Economics by PN90n70X


									 The History of Economic Ideas:

How Did We Get Here from There?

             Peter Fortune
        Ph.D. Harvard University

 The Primary Reference for this Course Is:

Blaug, Mark. Economic Theory in Retrospect,
   Fifth Edition, Cambridge, England, 1997

       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
   •By Functional Shares (Labor, Capital, Land)
  • By Wealth Holder or Income Recipient (Percentile)

          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
   • 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
  Economic Thinking

  Before Adam Smith:

Mercantilism and Physiocracy

Jean-Claude Colbert



 Jean-Baptise Colbert (1619-1683)

  • Finance Minister to Louis XIV (1665-1683)
  • Louis XIV was extravagant and constantly at war—needed
  • Colbert believed that the source of national strength is money
  • … and that government must encourage specie inflows
  • … especially to the King‘s coffers!

 Colbert’s Policies

  • Tariffs on imported goods to discourage imports and generate
     tax revenue
   • Internal improvements (bridges, roads, canals) to promote
   • Regulation of French product characteristics to promote brand
   • 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

Critics of Mercantilism

 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

 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
   • laid the foundations for David Hume‘s ―Price-Specie Flow
   • … and for the ―Quantity Theory of Money‖

 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

 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
 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

Francois Quesney



 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

  • Wrote the Tableau Economique, considered by many the
    first great economic analysis

 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

 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

Adam Smith

       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,‖

 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
 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
 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

 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
   • In the Short Run value in exchange is determined by
     ―Demand and Supply‖
   • Resources shift between industries when LR value differs
     from SR value

                       Value in Exchange vs. Value in Use
                            The Example of Free Water

Price per Gallon

                         Value in Use

                         S                                                    Gallons Consumed
                       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
• 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,
 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

 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

 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
  • 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)

 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
  • 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

 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

 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
       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

 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

 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.

 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
        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.

 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

 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‖

 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
   • Malthus‘s contribution to economics is negligible, but his
     contribution to how economics is seen in the popular
     mind is extremely powerful

      David Ricardo

The First Economic Theorist

 David Ricardo (1772-1823)

  • A stockbroker considered the first rigorous economic
  • 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

 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
 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
  • Land is required for production, but it is not a‖factor of
    production,‖ that is, not a required cost of producing

 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
    • 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.

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

                                       Ricardo's Extensive Margin
                                     Forty Farms of Different Qualities


Percent of Total




                         1   3   5     7   9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39


                                                   Wages + Profits   Rent

           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

 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

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




                                                                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).
 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
  • Saving (consumers‘ abstaining from consumption)
    could generate offsetting demand only if it led to investing
    (business capital expenditures).
  • In the early 19th century almost all saving was by
    businesses in the form of retained earnings that were
    intended to buy investment goods. So there was a strong
    link between saving and investment
  • The subsequent development of financial institutions
    weakened the saving-investment link, making general gluts
    more likely
 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
  • The reason for the note depreciation was hotly debated in
    ―The Bullionist Controversy,‖ in which Ricardo played an
    important role.

 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]

 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
 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
   • 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

Jean-Baptiste Say

 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

 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
     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
     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
    Ricardian Spinoffs

Henry George and the Fabians

 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
           The Single Tax would be ―efficient,‖ having no excess
            burden because landowners would not reduce
           The Single Tax would also have the advantage of
            discouraging speculation in land (but is speculation

 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)
 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

 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

 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
    • BUT the facts were different
          Land rent was about 5% of national income
          The land rent share had been declining

 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.
 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

      Karl Marx

The Communist Critique

    Of Capitalism

 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-
   • Marx‘s philosophy of ―dialectical materialism‖ applied
     Hegel to the economic (material) system

 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
  • Thus, the necessary costs of production are c+v, the cost of
    the dead labor plus the cost of the living labor
 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
 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
   • 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
    • And so it goes…

 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
 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
      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.
 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
      Three problems with this:
        - Evidence does not suggest that technical progress is
        - What prevents the unemployed workers from getting
           jobs by reducing wage demands?
        - Capitalist economies do not exhibit chronically high
 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

     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

 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

      Neoclassical Economics

The Integration Of Demand and Supply

              And The

Determination of Prices and Quantities

 John Stuart Mill and Alfred Marshall

John Stuart Mill

 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
  • 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

              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

The Mill-Marshall ―Neo-Classical‖ Analysis of Markets




  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
         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

          P*    Economic

                  S Costs
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

 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)

 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
 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).

                    The Social Cost (Excess Burden) of an Excise Tax


                                      D                    Unit Tax (t)
                          P1* + t


                               P1*                                  D
                                                                  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
 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
        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
        the test of excess money was an exchange rate above the
        gold export point

 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.
Interest Rate
(% per year)



             S             D‘

                           Quantity of Loans

 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

 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
      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
      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
           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
   • 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
 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

 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
   • 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
         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).

                  The Incidence of an Excise Tax

                           D                    Unit Tax (T)

                P1* + T

          T        P0*

                    P1*                                  D
                                                      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
 A Debt-Financed Increase in Government Spending
            Interest Rate
            (% per year)
                            D0                   S



                            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

                      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

Alfred Marshall

under construction

  The Great Debate Of The

           20th Century:

   Capitalism vs. Socialism

Joseph Schumpeter And Friedrich Von Hayek

 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
 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
 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

   • 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
      • In The Long-Run The Short Term Rents Are Competed
        Away By Copy-Cat Firms Entering The Innovating
      • 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
      • 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
    Friedrich von Hayek

          And The

―Austrian School Of Economics‖

 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
          Early Application Of Marginal Utility Analysis Of
           Product Demand

 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

 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
  The Great Depression

        And The

Advent of Macroeconomics

  John Maynard Keynes

  An Overview

     of the

Great Depression

 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
   • 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‖
 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
      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
                         Wage-Price-Interest Rate Flexibility
                              Price Level              D1
                                                D0         b
                                        P0*                                   a

                                        P1*                                   c

                                                                                                        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).
 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.

 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
         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

 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
  • A burst of new investment was encouraged by high-tech
     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

 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.
 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

               Index of Macroeconomic Variables
                  During the Great Depression






      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 1930 1931 1932    1933 1934 1935 1936    1937 1938 1939 1940
           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

John Maynard Keynes

 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
      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
 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
 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

 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
      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
 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
      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)
 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
      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

 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
     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

Milton Friedman



 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‖
 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



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