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The History of Economic Ideas:
How Did We Get Here from There?
Peter Fortune
Ph.D. Harvard University
www.econseminars.com
1
The Primary Reference for this Course Is:
Blaug, Mark. Economic Theory in Retrospect,
Fifth Edition, Cambridge, England, 1997
2
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)
•
3
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
4
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
5
Economic Thinking
Before Adam Smith:
Mercantilism and Physiocracy
6
Jean-Claude Colbert
and
Mercantilism
7
 Jean-Baptise Colbert (1619-1683)
• Finance Minister to Louis XIV (1665-1683)
• Louis XIV was extravagant and constantly at war—needed
treasure
• Colbert believed that the source of national strength is money
(specie)
• … and that government must encourage specie inflows
• … especially to the King’s coffers!
8
 Colbert’s 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
9
Critics of Mercantilism
10
 Richard Cantillon (1680-1734)
• Irishman with Spanish name writing in French--little is known
about him
• A speculator in John Law’s 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
11
 Cantillon’s 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 Hume’s “Price-Specie Flow
Mechanism”
• … and for the “Quantity Theory of Money”
12
 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 create—moral
rules exist because we all benefit; Influenced Smith’s
“Theory of Moral Sentiments (1759)
• Died in 1776 -- the year “The Wealth of Nations” was
published
13
 David Hume’s 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
14
15
 Hume on Money and Inflation
• Hume formalized the money-price level link as the
“Equation of Exchange” (MV=PT)
• Is this a tautology? If VPT/M then MV=PT reduces to
PT=PT! 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
16
Francois Quesney
and
Physiocracy
17
 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
18
 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
19
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”
20
The Advent Of Economic Science
Smith, Ricardo, Malthus and Marx
21
Adam Smith
22
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 Hume’s view that morality came from our
experience and psychology, not from innate principles or
from reason, but rejected Hume’s 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,”
23
 Smith’s 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
24
 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
25
 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 lowpriced imports and sale of high priced exports
26
 Smith’s 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: wages+profits
(+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
27
Price per Gallon
Value in Exchange vs. Value in Use
The Example of Free Water
D
Value in Use
0
S’
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 ) 28
 Smith’s 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)
29
 Smith’s 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
•
30
 Smith’s 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
31
 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 Smith’s 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)
32
 Measuring Real National Income
• Smith’s 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/w=N)
• 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.
33
 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
34
 Fallacies in the Real Bills Doctrine
•
The fallacies in the Real Bills Doctrine were the subject
of Henry Thornton’s 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
35
Thomas Robert Malthus
Economics As The Dismal Scence
36
 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--mankind’s lot in life is grim, illness-ridden, and
plagued by early death-- and that’s the good news!
• Thomas corresponded regularly with David Ricardo, with
whom he disagreed on almost everything economic
37
 Malthus’s View of Economic Dynamics
• The subsistence wage is the bare minimum, not just Smith’s
“ 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.
38
 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.
39
 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 (labor+capital) 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
40
 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 him—that
was the “Keynesian Revolution”
41
 Malthus’s 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
• Malthus’s contribution to economics is negligible, but his
contribution to how economics is seen in the popular
mind is extremely powerful
42
David Ricardo
The First Economic Theorist
43
 David Ricardo (1772-1823)
•
A stockbroker considered the first rigorous economic
theorists
• Made major contributions building on Smith’s ideas
• Best known for theory of land rent and theory of comparative
advantage in international trade
• Frequent correspondent with Thomas Malthus
44
 Ricardo’s 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 season’s
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
45
 Ricardo’s Theory of Land Rent: The Results
• Each farm will add doses until the marginal product of a dose
equals the cost of a dose—the “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 rent—the “extensive margin”
• Rent is not a necessary cost of production—it is the residual
between output and costs; rent is price-determined, not price
determining
• Land is required for production, but it is not a”factor of
production,” that is, not a required cost of producing
46
 Ricardo’s 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 production—the only effects would be on the
distribution of income—landlords 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.
47
David Ricardo's Theory of Differential Rent
Assumptions:
Corn price = $10 per bushel
Dose cost = $900 labor + $100 profit
Diminishing returns within farms (intensive margin)
Diminishing returns across farms (extensive margin)
The Intensive Margin
The Best Farm
Doses
(K+L)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Total
Gross Revenue
$10,000
$19,000
$27,000
$34,000
$40,000
$45,000
$49,000
$52,000
$54,000
$55,000
$55,000
$54,000
$53,000
$52,000
$51,000
Average
Gross Revenue
$10,000
$9,500
$9,000
$8,500
$8,000
$7,500
$7,000
$6,500
$6,000
$5,500
$5,000
$4,500
$4,077
$3,714
$3,400
Marginal
Gross Revenue
$10,000
$9,000
$8,000
$7,000
$6,000
$5,000
$4,000
$3,000
$2,000
$1,000
$0
-$1,000
-$1,000
-$1,000
-$1,000
Average
wage
Average
Profit
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
Marginal
Cost
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
The Poor Farm
Total
Gross Revenue
$5,000
$9,000
$12,000
$14,000
$15,000
$15,000
$14,000
$13,000
$12,000
$11,000
$10,000
$9,000
$8,000
$7,000
$8,000
Average
Gross Revenue
$5,000
$4,500
$4,000
$3,500
$3,000
$2,500
$2,000
$1,625
$1,333
$1,100
$909
$750
$615
$500
$533
Marginal
Gross Revenue
$5,000
$4,000
$3,000
$2,000
$1,000
$0
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
-$1,000
Average
wage
Average
Profit
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$900
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
$100
Marginal
Cost
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
48
Ricardo's Extensive Margin
Forty Farms of Different Qualities
Percent of Total
Revenue
100
80
60
40
20
0
1
3
5
7
9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39
Farm
Wages + Profits
Rent
49
Ricardo on the Direction of Int’l Trade
 Ricardo’s 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
condition—suppose 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.
50
 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?
51
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 doesn’t trade it must consume along the line FF’; England will consume along EE’
if it doesn’t 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 England’s higher price—consuming along F’F’’. England will specialize in corn and sell it to
France at France’s higher price. The trade pattern is determined by comparative advantage, 52
not by absolute advantage
 General Gluts: Ricardo vs. Malthus
• Malthus argued that an economy could suffer protracted
periods of depression—periods with excess capacity,
including high unemployment
• Ricardo responded with Say;’s 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).
53
 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
54
more likely
 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.
55
 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]
56
 Ricardo’s “Invariable Measure of Value”
• Ricardo’s 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
57
cost of producing that good is rising (falling) relative to all goods
 Ricardo’s 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
58
Jean-Baptiste Say
59
 Jean-Baptiste Say (1767-1832)
• Laissez-faire French economist who built on Smith’s
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
60
 Say’s 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 supplier’s $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 61
($1000 of spending)
 The Problem of Hoarding
• Economists after Say accepted one caveat to Say’s
Law—if 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 occur—a 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
62
Ricardian Spinoffs
Henry George and the Fabians
63
 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
64
 Henry George’s 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?)
65
 Henry George’s 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)
66
 The Fabian Society
•
Formed in 1864; named after Quintus Fabius Maximus, the
Roman General whose tactics against the Carthaginians
involved delay and attrition—the 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
67
 The Fabian Society’s 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
68
 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 Britain’s 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
.
69
 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.
•
70
 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 owner’s Interest payments or opportunity costs
 The owner’s management expenses and taxes
 The owner’s opportunity cost of other uses of the land
71
Karl Marx
The Communist Critique
Of Capitalism
72
 Karl Marx (1818 - 1883)
• Marx’s 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 Hegel’s philosophy of “thesisantithesis-resolution’
• Marx’s philosophy of “dialectical materialism” applied
Hegel to the economic (material) system
73
 Marx’s 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 c+v, the cost of
the dead labor plus the cost of the living labor
74
 Marx’s 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/(c+v)] 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
75
 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 economy’s 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.
76
 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…
77
 Marx’s 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
78
 Fundamental Problems in Marx’s 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.
79
 Fundamental Problems in Marx’s Economic Analysis
• What keeps wages down in Marx’s 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
80
 Fundamental Problems in Marx’s 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
wouldn’t 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
81
 Fundamental Problems in Marx’s Economic Analysis

Does Marx’s Analysis Fit the Data?
PREDICTION
TRUE
Wage rate constant over long periods
FALSE
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
82
 Marx’s Place in the Economic Pantheon
• Marx was not a Great Economist
 Marx’s work is filled with inconsistencies, contradictions,
and poorly developed ideas
 Marx’s 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
83
Neoclassical Economics
The Integration Of Demand and Supply
And The
Determination of Prices and Quantities
John Stuart Mill and Alfred Marshall
84
John Stuart Mill
85
 John Stuart Mill (1806-1873)
• Mill’s 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 186566, advocating womens’ suffrage, a light hand on Ireland,
proportional representation, labor unions, and other liberal
86
causes
 Mill’s Contributions to “Price Theory” (Demand and Supply)
• Introduced the idea of demand and supply as relationships
between price and quantity—the 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 microeconomics—the 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
87
The Smith-Ricardo “Classical” Analysis of Markets
Price
Price
D
S
D
P*
S’
S
D’
P*
S’
D’
Quantity
Q*
Classical Case 1:
Quantity is Demand-Determined
Price is Supply-Determined
Q*
Quantity
Classical Case 2:
Price is Demand-Determined
Quantity 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
88
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
89
 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
90
Trade.”
The Gains from Trade:
Measuring an Economy’s “Value Added”
Price
Demand
Schedule
Supply
Schedule
Consumer
Surplus
P*
Economic
Profit
Producer
S Costs
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
= Society’s Net Gain from Trade
91
 Mill’s 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 = K/w
Employment (N) is equal to the wages fund (K) divided by the
wage rate (w)
92
 Implications of the Wages Fund Doctrine
•
An increase in wage rate causes an equal proportional
reduction in employment
• The wage rate and/or employment can increase only when
capital grows
• Capital is equated to “goods in process,” not fixed capital
(plant and equipment)
• Productivity increases accrue entirely to the employer in the
short run
 The legacy of the wages fund doctrine
•
It is a useful style of thinking because it stresses that
sometimes current choices are conditioned by past decisions)
• The notion of advance economics still exists in the Austrian
theory of capital, and cash-in-advance macroeconomic models
• But it is no longer a useful concept in labor market analysis
93
 Mill on Economic Decisions and Tax Policy
• Mill’s focus on prices paid (and received) as signal to producers
and consumers led naturally to the idea that government, through
its power to tax and to subsidize, could alter private decisions
• Mill believed that government could levy taxes on “bad” goods
and give subsidies to “good” goods, thereby improving the
allocation of resources and enhancing the general welfare.
• Mill recognized that any tax creates an “excess burden,” that is,
it doesn’t simply transfer income from taxpayers to government,
it creates a social cost in lost production (see next figure).
94
The Social Cost (Excess Burden) of an Excise Tax
S1
D
Unit Tax (t)
Price
S0
P1* + t
P0*
P1*
S1
D
S0
Quantity of Soybeans
Q1*
Q0
*
An excise tax of t per unit of production is levied. Producers must charge T additional dollars for
each unit in order to cover their costs so the supply schedule shifts up To S1S1. The price to the
consumer rises and fewer units of soybeans are bought. The least efficient producers cut back
production or go out of business. In the new equilibrium the price received by producers is P 1*
and the price paid by consumers is P1* + T.
Area
Area
Area
= Loss of Consumers’ Surplus and Area
= Loss of Producers’ Surplus
+ Area
= Excess Burden (Cost of Tax to Society)
= Excise taxes paid by firms, collected from consumers
95
 Mill on Money and Inflation
•
Mill followed Ricardo’s “Currency School”
 The Quantity Theory of Money—inflation was a matter of too
much money
 The real bills doctrine was a very poor guide to monetary
management
 A “convertible currency would not cause inflation because the
banking system could not create too much money; if it did,
specie would be exported and the money supply would return
to the original level
 An inconvertible currency unhooked from specie would allow
inflation
 the test of excess money was an exchange rate above the
gold export point
96
 Mill’s Theory of the Rate of Interest
•
Previous economists had no theory explaining the interest
rate—it was a given
• Mill proposed the “Loanable Funds Theory of Interest”
 The quantity of loanable funds supplied is the annual
amount of saving in the economy less the amount of
annual “hoarding” of money; it is positively related to the
rate of interest
 The quantity of loanable funds demanded is the annual
amount of borrowing or stock issue to finance capital
expenditures or government spending; it is negatively
related to the rate of interest
 The equilibrium rate of interest is determined by the
equality of demand and supply, that is, it is the interest rate
at which investment by firms + govt spending is equal to
saving by firms and individuals + govt tax receipts.
97
Interest Rate
(% per year)
D
S’
r*
S
D’
Quantity of Loans
L*
98
 Mill on International Trade
• Recall Ricardo’s theory of Comparative Advantage:
 Countries produce and export goods in which they have
the lowest relative cost of production
 Each country will specialize in that good—producing
only that good (“corn”) and exporting some of it in trade
for the other country’s good (“wine”) in which that
country specializes
 The relative prices of the two goods in international
markets will be somewhere between the relative
production costs in the two countries
 This indeterminacy of prices in international trade occurs
for two reasons: (1) there is no consideration of the role
of demand factors; (2) it is assumed that production
costs are constant
99
 Mill’s on International Trade
• Mill resolved ths indeterminacy of relative prices by bringing
demand for traded goods into consideration. The result was
that in equilibrium with international trade two things would
happen:
 the relative price of the two goods would be equal for all
buyers and sellers in both countries
 at the equilibrium prices trade accounts would be
balanced; that is, the value of wine that France wanted to
export would be just the value that England wanted to
import, and vice versa.
• An increase in (say) England’s demand for wine would
have
 The price of wine would rise as the English shifted from
corn to wine
 the French would shift from wine to corn in response
 A new equilibrium would emerge with England drinking
100
more wine and France eating more corn
 Mill on Monetary Management
Mill was among the first to argue that the “bank rate” was
an important consideration in the Hume price-specie flow
mechanism
• The bank rate was the interest rate that the Bank of
England charged on loans to British banks. It is the
equivalent of the Federal Reserve System’s discount
rate. Thus, the bank rate determined the short-term
interest rate.
• Hume had argued that when the market-determined foreign
exchange rate was above (below) the gold export (import)
point, gold would flow out to (in from) other countries and
the domestic money supply would fall (increase). The
effect would be a fall (rise) in domestic prices and a rise
(fall) in foreign prices until the exchange rate moved to
within the gold flow points
•
101
 Mill on Monetary Management
• Mill argued that gold flows would also affect interest rates in
each country—as gold flowed out and money supply fell,
credit would tighten and domestic interest rates would rise
while foreign interest rates would fall.
• The rise in the relative interest rate in Britain would induce
foreigners to make loans to British borrowers. This would
increase the demand for UK notes and help to move the
pound back within the gold-flow points
• Mill went even farther, arguing that the Bank of England
could alter the bank rate to affect the exchange rate, hence
not waiting for the automatic price-specie flow mechanism
to work.
• Mill’s insight that the bank rate could be an instrument of
monetary policy was a major advance
102
 Mill on The Incidence of Taxation
• Mill was among the first to discuss the “incidence of
taxes”—this is the question of who really bears the tax
burden.
• Consider the case of an excise tax in which producers pay
say) $10 in tax per unit produced. With 1000 units made,
the producers write checks totalling $10,000. But is that
really the producers tax burden?
• Mill argued that the producer would try to pass the tax on to
consumers, but consumers would reduce their purchases in
response to the higher price. This would mitigate the price
increase. In the end less would be produced, and it would
be sold to consumers at a higher gross price with producers
keeping a lower net
 Consumers who still bought the good would pay part in
a higher price, while producers would get a lower net
price for the units produced. The burden of the tax
103
actually paid is shared by buyers and sellers.
 Mill on The Incidence of Taxation
• Thus, there would be a sharing of the burden of the tax
 Consumers who still bought the good would pay part
in a higher price
 Producers would get a lower net price for the units
produced. The burden of the tax actually paid is
shared.
 In addition there is an “excess burden” of the tax.
Because less is produced, both consumers and
producers lose the value of the lost output (and, of
course, government gets no tax revenues fro the
output not produced).
104
The Incidence of an Excise Tax
S1
Price
D
Unit Tax (T)
S0
P1* + T
T
P0*
P1*
S1
D
S0
Quantity of Soybeans
Q1*
Q0
*
An excise tax of T per unit of production is levied. Producers must charge T additional dollars for
each unit in order to cover their costs so the supply schedule shifts up To S1S1. The price to the
consumer rises and fewer units of soybeans are bought. The least efficient producers cut back
production or go out of business. In the new equilibrium the price received by producers is P 1*
and the price paid by consumers is P1* + T.
Amount
Amount
Amount
Amount
“paid” by consumers but not collected as taxes (lost consumer surplus)
“paid” by producers but not collected as taxes (lost producers surplus)
of taxes actually paid by consumers to producers for tax collection
of taxes actually paid by producers for tax collection
+
= Tax collections by government (tax check written by producers)
105
 Mill on Government Deficits and “Crowding Out”
•
Mill was among the first to raise the possibility that a
government deficit might crowd out of private investment
 Recall the loanable funds theory of interest—as debtfinanced government spending increases, the demand
for loanable funds rises, increasing the equilibrium rate
of interest.
 As the interest rate increases the economy slides along
the fixed supply of loanable funds schedule, creating a
reduction in interest-sensitive spending, particularly
business investment in plant and equipment
 In the new equilibrium the interest rate is higher,
government debt is greater, and investment is smaller
• This “crowding out” means that future generations are
saddled with a smaller capital stock and lower productivity
(output per man hour). This is the real cost of deficit
finance—everything else is a zero-sum transfer
106
A Debt-Financed Increase in Government Spending
D1
Interest Rate
(% per year)
D0
S
r1*
r0*
D1’
D0’
S’
Quantity of Loans
L0* L1*
An increase in government spending shifts the demand for loanable funds up (or out).
The economy moves along the original supply curve, reaching a new equilibrium
at interest rate r1* and loan volume L1*. As the economy moved along the SS
Curve, private saving increases; but the higher interest rate also chokes off some
private investment. The increased government debt has “crowded” out private
investment.
107
But…Enough on Mill!
We could continue much longer, but now we can appreciate why
his 1848 textbook was widely used for fifty years
The next generations up until the Keynesian Revolution in the 1930s
were devoted to improving and expanding Mill’s vision
The primary contributor to this work was Alfred Marshall,
a British economist at Cambridge University
108
Alfred Marshall
under construction
109
The Great Debate Of The
20th Century:
Capitalism vs. Socialism
Joseph Schumpeter And Friedrich Von Hayek
110
 Joseph A. Schumpeter (1883-1950)
• Shumpeter’s Career
 Czech-Born, Moved To Vienna As Teenager
 Educated At University Of Vienna, Center Of “The Austrian
School Of Economics”
 Taught At Several European Universities, Ending At
University Of Vienna
 Achieved First Notoriety With The Theory Of Capitalist
Development (1911)
 Left University Of Vienna To Become Partner In Major
Austrian Bank
 Served As First Post-WWI Austrian Finance Minister
 Joined Harvard Faculty In 1932, Staying Till His Death In
1950
111
 Schumpeter’s Vision
• Father Of The Field Of “Business Economics”
• Integrated History, Sociology, Economics, And Business
In An Analysis Of Capitalism’s Nature And Direction
• Contributed Much To Modern Business Discourse
 Role Of “Entrepreneur”
 Process Of “Creative Destruction”
 Viewed Capitalism As Unstable And Chaotic But
Conducive To Great Material Growth
 Deep Distrust Of Government Intervention In
Economic Affairs
 Believed That High Taxes Discouraged Entrepreneurial
Activity And Innovation
• Viewed “Big Business” As The Engine Of Growth
 Had The Financial Resources And Security To Risk
Funding Research Efforts
112
 Schumpeter’s Scholarly Contributions
• The Theory Of Economic Development (1911)
 Emphasized Entrepreneurial Creativity As The Source Of
Economic Growth
 Argued That Big Business Had The Financial Resources
To Fund Creative Developments And To Keep The
Advantages To Themselves By Inhibiting Competition
• Business Cycles (1939)
 Emphasized The Chaotic Nature Of Capitalist Development
 Eschewed The Idea That “Equilibrium” Was A Capitalist
Characteristic; Rather, Capitalsm Was Characterized By
Disequilibrium
• Capitalism, Socialism, And Democracy (1942)
 His Best-Known Work; Assesses Karl Marx And Argues
That Capitalism Will Decline But For Entirely Different
Reasons
113
 Schumpeter’s View Of The Business Cycle
• Innovation In Products And Techniques Is The Essential
Contribution Of Capitalism
• Innovation Creates Dramatic Rises In Some Industries
And Declines In Others
• The Innovating Industries Enjoy Monopoly Rents In The
Short Run, Which Attract High Prices For Their Common
Stocks
• In The Long-Run The Short Term Rents Are Competed
Away By Copy-Cat Firms Entering The Innovating
Industry
• As Investors Discover They Have Overpaid, The Share
Prices Decline, Investment In The New Industry Slows,
And The Economy Slows
• If The New Industry And Its Investors Have Been Heavy
Borrowers, Lenders (Banks) Fail And A Financial Crisis
Deepens The Economic Decline
• Ultimately A New Set Of Innovations Emerges And The 114
Cycle Recurs
 Schumpeter’s View Of Capitalism’s Future
• Marx Believed Capitalism Would Die Because Of The
Rise Of Big Business
 The Declining Rate Of Profit As Big Business Rises…
 Creates Capitalist Defensive Reactions, Such As
Labor-Saving Innovation, That Displace Labor…
 Leading To The “Increasing Immiserization Of
Labor” …
 Class Warfare (Capital vs. Labor) Leads To
Increased Tensions…
 And The Proletariat Revolts--The Expropriators Are
Expropriated
• Schumpeter Agreed That Capitalism Would Give Way To
Socialism, But For Very Different Reasons
 Capitalism’s Emphasis On Impersonal Markets Cuts
The Social Threads That Create Widespread Support
 Big Business Faces Increasing Government
115
Intervention That Throttles Innovation
Friedrich von Hayek
And The
“Austrian School Of Economics”
116
 The Austrian School
• Major Figures
 Carl Menger (1840-1921)
 Ludwig von Mises (1881-1973)
 Friedrich von Hayek (1899-1992)
• Major Ideas
 Libertarian Philosophy
 Economic Analysis Is Central To Understanding The
Human Condition And Human Choices
 Axiomatic Foundation Of Economic Analysis—Contrast
With The Inductive Method Of German Historical
School
 Early Application Of Marginal Utility Analysis Of
Product Demand
117
 Friedrich von Hayek (1899-1992)
• Hayek’s Career
 Educated At University Of Vienna, Center Of “The Austrian
School Of Economics”
 Did Scholarly Work In A Broad Range Of Topics: From
Neurology To Political Philosophy To Monetary Theory And
Business Cycles
 Best-Known Book: The Road To Serfdom (1944)
 Became U.K. Citizen In 1938; Eventualy Took Faculty
Position At University Of Chicago
 Received Nobel Prize In Economcs In 1974 For Work In
Monetary Theory
118
 The Road To Serfdom
• Centrally Planned (“Collectivist” or “Socialist”)
Economies Are Inherently Incompatible With Democracy
 In Theory A Collectivist Economy Could Allocate
Resources As Efficiently As The Market Economy, But In
Practice This Is Impossible
 The “Aggregation Problem” Is At The Heart Of This Failure
- The Preferences Of Each Consumer And The Costs Faced
By Each Producer Are Reflected In Prices In A Market
Economy, Leading To Efficient Allocation
- A Centrally Planned Economy Can Never Collect The
Necessary Information To Mimic The Resource Allocation
Achieved In A Market Economy
 The Failure Of Central Planners Leads To Ever-Increasing
Centralization Of Power To Allow The Central Plan To Be
Achieved. This Undermines Democracy
119
The Great Depression
And The
Advent of Macroeconomics
John Maynard Keynes
120
An Overview
of the
Great Depression
121
 The Classical View of General Gluts
• As a general rule, economists before the 1930s did not
accept the idea of long-lasting economy-wide depression.
Both labor and capital tended to be fully utilized in the long
run
• Malthus had debated this with Ricardo, a debate that Ricardo
won on points. Ricardo, appealing to Say’s Law, argued that
excess capacity in one industry occurred as part of the
process by which resources shifted from declining industries
to growing industries. Because declining industries were
typically mature and thus affected more people, this gave the
impression of a general slump
• Marx had taken an intermediate position, believing that
capital was fully employed but that there was, by capitalist
design, a “reserve army of the unemployed”
122
 The Neoclassical View General Gluts
• While Ricardo argued that a general glut could not happen,
“neoclassical” economists prior to the 1930s argued that a
glut could occur but that it would be short because the
economy was “homeostatic,” or self-correcting.
• The mechanism ensuring homeostasis was flexibility in
wages, prices and interest rates. In a depression or
recession:
 Wages would fall in response to high unemployment,
inducing businesses to maintain their labor force
 The general price level would fall in response to an excess
supply of, encouraging a rise in consumption as real
wealth increased
 Interest rates would fall in response to a collapse in
investment spending, encuraging businesses to spend
123
more
Wage-Price-Interest Rate Flexibility
Price Level
(P)
P0*
D1
D0
S
b
a
c
P1*
S’
0
Q
Q*
D1’
D0’
Aggregate Production
(Q)
SS’ is the aggregate supply curve at full employment. At full employment all labor is employed and all capital
is utilized. Full eployment output is Q*. D0D0‘is the initial aggregate demand schedule. Aggregate demand
equals aggregate (full employment) supply at price level P0*. So the economy is initially at point a. Now Consider
the following events:
● Capitalists become less optimistic about future profits so the aggregate demand schedule shifts leftward to D1D1‘. At each price
level the aggregate output demanded is smaller. If the price is fixed at P0* the economy would move to point b: The entire effect
of the decrease in demand is on output, which falls to QQ. There is a general glut, with excess capacity of both capital and labor.
● If, however, interest rates, wages, and prices are downwardly flexible, the glut at point b induces movement down the new demand
schedule toward point c. This movement arises from a decline in interest rates, which acts to increase investment from its low level
at point b, from a decline in money wages, which tends to reduce the real wage rate and induce firms to rehire labor, and from a
decline in the price level, which (a) increases real cash balances, inducing consumers to spend more, and (b) redistributes wealth
from creditors to debtors, thereby increasing investmebnt since the majority of debt is issued by businesses
So, in the end, rice flexibility ensures full employment. It was also believed that this process worked quickly (within, say, a year).
124
 The 1920s: The International Scene
• German War Reparations and U.S. War Loans
 Treaty of Versailles imposed punitive payment to Britain
and France
 Germany followed a policy of undervaluing the mark in
order to promote exports and discourage imports so that it
could earn the foreign exchange
to pay the debt; this reduced German production available
for domestic investment and consumption
 Germany printed money hand-over-fist to encourage
domestic consumption and investment. But without goods
to buy, this generated hyperinflation
 Britain and France used German reparations payments to
pay war loans from the U.S.
125
 The 1920s: The International Scene
• In 1925 Britain restored convertibility at the pre-war exchange
rate of $4.86 per pound in spite of the high war-time inflation
that it had experienced
 The greatly overvalued pound encouraged British imports
and discouraged exports, creating a slump in aggregate
demand and a chronic economic recession throughout the
1920s
 Keynes called this recession “The Economic
Consequences of Winston Churchill,” who was Chancellor
of the Exchequer at the time
• Thus, through the 1920s Britain and much of Europe was
having hard times
126
 The 1920s: The U.S. Economy
• Severe but short post-WWI depression in 1920-21, initiated
by reduced postwar demand and a surge in the civilian labor
force.
• A burst of new investment was encouraged by high-tech
innovations:
 the spread of electricity requiring construction of generating
and transmission facilities, and creating a demand for
electrical appliances the
 the spread of the automobile, requiring construction of
plants, roads, and roadside facilities as well as expansion of
oil extraction and gasoline refining facilities
 the advent of commercially-viable radio with consequent
construction of transmitting facilities and demand for radios
127
 The 1920s: The U.S. Economy
• Consumer demand increased, driven by
 purchase the new technologies
 availability of a new form of finance: consumer credit
• The prosperity—high investment and consumption, high
employment, and stable prices—created optimistic
expectations for future corporate profits and led to a
stock market boom concentrated in the new industries
• The investment boom was excessive, with capacity
expanding beyond demand, and it was based on highly
levered industries that borrowed heavily from banks.
• The stock market boom led to stock purchases financed
by bank loans (margin loans) by both regular folk
unable to assess the risks as well as by sophisticated
investors who expected the train to stay on the tracks.
128
 The 1928-29 Turnaround
• In August of 1928 the economy peaked, and in September
the stock market peaked
• In late 1928 the Federal Reserve System expressed concern
about the use of bank credit to buy common stocks
 banks maling significan margin loans had restricted
access to the discount window to heavy lenders
 the discount rate was increased from 1½% to 3½%
• The stock market collapse in 1929 was the initiating cause of
the Great Depression, as banks restricted credit in response
to loan losses and consumers cut back on spending
because of credit costs and declining wealth
129
Index of Macroeconomic Variables
During the Great Depression
(1929-100)
110
100
90
80
70
60
1929 1930 1931
1932 1933 1934
Real GNP
1935 1936 1937
1938 1939 1940
Private Nonag Employment
GDP Delator
Index of Macroeconomic Variables
During the Great Depression
(1929-100)
325
300
275
250
225
200
175
150
125
100
75
50
25
0
1929 1930 1931 1932
1933 1934 1935 1936
1937 1938 1939 1940
130
Real Money Stock
Real Nat'l Debt
Real Stock Prices
 Why was the Depression so Long and Deep?
• 1930:
 The Smoot-Hawley Act imposed high tariffs on imported
goods in order to shift demand to domestic products. But
the effect was to restrict demand for our exports because
foreign countries could not earn dollars to buy U.S. goods
 Widespread crop failures in the early 1930s (the Dust
Bowl) create foreclosures of farms and bank failures in the
interior extending to weakness at city correspondent banks
• 1931:
 Federal Reserve Board raised the discount rate from
1½% to 3½% in spite of serious deflation; over 2000
banks collapse;
 The Federal Reserve Board failed to expand bank
reserves enough to offset the credit contraction
effects of sizable runs on banks
 Britain suspended convertibility, ending its overvaluation
of the pound, reducing its imports from the U.S., and 131
increasing its exports to the U.S.
 Why was the Depression so Long and Deep?
•
1932: To balance the budget, Hoover signed a bill increasing
personal income taxes from 25% to 63%
• 1933: FDR suspends convertibility of the dollar, followed in
1934 by prohibition of private ownership of gold and an
increase in the price of gold from $20.67 to $35
• 1935: FDR signs Social Security Act that will levy a payroll
tax beginning in 1937, hence playing a role in a 1937-38
recession in a depression
 Not until 1938 did FDR openly accept a federal deficit;
prior to that he had attempted to balance the budget by
raising taxes, or had grudgingly accepted it
132
John Maynard Keynes
133
 John Maynard Keynes (1883-1946)
• Keynes “rhymes with rains” was a major figure in
British social, business, and intellectual life
 a member of the Fabian society and the Bloombergs,
both major collections of the British literati
 married to a world-famous ballerina, Lydia Lopokova
 a Cambridge Don who was a prolific economist
 a very successful speculator in commodities and
currencies
 an important advisor to the British government
 the intellectual father of the Bretton Woods Agreement
reshaping international currency relationships after WWII
• Published The General Theory of Employment, Interest and
Money in 1936
134
 The Main Arguments of The General Theory
• Rejected Say’s Law
 A General Glut could be both serious and prolonged
 The cause of the Depression was insufficient demand for
goods and services, particularly arising from decreases
investment in fixed capital
 Both hoarding and excess saving created the general glut
 There were no automatic mechanisms ensuring full
employment of labor and capital
 In the absence of sufficient wage-price flexibility, aggregate
income (=aggregate production) would decline—a
depression would emerge
 the economy would stay in a high unemployment condition
as long as wages and prices failed to adjust sufficiently
• Argued that spending by government was a solution to the
underemployment equilibrium
135
 Reasons for Insufficient Wage-Price Flexibility
• Workers focus on the money wage rate, resisting its decline
even when prices are falling. As a result, the real wage rate
rises and businesses lay workers off
• Interest rates fail to fall as much as they should because of
“liquidity preference—as interest rates fall, people choose to
hold more money. This creates temporary hoarding
 Multiplier-Accelerator Effects
• A decline in workers’ income creates a reduction in consumer
spending, which is exacerbated by the “consumption multiplier”
• The “investment accelerator” further exacerbates the
downward adjustment of spending
136
 Keynes’s Arguments against Say’s Law
• Say’s economic world was simple:
 Household saving was almost nonexistent except for the
affluent landowners and capitalists—the problem of
excessive saving was not due to household behavior
 businesses were the primary source of saving via retained
earnings that were reinvested in the business—businesses
did not resort to external finance, neither did they invest
saving in financial instruments
 As a result, saving was quickly transmitted to spending
because the savers (businesses) were the spenders
• In a modern economy, saving and investment decisions are
separated
 Households place their savings with financial institutions
 Businesses engage in external finance by borrowing from
137
financial institutions or investors
 Why Wouldn’t Interest Rate Flexibility be Sufficient
• Interest rate flexibility existed, but was impeded by two
monetary factors
 Induced hoarding: the decision about how much
money to hold depends (inversely) on the rate of
interest on bonds, which is the opportunity cost of
money. As interest rates decline, firms and
household want to hold more money.The resulting
shift toward money balances was akin to hoarding—it
reduced the amount of consumer saving that went
into loanable funds
 A liquidity trap might prevent interest rates from
falling enough: At a very low interest rate money
would be preferred to bonds, and loanable funds
would be drained off into hoarding
138
 Why Wouldn’t Wage and Price Flexibility be Sufficient
• Wage flexibility would be restricted by sociological
considerations. Workers resist cuts in money wages because:
 They have “money illusion” and confuse money wage cuts
with real wage cuts
 They are concerned about their position in the wage
distribution—”if I accept a cut, others might not and I
will be relatively worse off”
• Price flexibility would be restricted because
 Wage rigidities cited above would reduce the
willingness of firms to accept lower prices for their
products
 Businesses do not know if others would follow their
price cuts. If not, my shareholders would get less
income from sales while competitors would maintain
income (unless consumer shifted to lower price firms)
139
 Keynes’s Prescription: An Expansionary Monetary Policy
• The Central Bank should reduce interest rates (the bank rate
in England, the discount rate in the U.S.) to stimulate
business investment
• In the U.S. this means expanding bank reserves by open
market purchases of securities, or lending to banks through
the discount window
• This might not be sufficient if:
 there is a liquidity trap (the interest rate can’t be
reduced enough)
 business investment does not respond sufficiently to
interest rate reduction
• The evidence suggests that there is no clear affirmation
of a liquidity trap. However, business investment is not
very sensitive to interest rates (though spending on
home construction and on consumer durables is interest
sensitive)
140
 Keynes’s Prescription: Active Use of Fiscal Policy
• The federal government should increase government spending
and cut income taxes
 This would help to restore aggregate demand through both its
direct effects and through its multiplier and accelerator
effects
 the direct effects are increased employment and capital
utilization to produce goods for government use.
• The resulting increased federal deficit is not a problem when
the economy has excess capacity
141
 Why Aren’t We All Keynesians Now?
• Keynesian Analysis is useful only in the “Short Run”
 It rests on insufficient flexibility of wages and prices. In the
long run, wage-price flexibility will work unless government
policy intercedes
 Monetary and fiscal policy are short-run aids in hastening
the return to full employment, though experience suggests
that fiscal policy is less effective because of long lags in
implementation
 Keynesian analysis assumes backward-looking
expectations about future events.
• Keynesian Analysis Only Addresses Business Cycles Due to
Shifts in Aggregate Demand—Aggregate Supply is Ignored
 Recent Cycles Have Been From Supply Shocks
 “Real business cycle” theories have focused on shocks to
aggregate supply
142
 Why Aren’t We All Keynesians Now?
• The Keynesian Focus on the Short Run Diverts Attention From
Important Long Run Issues
 An increased government deficit, if not offset later, can
create crowding out of business investment by government
spending, thereby reducing the production of future
consumer goods—this is the real cost of a deficit
 If the central bank monetizes the government debt in an
effort to keep interest rates from rising, the result is an
increase in the money supply and subsequent inflation
 Easy monetary policy might create inflation in the long run
• After the 1970s attention shifted away from short-term
stabilization to long term growth
143
Milton Friedman
And
“Monetarism”
144
 Milton Friedman (1912 – 2006)
• Career
 Began His Career Was As A Loyal Keynesian, But Rejected
Keynesianism In The 1950s
 Served As Government Economist During WWII
 Joined University Of Chicago Faculty In
 Received The Nobel Prize In Economcs in 1976
• Philosophy
 Advocated Libertarian Philosophy With Minimal Intrusion Of
Government In Economic Affairs
 Believed That The Business Cycle Was The Result Of
“Monetary Mischief,” Rejecting The Keynesian Emphasis On
“Animal Spirits”
145
 Milton Friedman (1912 – 2006)
• Major Scholarly Contributions
 A Permanent Income Theory Of Consumer Spending (1957)
Arguing That Consumption (Accounting For About 2/3
Of National Spending) Was Determined By Long-Term
Expectations Of Future Income
 Capitalism And Freedom (1962), Advocating The Use
Of Microconomic Analysis In The Analysis Of Public Policy
 A Monetary History Of The United States (1963), A
Detailed Analysis Of Monetary Institutions And The Role Of
“Money” In Inflation And Unemployment
 Published Hundreds Of Articles And Essays On Economic
Theory And Policy
146
FINIS
147