Economics

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—

14

gold flows do not increase real purchasing power

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 low-

priced 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

Value in Exchange vs. Value in Use

The Example of Free Water



Price per Gallon

D









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 ) 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 The Poor Farm

Doses Total Average Marginal Average Average Marginal Total Average Marginal Average Average Marginal

(K+L) Gross Revenue Gross Revenue Gross Revenue wage Profit Cost Gross Revenue Gross Revenue Gross Revenue wage Profit Cost

1 $10,000 $10,000 $10,000 $900 $100 $1,000 $5,000 $5,000 $5,000 $900 $100 $1,000

2 $19,000 $9,500 $9,000 $900 $100 $1,000 $9,000 $4,500 $4,000 $900 $100 $1,000

3 $27,000 $9,000 $8,000 $900 $100 $1,000 $12,000 $4,000 $3,000 $900 $100 $1,000

4 $34,000 $8,500 $7,000 $900 $100 $1,000 $14,000 $3,500 $2,000 $900 $100 $1,000

5 $40,000 $8,000 $6,000 $900 $100 $1,000 $15,000 $3,000 $1,000 $900 $100 $1,000

6 $45,000 $7,500 $5,000 $900 $100 $1,000 $15,000 $2,500 $0 $900 $100 $1,000

7 $49,000 $7,000 $4,000 $900 $100 $1,000 $14,000 $2,000 -$1,000 $900 $100 $1,000

8 $52,000 $6,500 $3,000 $900 $100 $1,000 $13,000 $1,625 -$1,000 $900 $100 $1,000

9 $54,000 $6,000 $2,000 $900 $100 $1,000 $12,000 $1,333 -$1,000 $900 $100 $1,000

10 $55,000 $5,500 $1,000 $900 $100 $1,000 $11,000 $1,100 -$1,000 $900 $100 $1,000

11 $55,000 $5,000 $0 $900 $100 $1,000 $10,000 $909 -$1,000 $900 $100 $1,000

12 $54,000 $4,500 -$1,000 $900 $100 $1,000 $9,000 $750 -$1,000 $900 $100 $1,000

13 $53,000 $4,077 -$1,000 $900 $100 $1,000 $8,000 $615 -$1,000 $900 $100 $1,000

14 $52,000 $3,714 -$1,000 $900 $100 $1,000 $7,000 $500 -$1,000 $900 $100 $1,000

15 $51,000 $3,400 -$1,000 $900 $100 $1,000 $8,000 $533 -$1,000 $900 $100 $1,000









48

Ricardo's Extensive Margin

Forty Farms of Different Qualities



100



80

Percent of Total

Revenue









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

cost of producing that good is rising (falling) relative to all goods

57

 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 ―thesis-

antithesis-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 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









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 1865-

66, advocating womens‘ suffrage, a light hand on Ireland,

proportional representation, labor unions, and other liberal

causes 86

 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 D‘

P* S S‘ P*



D‘ S‘

Quantity Quantity

Q* Q*

Classical Case 1: Classical Case 2:

Quantity is Demand-Determined Price is Demand-Determined

Price is Supply-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

Trade.‖ 90

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*



S1

P1* 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 = Loss of Consumers’ Surplus and Area = Loss of Producers’ Surplus

Area + Area = Excess Burden (Cost of Tax to Society)

Area = 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

actually paid is shared by buyers and sellers. 103

 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*



S1

P1* 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 “paid” by consumers but not collected as taxes (lost consumer surplus)

Amount “paid” by producers but not collected as taxes (lost producers surplus)

Amount of taxes actually paid by consumers to producers for tax collection

Amount 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 debt-

financed 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‘



S‘ D0‘

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

Intervention That Throttles Innovation

115

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 D1

(P)

S

D0 b

P0* a







P1* c

D1‘







D0‘

S‘

Aggregate Production

0 Q Q* (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 1935 1936 1937 1938 1939 1940



Real GNP 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

financial institutions or investors 137

 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