed
D
Value in Use Total That Would Be Paid (Total
Utility) Value in Exchange Value That Must Be
Paid (Marginal Utility, or Price )
29

• ? Smiths Theory of Wages
• The Subsistence Theory of Wages subsistence
  is the
• natural price of labor -- the wage at
  which population is
• constant
• The subsistence wage might increase over
  time as
• standards of living improve
• Deviations between subsistence wage and
  actual wage
• induce population changes
• Relative wages (the wage structure) is
  determined by
• differences in cost of employment, and the
  desirability of
• each job (compensating differences)
• Distinguishes between productive labor
  (employed in
• adding value, such as factory or farm) and
  unproductive
• labor employed in the consumption sector
  (servants,
• professors)

30

• ? Smiths Theory of the Profit Rate
• The natural rate of profit is the
  interest rate plus a
• premium for risk
• Deviations between the actual profit
  rate and the natural
• rate induce resource reallocations
• In the long run, free entry and exit
  into production and
• trade leads to zero economic profits
• There is a secular tendency for the
  profit rate to decline
• because of the capitalists proclivity
  to accumulate even in
• the face of diminishing investment
  opportunities

31

• ? Smiths Theory of Land Rent
• Land rent arises from differential soil
  qualities
• (differential rent) not land scarcity
  (scarcity rent)
• Land rent is price-determined,, it is not
  a production cost
• (anticipates Ricardo, Henry George)
• Land rent is a cost of production--Smith
  contradicted
• himself on this issue

32

• ? Smith on Measuring Economic Welfare
• Smith proposed an Invariable Measure of
  Value as a
• measure of price level--something whose
  real value in use
• (utility) does not change over time.
  The price of that thing
• is a price index that can be used to
  deflate nominal
• output
• Today we use price indexes--the average
  price of a
• representative basket of goods. But no
  such thing existed
• in Smiths time
• Smith thought that the the real pain and
  suffering of an
• hour of work was constant and chose the
  money wage rate
• as the price index (the corn wage had
  been constant)

33

• ? Measuring Real National Income
• Smiths measure of national wealth was
  command over
• labor, defined as the amount of labor
  that output can buy
• if there is 100 of of gross product
  (Y) and the wage rate
• (w) is 5, then there are Y/w 20 units
  of labor
• commanded
• Effectively, this made the employed labor
  force his
• measure of national wealth (Y/wN)
• One might argue that the inverse is a
  better measure--the
• less labor is employed to produce
  national output, the
• greater is productivity and the more
  output can be
• produced.

34
? Monetary Policy The Real Bills Doctrine
Real bills were bank loans on paper used
to trade in newly produced goods. This
was self-liquidating because the
loan would be paid off when the
transaction was completed. Smith
proposed the Real Bills doctrine of money
banks would not create too much money
(leading to inflation) if they
discounted real bills The Real Bills
doctrine, though fallacious, had a long
life and was a tenet of the 1913 Federal Reserve
Act
35
? Fallacies in the Real Bills Doctrine
The fallacies in the Real Bills Doctrine
were the subject of Henry Thorntons
classic An Enquiry Into the Nature and
Effects of The Paper Credit of Great Britain
(1802). The Fallacies ? The
money created by discounting real bills
stayed in circulation during the life of the
bill. But if the velocity of
circulation is normally greater than 1,
lending on real bills adds more to total
spending than the purchase of the
good whose bill was discounted.
? Banks could not distinguish between bills
presented to trade in newly produced
goods and those presented to trade
in existing goods, so money creation
exceeded new production
36
Thomas Robert MalthusEconomics As The Dismal
Scence
37
? Thomas Robert Malthus (1766-1834) Son
of, and frequent debater with, Daniel Malthus --
a perfectabilist who believed that
mankind would constantly improve
materially, spiritually, and morally
Thomas wrote An Essay on Population (1798) to
argue the opposite--mankinds lot in
life is grim, illness-ridden, and
plagued by early death-- and thats the good
news! Thomas corresponded regularly with
David Ricardo, with whom he disagreed
on almost everything economic
38
? Malthuss View of Economic Dynamics
The subsistence wage is the bare minimum, not
just Smiths wage rate at which
population remains constant When wages
rise above the subsistence wage, population
will increass at an exponential rate
Agricultural output (corn--the wage good)
increases at only an arithmetic rate
The outstripping of food supply by
population raises the price of food
(corn), driving the real wage to below the
subsistence, creating starvation, illness
and death This stops when populatio has
fallen enough to raise wages to the
original subsistence level. level again.
39
? The Inevitability of the Malthusian
Apocalypse In later editions of The
Essay, Malthus accepted the possibility
of several automatic checks preventative
factors which weakened the message of
inevitability. These included
? late marriage (fewer births per family)
? moral restraint (fewer illegitimate
births), ? vice (fewer births per
female) ? a high death rate due to
starvation, illness, etc.
40
? The Law of Diminishing Returns Malthus
was among the first contributors to the idea
that there are diminishing return in
agriculture as more variable factors
(laborcapital) are added to an acre,
the average product of labor falls.
Diminshing Returns is one of the reasons why
population growth necessarily exceeds the
growth of food supply David
Ricardo drew on Malthus and others to develop a
more complete theory of diminishing returns
41
? The Possibility of General Gluts
(Depressions) Malthus, in
correspondence with Ricardo, argued that
there could be general gluts, periods of
unsold production and high
unemployment Ricardo disagreed, arguing
that supply creates its own demand the
act of production generates income (wages,
profits, and rent) that was just enough to buy
the produced goods. Ricardo won
the argument in the 19th century mind,
but Malthus is now vindicatedn the general glut
issue It took until the 1930s for
economists to side with himthat was the
Keynesian Revolution
42
? Malthuss Place in the Pantheon
Malthus ignored evidence to the
contrary--agricultural improvements, a
growing British population without the
Malthusian consequences. He was not a good
empiricist Malthus was unscientific (his
theory was not testable because it
allowed for no circumstances in which it could
fail). and his theory had no teeth. He
was not a good theorist
Malthuss contribution to economics is
negligible, but his contribution to how
economics is seen in the popular mind is
extremely powerful
43
David RicardoThe First Economic Theorist
44

• ? David Ricardo (1772-1823)
• A stockbroker considered the first
  rigorous economic
• theorists
• Made major contributions building on
  Smiths ideas
• Best known for theory of land rent and
  theory of comparative
• advantage in international trade
• Frequent correspondent with Thomas
  Malthus

45

• ? Ricardos Theory of Land Rent The Assumptions
• Land is divided into Farms of
  different soil qualities,
• ranging from Best Farm to Worst
  Farm
• Farms produce corn which is used to pay
  the next seasons
• workers (the wages fund) or to
  provide seed for planting
• (circulating capital) or to keep as
  rent
• Corn can be sold at national price
  (farms are price-takers)
• Capital and Labor work together in
  doses with fixed
• proportions labor receives only a
  subsistence wage capital
• earns a normal rate of profit
• On each farm there are diminishing
  returns to increased
• doses the average product (corn per
  dose) declines, so the
• marginal product is less than average
  product and declines
• even faster
• Good farms will be cultivated first,
  then poorer farms. The
• worst farm is the last to be
  cultivated

46

• ? Ricardos Theory of Land Rent The Results
• Each farm will add doses until the
  marginal product of a dose
• equals the cost of a dosethe intensive
  margin
• Rent on each farm is the excess of total
  product over total
• cost of doses
• The best farm will use the most doses,
  produce the most
• corn, and receive the highest rent
• The worst farm produces just enough corn
  to pay for doses
• used it will produce the least corn and
  the landlord will
• receive no rentthe extensive margin
• Rent is not a necessary cost of
  productionit is the residual
• between output and costs rent is
  price-determined, not price
• determining
• Land is required for production, but it is
  not afactor of
• production, that is, not a required cost
  of producing

47

• ? Ricardos Theory of Land Rent Policy
  Implications
• Ricardo argued for an end to the Corn
  Laws (1804-1846),
• which levied a stiff tariff on imported
  corn, because the Corn
• laws raised the price of corn,
  benefiting landlords (who would
• get increased rent) and harming
  manufacturers (who would
• have to pay higher real wages and would
  suffer a fall in
• profits).
• A confiscatory tax on rent could be
  introduced without
• affecting corn productionthe only
  effects would be on the
• distribution of incomelandlords would
  lose and the public
• would gain via increased revenues. On
  this same issue, see
• Henry George and the Fabian Society
• Note In Britain corn was a generic term for
  cereal grains. What we call corn was called maize.

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Ricardo on the Direction of Intl Trade

• ? Ricardos On International Trade Comparative
  Advantage
• Smith proposed that a country would
  produce and export
• a good if it was produced at a lower
  cost than in another
• country (Absolute Advantage)
• Ricardo argued that this could only be
  a temporary
• conditionsuppose a country could
  produce all goods at
• least cost. This would mean that the
  second country
• would export no goods, paying for
  imports with specie,
• driving prices down in the second
  country and up in the first.
• In the long run, imported goods must be
  paid for by
• exported goods, so each country must
  have something to
• export.

51
? The Classic Example of Comparative Advantage
England and France both produce
corn and wine. France produces 2 cases
of wine for each bushel of corn (so the
French corn price of wine is 0.50) England
produces 1 case of wine for each bushel
of wheat (so the English corn price of
wine is 1.0). Question Which Goods
Will Each Country Export to the
other?
52
Comparative Advantage and the Direction of Trade
Answer England specializes in corn and trades
with France for wine to (say) point e
France specializes in wine and trades with
England for corn to (say) point f
Eventually, world corn price of wine settles
between 0.5 and 1.0 Trade pattern
is determined by comparative advantage
Cases of Wine
E
E
F
Bushels of Corn
F
F
E
Analysis If France doesnt trade it must consume
along the line FF England will consume along
EE if it doesnt trade. Both
countries can improve their consumption
possibilities by specializing
in different products, then trading its surplus
France will specialize in wine and sell it to
England at Englands higher
priceconsuming along FF. England will
specialize in corn and sell it to
France at Frances higher price. The trade
pattern is determined by comparative advantage,
not by absolute advantage
53

• ? General Gluts Ricardo vs. Malthus
• Malthus argued that an economy could
  suffer protracted
• periods of depressionperiods with
  excess capacity,
• including high unemployment
• Ricardo responded with Says Law
  Jean-Baptiste Say had
• argued that general gluts were
  impossible because goods
• trade for goods. By this he meant that
  the act of producing
• 100 worth of goods was simultaneously
  an act of creating
• 100 of income (wages and profits) to
  buy the goods.
• Thus, Supply creates its own Demand.
• Ricardo believed that what looked like a
  general glut was
• simply a transitional period when
  resources were shifting
• from declining industries to growing
  industries (buggy
• whips to auto horns).

54

• ? Why Might Gluts Occur?
• One proposed source of gluts was excess
  saving Instead
• of spending the income received from
  producing goods,
• workers and capitalists could save
  (abstain from
• consuming)
• Saving (consumers abstaining from
  consumption)
• could generate offsetting demand only if
  it led to investing
• (business capital expenditures).
• In the early 19th century almost all
  saving was by
• businesses in the form of retained
  earnings that were
• intended to buy investment goods. So
  there was a strong
• link between saving and investment
• The subsequent development of financial
  institutions
• weakened the saving-investment link,
  making general gluts
• more likely

55

• ? Gold Exports and Note Depreciation in the
  Napoleonic Wars
• England ran large international deficits
  to buy war goods,
• borrowing heavily to finance the wars.
  Poor wheat harvests
• compounded the deficit by raising
  imports of foodstuffs.
• The demand for foreign exchange increased
  sharply, leading
• to a price of gold, at the gold export
  point. Gold began
• flowing out of the Exchequer.
• To prevent the loss of gold, the
  Exchequer and the Bank of
• England suspended convertibility of
  notes into gold. As a
• consequence, the price of gold (in
  notes) rose to a premium
• above the mint parity stated in
  language of the day, notes
• depreciated.
• The reason for the note depreciation was
  hotly debated in
• The Bullionist Controversy, in which
  Ricardo played an
• important role.

56

• ? The Bullionist Controversy
• Ricardo argued that the premium on notes
  was due to the
• suspension of convertibility the Bank of
  England had
• weakened the currency, thereby inducing
  inflation in the note
• price of gold and other goods. This
  became known as The
• Currency School.
• The Bank of England responded that it
  could not cause
• inflation because it adhered to the
  real bills doctrine,
• creating notes by discounting real
  bills (self-liquidating
• commercial notes created by trade). This
  became known as
• The Banking School.
• Who was right? Ricardo had the upper hand
  because the real
• bills doctrine was a fallacy see Adam
  Smith

57

• ? Ricardos Invariable Measure of Value
• Ricardos Invariable Measure of Value was
  designed to serve
• two goals
• ? Provide a price index to compute
  real national output
• ? Determine the source of variation in
  relative prices
• Ricardo proposed using the commodity with
  average capital
• and labor per unit produced, and with
  average durability of
• capital. Its price (average cost of
  production) would be the
• average of all prices, against which both
  relative prices and
• the price level could be measured
• Ricardo arbitrarily chose gold as the
  average commodity, so
• the price of gold was his price index
• ? By dividing the value of national
  product in pounds sterling
• by the sterling price of gold the
  real value of national
• could be calculated
• ? If the price of a good is rising
  (falling) relative to gold, the
• cost of producing that good is rising
  (falling) relative to all goods

58
? Ricardos View of the Dynamics of Economic
Growth As an economy grows its labor
and capital both grow As labor
increases, the demand for food (corn) rises,
the price of corn increases relative
to the price of manufactured goods
(cloth) As the price of corn rises,
less fertile land is brought into
production, and total land rent increases
The increasing price of corn relative to cloth
raises wage rates relative to the
price of cloth and the profit rate
declines In summary, as an economy
grows the share of output going to
rent increases, the profit rate on capital falls,
and the real wage rate rises
59
Jean-Baptiste Say
60
? Jean-Baptiste Say (1767-1832)
Laissez-faire French economist who built on
Smiths The Wealth of Nations
Published A Treatise on Political Economy in
1803 Worked as a finance secretary to
Napoleon government until 1804, when
Napoleon told him to rewrite the Treatise
to support his war aims. Say left
government and went into the textile business
Say taught at French universities after
leaving the textile industry in 1812. He
had become wealthy and was an active
speculator In 1832 Say was given the first
chair in economics at the prestigious
College de France
61
? Says Law Jean-Baptiste Say was first
to argue against the possibility of
extended periods of excess capacity (general
gluts) His claim was that commodities are
bought with commodities, by which he
meant that the act of producing generated the
income necessary to buy an equal amount of
goods Example ? A widget maker
produces 100 widgets and sells them at 10
each ? The 1000 received is paid out
to labor (750), kept as business
profit (150), or used to pay suppliers 100)
? Workers spend 750 on corn and cloth, the
widget factory owner spend 150 on
equipment to produce more widgets,
and the suppliers 100 is also distributed as
wages (and spent by workers) or kept
as profits (and spent on new
equipment) ? Supply (1000 of goods sold)
has created its own demand (1000 of
spending)
62
? The Problem of Hoarding
Economists after Say accepted one caveat to Says
Lawif businesses and individuals use
their income to accumulate cash (read
gold or silver) that breaks the link
between income received from production and
spending on produced goods, creating an
excess supply of goods and a busness
contraction. The opposite could also
occura boom could be created by
dishoardin But hoarding and dishoarding
are temporary phenomena. Once the
desired money balances are accumulated or
decumulated, the hoarding or dishoarding ends
So even if hoarding is a problem, it can
not explain a prolonged state of excess
capacity and high unemployment
63
Ricardian SpinoffsHenry George and the Fabians
64

• ? Henry George (1839-1897)
• George was a journalist,
  author, and speaker on economic
• matters who was influenced by David
  Ricardo and John
• Stuart Mill
• Wrote Progress and Poverty (1879),
  arguing that
• ? Economic rents (from monopoly,
  land ownership, etc)
• were the source of an unequal
  distribution of income
• ? Taxes affected incentives to
  produce, consume, invest,
• work, and save. In modern
  terms, taxes had an excess
• burden, creating a loss to
  society, not just a transfer of
• purchasing power
• ? On Ricardian grounds, land rent
  was an unnecessary
• payment that could be taxed
  without altering the
• allocation of resources
• ? The only tax should be a tax on
  land rents sufficient to
• generate the required revenue
  this was the Single Tax
• proposal

65

• ? Henry Georges Single Tax
• The only tax should be a tax on
  land rents sufficient to
• generate the required revenue this
  was the Single Tax
• proposal
• ? The Single Tax would be
  efficient, having no excess
• burden because landowners would
  not reduce
• cultivation
• ? The Single Tax would also have
  the advantage of
• discouraging speculation in land
  (but is speculation
• bad?)

66

• ? Henry Georges Single Tax
• Critics argued that
• ? this was nationalization and that
  landowners should be
• fully compensated for the taxes
• they would pay.
• ? George realized that this would gut
  the idea by requiring
• government to pay for the future
  taxes in a lump sum.
• The Single Tax was a very popular idea
  but had a number of
• problems. Chief among them
• ? The difficulty in separating the
  site value of land from the
• value of improvements
• ? The issue of compensation
• ? The possibility that if land had
  alternative uses not all
• rents were unnecessary payments
  (e.g. if arable land
• could be converted to residential
  uses)

67

• ? The Fabian Society
• Formed in 1864 named after Quintus
  Fabius Maximus, the
• Roman General whose tactics against the
  Carthaginians
• involved delay and attritionthe tactics
  used by the
• Fabians in their reform efforts.
• The Fabians were the preeminent British
  intellectual society
• of the time, with members like Sidney
  and Beatrice Webb,
• George Bernard Shaw, John Maynard
  Keynes, and a host
• of other leading lights
• The Fabians were instrumental in
  creating the Labour Party
• The Webbs and Bernard Shaw started the
  London School
• of Economics

68

• ? The Fabian Societys Political Agenda
• Improving the distribution of income
• Encouraging universal public education
• Nationalizing land and essential
  capital-intensive
• busineses (utilities, transportation,
  etc)
• Protectionism in international trade

69

• ? The Fabian View of Economic Dynamics
• Land rent was an unnecessary payment to
  the landowner of about
• 15 of national income (according to
  Shaw)
• As Britains population grew, land rent
  would grow as a share of
• national income (according to Shaw)
• Public ownership of land would have no
  effect on agricultural
• production but rents would go to the
  national treasury for public
• uses
• BUT the facts were different
• ? Land rent was about 5 of national
  income
• ? The land rent share had been
  declining
• .

70

• ? George Bernard Shaw and Sidney Webb
• Were the leaders of the Fabian Society
  in the last decades of
• the 19th century.
• Both were economic dilettantes though
  tutored by Jevons
• and Wicksteed.
• Shaw and Webb believed that
• ? the distribution of income in Britain
  was grossly unfair and
• ? public ownership of land (and some
  capital) was a way of
• addressing the inequality of income
  distribution
• ? the Marxian argument for socialism
  (public ownership of
• capital) was seriously flawed but
  the Ricardian argument
• for public ownership of land was
  solid
• ? Webb and Shaw attempted to extend
  their conclusion to
• urban rents by trying
  (unsuccessfully) to treat interest on
• capital (urban buildings) as
  equivalent to land rent.

71

• ? Rural Land Rent vs. Urban Ground Rent
• Webb and Shaw attempted to extend their
  conclusions to
• urban land
• The problem with urban rents is that
  most of it consists of
• necessary expenses
• ? The owners Interest payments or
  opportunity costs
• ? The owners management expenses
  and taxes
• ? The owners opportunity cost of
  other uses of the land

72
Karl MarxThe Communist Critique Of Capitalism
73

• ? Karl Marx (1818 - 1883)
• Marxs chief cheerleader was Frederick
  Engels, with
• whom he wrote The Communist Manifesto
  (1848)
• Published three-volume Das Kapital (Vol
  1, 1867, Vol 2,
• 1885 Vol 3, 1894) the last two
  volumes were
• posthumous, completed by Engels
• Viewed his work as the natural result of
  Smith and
• Ricardo, but believed that Smith and
  Ricardo failed to
• see that capitalism was a transitional
  system
• Marx wanted to demonstrate that
  capitalism was
• unsustainable and would morph into
  socialism
• Marx was an adherent of Hegels
  philosophy of thesis-
• antithesis-resolution
• Marxs philosophy of dialectical
  materialism applied
• Hegel to the economic (material) system
  

74

• ? Marxs View of Production Costs
• All production is attributable to either
  living labor (current
• workers) or to dead labor (machinery
  constructed by past
• labor). Thus, the value of a machine is
  its embedded labor
• Payments to labor per unit of output
  (variable capital,
• denoted as v) are labor hours employed
  times wage rate
• required to just maintain the worker
• Payments to capital per unit of output
  (constant capital,
• denoted as c) are the value of the
  dead workers labor
• embedded in the equipment. This is equal
  to the price paid for
• the machine (that is, the value of the
  embedded labor) divided
• by the years the machine lasts we call
  this straight line
• depreciation
• Thus, the necessary costs of production
  are cv, the cost of
• the dead labor plus the cost of the
  living labor

75

• ? Marxs Theory of Surplus Value
• Labor produces a surplus value (call it
  s) which goes to the
• capitalist because of his control over
  the access to capital.
• Surplus value is the value of labor
  employed by the capitalist
• but not paid out as wages.
• Surplus value does not exist because of
  any necessary returns
• to capital. It is simply expropriated
  labor.
• Surplus value can be thought of as extra
  hours the worker is
• required to work beyond those hours
  necessary to pay his
• subsistence wage.
• Both the rate of profit (s/(cv) and the
  rate of surplus value
• (s/v) are the same for all capitalists
  because of competition
• ? Machinery (constant capital) will move
  from lower to higher
• profit rate industries until the
  profit rate is equal in all industries
• ? Labor (variable capital) will move
  from higher to lower
• surplus value rate industries until
  the profit rate is equal in all
• industries

76

• ? The Internal Contradictions of Capitalism
• Capitalists save all surplus value,
  investing the proceeds
• in labor-saving constant capital
  
• As constant capital increases, labor
  demand increases,
• wages rise, population increases, and
  national product
• grows
• The economys capital/labor ratio grows
  as capital grows
• more rapidly than labor--firms become
  more capital
• intensive, and big business emerges
• As businesses become more capital
  intensive the rate of
• profit falls
• To maintain profits, capitalists engage in
  strategies to
• increase the rate of surplus value, i.e.
  they increase the
• exploitation of labor by lengthening the
  work day, they
• substitute equipment for workers in an
  effort to increase
• productivity, they shift capital to
  foreign (low wage)
• regions, they intimidate workers through
  government
• repression, and so on.

77

• ? The Final Phase of Capitalism
• Ultimately--and inevitably--exploitation
  turns into
• revolution and the exploiters become
  the exploited a
• worker state is formed and the means
  of production are
• owned and controlled by a workers
  government
• Socialism is the new thesis, and it
  will have its own
• internal contradictions which create
  tensions that
• eventually lead o yet another economic
  system, as yet
• unknown.
• And so it goes

78

• ? Marxs Labor Theory of Value
• Marx adhered to a labor theory of
  value--The relative price of
• any two goods is the relative labor
  living labor content of
• the goods, that is
• (p1/p2)
  (v1/v2)
• The Labor Theory of Value is extremely
  flawed because it
• contains a great contradiction
• ? On the one hand, Marx recognized that
  capital costs
• (constant capital) are costs of
  production that should be
• recovered in the price of the
  product
• ? But Marx insisted that only living
  labor affects relative
• costs

79

• ? Fundamental Problems in Marxs Economic
  Analysis
• The Transformation Problem
• ? The Transformation Problem is the
  problem of how relative
• labor values can be transformed into
  relative prices of
• goods
• ? The only resolution is that all goods
  must be produced with
• the same c/v, which Marx called the
  organic composition
• of capital, and we now call the
  capital-labor ratio.
• ? Both Ricardo and Smith had rejected a
  labor theory of
• value precisely because goods are
  produced with different
• capital-labor ratios. But Marx
  insisted that the labor theory
• of value was valid.
• ? The transformation problem bothered
  Marx greatly, and it
• lead to many years of study before
  his (incorrect)
• resolution appeared in Volume 3 of
  Das Kapital.

80

• ? Fundamental Problems in Marxs Economic
  Analysis
• What keeps wages down in Marxs
  capitalist system?
• ? Marx rejected the Malthusian
  concept of wage-related
• population changes instead, he
  postulated a reserve
• army of the unemployed as a
  mechanism keeping wages
• down--high unemployment was
  chronic and was created
• for the benefit of capitalists
• ? The reserve army was created as a
  result of labor-saving
• bias in new capital
  goods--workers were displaced by
• equipment.
• ? Three problems with this
• - Evidence does not suggest that
  technical progress is
• labor-saving
• - What prevents the unemployed
  workers from getting
• jobs by reducing wage demands?
• - Capitalist economies do not
  exhibit chronically high
• unemployment

81

• ? Fundamental Problems in Marxs Economic
  Analysis
• Can Surplus Value Exist in a Capitalist
  System?
• ? Marx argued that profits are surplus
  value--free labor
• extracted from workers because
  capitalists control the
• means of production--and that the
  rate of surplus value was
• the same in all industries
• ? But if surplus value is costless to
  the capitalists, why
• wouldnt they bid for labor until
  the workers were paid the
• whole product and surplus value is
  zero?
• ? Thus,something must prevent this
  competition for labor
• Marx rejected centralized business
  (monopoly power) in
• his analysis and had no other
  answers

82
? Fundamental Problems in Marxs Economic Analysis
? Does Marxs Analysis Fit the Data?
PREDICTION TRUE FALSE
Wage rate constant over long periods X
Rise of Big Business X
Increasing Capital per Worker X
Falling Profit Rate X
Increasing Investment Abroad X
Rise of Socialism X X
Decline of Capitalism X
High unemployment (Reserve Army of the Unemployed) X
Labor-saving bias in technology X
83
? Marxs Place in the Economic Pantheon
Marx was not a Great Economist ?
Marxs work is filled with inconsistencies,
contradictions, and poorly
developed ideas ? Marxs worst misses
were in the areas that modern
economists value most Marx scores much
better as a visionary ? Foresaw the
rise of Big Business long before it appeared
? Predicted the emergence of colonialism
driven by economic interests
? Understood the importance of government as a
source of support for economic
interests Marx is best viewed as a
powerful sociologist, not an economist
84
Neoclassical Economics The Integration Of Demand
and Supply And The Determination of Prices and
Quantities John Stuart Mill and Alfred Marshall
85
John Stuart Mill
86

• ? John Stuart Mill (1806-1873)
• Mills father, James Mill, was an eminent
  economist his
• godfather was Jeremy Bentham, the
  founder of utilitarianism
• (whose skeleton still stands in a
  conference room at
• Cambridge University)
• Mill was an important philosopher among
  his major
• contributions were A System of Logic
  (1843), On Liberty
• (1859), Considerations on Representative
  Government
• (1860), and Utilitaranism (1863)
• His The Principles of Political Economy
  (1848) was the
• premier economics textbook until the
  1920s. Mill considered
• himself a follower and expositor of
  Smith and Ricardo-not an
• innovator
• He served as an independent Member of
  Parliament in 1865-
• 66, advocating womens suffrage, a light
  hand on Ireland,
• proportional representation, labor
  unions, and other liberal
• causes

87
? Mills Contributions to Price Theory (Demand
and Supply) Introduced the idea of
demand and supply as relationships
between price and quantitythe price of a good
and its quantity produced (consumed) are
simultaneously and jointly determined
in a process of market clearing It was no
longer necessary to treat prices as determined
only by cost-of-production only and
quantities as determined only by
price-insensitive demand This initiated
the development of microeconomicsthe study
of the role of prices as signals and of the
allocation of resources (capital, labor,
land) between industries and firms It
also introduced the analysis of prices as
incentives, an idea that had been
loosely introduced by Smith but had not been
an integral part of economic analysis
88
The Smith-Ricardo Classical Analysis of Markets
Price
Price
D
S
D
D
P
P
S
S
S
D
Quantity
Quantity
Q
Q
Classical Case 1 Quantity is Demand-Determined Pr
ice is Supply-Determined Note that in both
cases, Price and Quantity Changes are independent
(uncorrelated) An increase in demand (rightward
shift) raises quantity produced, not price an
increase (upward shift) in supply raises price
but does not affect quantity
Classical Case 2 Price is Demand-Determined Quant
ity is Supply-Determined
89
The Mill-Marshall Neo-Classical Analysis of
Markets
Price
D
S
P
D
S
Quantity
Q
Price and Quantity are Jointly Determined. As
Alfred Marshall said price determination
requires two blades of the scissors A Test for
Demand or Supply Shifts Prices and Quantities
are positively correlated when demand
shifts Prices and Quantities are negatively
correlated when supply shifts Note that the
analysis involving shifts of only DD or SS
assumes that demand and supply shift for
different reasons. In neoclassical theory, demand
depends on tastes, on prices of substitute or
complementary goods, and on consumer income.
Supplty depends on technology and the costs of
factors of production
90
? Mill on the Gains from Trade The
Physiocrats and the Classical Economists had
great trouble explaining why markets
create value added for a society
? If the cost of producing every unit of a
good is the same, the total cost
of production is equal to the value
to the total value to consumers ?
In this case, markets simply transfer alue from
one part to another. The is no
net value added. Mill distinguished
between average production costs (total
cost per unit) and marginal costs (the cost of
producing the last unit
Similarly, he distinguished between the average
value of a good to consumers (total
value divided by number of units
consumed) and the marginal value (value of the
last unit) As a result, he could show
that trade in markets created value added
for all concerned. This was called the Gains
from Trade.
91
The Gains from Trade Measuring an
Economys Value Added
Demand Schedule
Price
Supply Schedule
Consumer Surplus
P
Economic Profit
Producer Costs
S
Quantity
Q
P x Q Area Area
Consumer Spending on Soybeans
Revenue (Sales) of Soybean Producers
Cost of Soybean Production to Society Area
Area Consumer
Surplus
Economic Profit

Societys Net Gain from Trade
92
? Mills View of the Link between Wage Rates and
Employment Mill adhered to the Wages Fund
Doctrine, arguing that because of lags
between production of goods and consumption by
workers the capitalist had to save previous
production in order to pay workers
Saving was an advance of wages, not
accumulation of fixed capital If K is the
wages fund to be paid out in this production
period, then the wage rate per hour (w)
and the number of man-hours employed was
related by the simple equation
wN K or N