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History of Economics Thought II ch-2.pptx

  1. 1. UNIT TWO: HETERODOX ECONOMIC THOUGHT 2.1.Early Critics of Neoclassical Economics  Neoclassical economics did not come into being without controversy.  As it was emerging, the German historical school challenged its methodological foundations, and throughout the late 1880s, there was a vigorous debate between the Austrians (one stream of neoclassical school), and some members of the German historical school over the proper method for economics.  There is also a critic or debate from American graduate students in economics to study for their Ph.D.s in Germany.  Many of these scholars returned home with a full knowledge and sympathetic view of the position of the German historical school, called institutional school. 1
  2. 2. 2 The Historical School The German historical school, which arose in the 1840s with the publications of Friedrich List and Wilhelm Roscher and ended in 1917 when Gustav Schmoller died, were generally critical of neoclassical economics like that of the socialists school. Four principles were basic in the thinking of the German historical economists: these are  (1): Evolutionary approach to economics. The historical school applied a dynamic, evolutionary perspective in its study of society. It concentrated on cumulative development and growth.  (2). Emphasis on the positive role of government: The historical school was nationalistic, whereas classical economics was individualistic and cosmopolitan.
  3. 3. cont’d  (3). Inductive/historical approach: The economists of the historical school emphasized the importance of studying the economy historically, as part of an integrated whole, and criticized the abstract, deductive, static, unrealistic, unhistorical qualities of classical and marginalist methodology.  (4): Advocacy of conservative reform. Political economy, said the historical economists, must not merely analyze motives that prompt economic activity but must weigh and compare the moral merit of these actions and their outcomes 3
  4. 4. cont’d The Older Historical School: The important writers of the older historical school are Friedrich List (1789- 1846), Wilhelm Roscher (1817-1894), Bruno Hildebrand (1812-1878), and Karl Knies (1821-1898).  They contended that classical economic theory did not apply to all times and cultures and that the conclusions of Smith, Ricardo, and J. S. Mill, though valid for an industrializing economy such as England’s, did not apply to agricultural Germany.  There was a great deal of nationalistic feeling in the economic analysis of Germen historical school writers.  Furthermore, they asserted that economics and the social sciences must use a historically based methodology and that classical theory, particularly in the hands of Ricardo and his followers, was mistaken in attempting to ape the methodology of the physical sciences. 4
  5. 5. cont’d  List expressed particularly strong nationalist views and refused to admit that the conclusions of classical theory regarding laissez faire were applicable to countries less developed than England.  While classical theory held that national well-being would result from the pursuit of individual self-interest in an environment of laissez faire, List argued that state guidance was necessary, particularly for Germany and the United States. He contended that whereas free trade would be beneficial to England, given the advanced state of its industry, tariffs and protection were necessary for Germany and the United States.  What was the historical method advocated by these writers? Their works reflect a belief that the chief task of economics is to discover the laws governing the stages of economic growth and development. the writers did collect large quantities of historical and statistical information to support their analyses of economic development. 5
  6. 6. cont’d The Younger Historical School: The second generation of the German historical school was represented by Gustav von Schmoller (1838-1917). Like the members of the older historical school, the writers of the younger historical school attacked classical economic theory, particularly the view that it was applicable to all times and places.  They preferred to use inductive methods and the application of marginal analysis and the construction of abstract deductive models by Menger, Jevons, and Walras in the early 1870s had little or no influence in Germany.  They also were very interested in social reform through state action.
  7. 7.  The institutionalist school, an American contribution to economic thought, began around 1900 and continues to the present. Thorstein Bunde Veblen (1857-1929) is the intellectual father of the branch of American heterodoxy that is often called institutionalism.  The social factors which lead to the rise of institutionalism may be briefly stated as follows. In the nineteenth century though American capitalism achieved tremendous success, the conditions of the working class was rather bad. Their standard of living and working conditions were miserable.  These groups of economists lead by Thorstein Veblen and his followers like Commons and Mitchell are referred to as institutionalists. 7 The Old Institutional School
  8. 8.  There was the influence of the German historical school on American institutionalist school.  Most of the leaders of the American Economic Association, which was founded in 1885, were familiar and friendly toward the German movement and its methodology. But, both share the inductive approach as superior over the abstract deductive approach.  Despite the methodological similarity the institutionalists were not nationalists; they were more liberal and democratic in their outlook. 8 Cont…;
  9. 9. The following were seven key ideas of institutional school:  (1) Holistic, broad perspective: The economy must be examined as a whole, rather than examined as small parts or separate entities isolated from the whole.  (2) Focus on institutions: This school emphasized the role of institutions in economic life, not by economic laws.  (3) Darwinian, evolutionary approach: The evolutionary approach should be used in economic analysis, because society and its institutions are constantly changing.  (4) Rejection of the idea of normal equilibrium:  (5) Clashes of interest:  (6) Liberal, democratic reform:  (7) Rejection of pleasure-pain psychology: 9 Cont…
  10. 10.  Veblen felt that both the classical and the neoclassical approaches were unscientific. Veblen was not interested in making small changes in the theoretical structure and he struck at the heart of neoclassical theory, asserting that the basic assumptions of its doctrine were unscientific.  Veblen said that all of orthodox economic theory from Smith through Marshall was based on the same assumption: that there is harmony in the system, or what Veblen called a “meliorative trend.”  To Veblen, the concept of equilibrium as used by orthodox theorists was normative: they implied, without proof, that equilibrium is good and that the results produced by markets in equilibrium are socially beneficial. 10 Cont…
  11. 11.  Other attacks of institutional on Neo-classical economics includes on consumer sovereignty, and Static system. government might be able to enhance overall well-being by restricting “wasteful” consumption by everyone.  Veblen “dynamics” essentially a deranged static condition.  Veblen was concerned with social economics instead of the business economics of price, profit, and ownership.  Finally, Veblen attacked the notion of perfect competition, which then dominated standard economic theory. He recognized that most businessmen had some monopolistic control over the prices they charged and that they used advertising to strengthen their market positions. This analysis, published in 1904, foreshadowed the rise of the theory of monopolistic competition in 1933. 11 Cont…
  12. 12. Thorstein Bunde Veblen (1857-1929)  The Theory of the Leisure Class (1899)  Theory of the Business Enterprise (1904)  The Engineers and the Price System (1921) See eblen.htm for a full list of Veblen’s publications 12
  13. 13. Cont.. • Veblen was the founder of the American Institutionalism School • He was a major critic of capitalism and of the analysis of capitalism in neoclassical economics • Veblen’s criticism of capitalism may be seen as a response to – the rough, violent, predatory, lawless, and monopolistic nature of American capitalism between the end of the Civil War and the beginning of World War I, and also to – the inability of neoclassical (or, marginalist) economics to reflect the realities of contemporary capitalism • Veblen coined the term ‘neoclassical economics’ to refer to the economics of Alfred Marshall and likeminded economists 13
  14. 14. rationality • Neoclassical economists saw consumer behavior as rational behavior by people with stable tastes • Veblen instead saw non-rational or instinctual behavior of people under the sway of instincts that evolve according to Darwinian rules Business Motivations  Neoclassical economists saw firms engaged in a clear- sighted but honest and by-the-book pursuit of profit maximization  Veblen instead saw deep conflicts within firms between businessmen, who wanted profits by hook or by crook, and engineers and other technical people who were mainly interested in making a good product. 14
  15. 15. Cont.. • Leisure Class; Veblen’s analysis of consumer behavior went along the following lines: • We instinctively seek high social status. • We achieve high social status when our peers admire us, when they regard us as winners and not losers. • To be considered a winner we need to show that we have stronger predatory abilities than others. To show our predatory abilities, we need to amass more wealth than our peers. • Moreover, that wealth must be acquired by force or by cunning and not by hard work – because the acquisition of wealth by hard work does not show any evidence of one’s predatory abilities – hard work is for wimps and losers. • Consequently, capitalist societies tend to generate a leisure class that rises to the top of the food chain by making money without having worked for the money. 15
  16. 16. Cont.. • Conspicuous Consumption;Not only must we acquire wealth without doing any labor, we must make sure everybody knows how wealthy we are. • This leads to – conspicuous consumption, – conspicuous waste, and – conspicuous leisure. • An act of consumption creates more utility when that consumption is observed by one’s peers than when it is done in private: what’s the point of drinking an expensive wine if no one sees you doing so? – To a neoclassical economist who swears by rational consumer behavior, this way of thinking would be considered perverse. – But to Veblen, this way of thinking about consumer behavior is a lot more realistic. 16
  17. 17. Cont… • Ostentatious waste—as in arranging a lavish wedding for one’s pet cats—would also help convince people that a lot of unearned wealth lies at the source of all the waste. • Similarly, a visibly leisurely lifestyle would also serve the same purpose. • Women’s clothing needs to be highly elaborate and obviously unsuitable for work in order to be regarded as fashionable 17
  18. 18. Cont… • Business Enterprise; Businessmen see the bizarre behavior of the leisure class and realize that the way to make money is by taking advantage of the whims of the leisure class and ripping them off. • Moreover, the general social admiration of predatory behavior leads businessmen to unscrupulous behavior. – For example, they sabotage their rival producers so that reduced overall output would create an artificial scarcity that would lead to high prices. • On the other hand, the engineers who do the technical work in the manufacturing industries are interested only in the quality of their products. – Their job satisfaction derives from simply doing a good job and producing products that serve some genuine need. • Veblen speculated that – these conflicts between the corrupt ideas of the businessmen and the sense of excellence of the engineers may be irreconcilable – the only hope for capitalism lay in the engineers taking over. 18
  19. 19. Cont… • Unions; Veblen’s view of labor unions wasn’t very positive either. • He argued that unions would be quite happy to procure gains for their members even if those gains come at the expense of non-union workers. • This idea was later formalized as the so-called insider-outsider theory of labor unions. 19
  20. 20. Cont.. • Darwin and Veblen; According to Veblen, our instincts—such as the instinct to admire predatory people—may have evolved according to Darwinian laws during a primitive phase of human society when might actually made right. • The problem, however, is that our instincts, once they are embedded in us, are hard to get rid of even after the conditions that once made them helpful give way to a new set of conditions under which they are a hindrance. 20
  21. 21. Cont… • Marx and Veblen; Veblen’s view of the evolution of our instincts is somewhat similar to Karl Marx’s conception of the inertial tendencies of the ideological superstructure. • Veblen’s views on the business cycle were also very similar to those of Marx. • However, Veblen did not believe in any deadly conflict, such as that envisioned by Marx, between the leisure class and the working class. • In fact, Veblen’s working class people admire the predatory prowess of the leisure class and hope to one day become members of the leisure class themselves. 21
  22. 22. Cont.. • A rising demand curve!; In 1950, Harvey Leibenstein introduced Veblen’s ideas on conspicuous consumption into formal demand theory and showed the possibility of a rising demand curve. • The leisure class does not want to be seen consuming cheap stuff. • Therefore, as the price of a product rises, it might become more popular with such people! Veblen is a pioneer of the relatively new discipline of behavioral economics – See for a taste of this subject 22 Thorstein Veblen
  23. 23. veblen Thorstein Veblen 23
  24. 24. The New Institutionalist School  The traditional institutionalism associated with Veblen, Mitchell, and Galbraith is generally critical of neoclassical economics and supportive of government intervention.  In contrast, new institutionalism tends to be theoretical, market-oriented, and anti-interventionist.  There are several identifiable strands of this new institutionalist thought, each emphasizing the importance of institutions in understanding economic (or political) behavior and outcomes. One strand is the work of Harold Demsetz (1930–) on the role of property rights in promoting economic efficiency. A second strand is the analysis by Richard Posner (1939–) of the relationship between law and economics. A third is the focus of Ronald Coase (1910–) and Oliver E. Williamson (1932–) on transaction costs in explaining the organization and behavior of firms. A fourth is the work of James Buchanan (1919–) and Gordon Tullock (1922–) on public-choice theory, including analyses of rent seeking, interest groups, voting rules, and constitutional economics. 24 The Development of Modern Heterodox School
  25. 25. Cont..  The most sweeping strand of new institutionalism, however, is that associated with Douglass North (1920–)  North criticizes neoclassical economics for its failure to recognize the importance of institutional constraints in economic decision making and its inability to explain the permanence of diverse economic institutions throughout the world.  Unlike traditional institutionalists like Veblen, however, North embraces the neoclassicist’s “choice theoretic” approach, which emphasizes rational economic decision making.  Institutions come into being because they minimize human interaction costs. They can be formal (for example, constitutions and laws) or informal (for example, unwritten codes of conduct).  Institutions are the formal and informal rules that govern economic and political behavior. 25
  26. 26.  The form that institutions take owes much to the bargaining power of individuals and groups representing them. But once institutions are in place, the behaviors and outcomes from individual choices reinforce their continued presence.  Institutional constraints thus vary both through time and across countries.  Wealthy nations essentially are wealthy because their institutional constraints define a set of payoffs to political and economic activity that encourages education and skill acquisition, capital expansion, new technology, and thus economic growth.  Poor nations are poor because their institutions define a set of payoffs to political and economic activity that discourages wealth creation. Property rights are poorly defined and enforced, the brightest minds enter government or emigrate, social and religious customs limit work and disparage material gain, and wealth redistribution is given more emphasis than wealth creation.  North’s genius has been to wed traditional neoclassical analysis with the analysis of institutions.  By so doing, he explains how institutions affect economic choices and how economic choices gradually alter institutions. 26 Cont…
  27. 27. The recent debate on institutions  There has been burgeoning literature within economics that discusses and analyses institutions (see North 1990; Nugent and Lin 1996; Nelson and Winter 1982; Jones and Hall 1998; Olson et al. 1998; Robinson et al. 2001; Glaeser et al. 2004; Bardhan 2005; Hodgson, 2007).  Acemouglu et al., 2001  Rodrik et al., 2004  The attention of international organisations and policy makers has focused more on the importance of institutions for economic growth. Institutional economists, economic research centres and international organisations have built indexes of governance which measure an institutional quality of developing and advanced countries. 27
  28. 28. Institutions and development  The importance of institutions in the economy and on the economic development is recognized from nearly all the economists who worked on LDCs (Lewis, 1955; Myrdal 1968; Kutznets 1973; Sen 1981; Hirschman, 1990; Solow 1994).  However the institutional economics remains too much often outside from the analysis of the neoclassical economic paradigm and from the greater part of the text books, where the neoclassical assumptions (perfect information, zero costs of transaction, profit maximizing etc) prevents whichever debate on the role of institutions in the economics. 28
  29. 29. Endogenous growth theory  Also the recent contributions of the endogenous growth theory (Romer 1986, Lucas 1988), take into consideration elements (such as increasing return to scale, human capital, externalities) whose origins it is not difficult to make to go back to the economic relations that are settled down between the agents, and therefore to the institutions. 29
  30. 30. SOLOW RESIDUAL (1956) Y- rK /Y *K - wL /Y *L= SOLOW RESIDUAL= TFP SOLOW RESIDUAL IS A BLACK BOX WHICH CAN BE EXPLAINED WITH INSTITUTIONS Questions concerning institutions role;  The role of the institutions in the economy;  Existence of different institutions;  The contribution of institutions on the productivity;  The existence of inefficient institutions;  The mechanisms of the institutional change 30
  31. 31. 31 Questions..  People say:“institutions matter.”  Great!  But, if institutions are nothing more than codified laws, organizations and other such explicit, intentional devices, why can’t badly-performing economies design (emulate) “good” institutions and implement them?  because they do not change so easily ...and they are informal… How do institutions change? “history matters” for development.
  32. 32. CENTRAL DILEMMA 32 The main problem in the institutional economic analysis is to establish what is the fundamental paradigm of the economic choices between the two:
  33. 33. 33
  34. 34. Formal institutions Formal institutions are generally defined as the law sphere, with constitutions, regulations and organisations. There is a direct connection between formal rules and a political economy framework such as governance, property rights, and judiciary system. Thus, reinforcing of the formal institutions is guaranteed by the legal system. 34
  35. 35. .. Informal institutions;They are a set of social norms, conventions, moral values, religious beliefs, traditions and other behavioural norms that have passed the test of the historical time and that determine the individual behaviour. 35
  36. 36. Cont.. The informal institutions can be called the Old Ethos or the Carriers of History. These informal rules are part of the dynamic evolution of a community and heritage of its culture. In addition these rules or institutions are self-reinforcing in course of time trough mechanisms such as imitations, traditions and other forms of teaching. They also serve as sanctions that facilitate the self-reinforcing process such as: community membership, fear of expulsion, reputation and fear to be the only one not to respect the rules. There is an inbuilt threat in this Hobbesian type Competition which allows the respect of the rules because otherwise the social relationships will become violent.(Solow R.. 1994) 36
  37. 37. A normative system  This highlights the complexity of a normative system that is characterized by one formal dimension and one informal dimension, each with the own characteristic  Hence, Institutions are “a set of social rules that structure social interactions” (Knight, 1992:2) 37
  38. 38. A complex framework 38 Formal rules Informal rules Conformity Legal sanctions Social obligation Reinforcing Legal incentives Reputation Motivation Functionality Orthodoxy Prevalence Tools Law, organizations, constitutions Tacite conventions, social normes, habits Legitimacy Judicial- state Cultural-traditional
  39. 39. What is an “institution” then?  Arrangements that coordinate the behavior of individuals in society.  Institutions are sets of regulatory norms.  An institution is a stable, valued, recurring pattern of behavior. 39 Where do we see “institutions”? 1. Is family an institution? 2. Friendship? 3. Love? 4. Marriage? 5. School? 6. Exam? 7. Market? 8. Firm? 9. Contract? 10. Polls (voting) 11. Political party? 12. Constitution? 13. Exchange rate regime? 14. Central bank independence? 15. Currency? 16. Theatre? 17. Literature? 18. Cinema? 19. Cinematography? 20. Poverty? 21. Social stratification? 22. Casta system in India? ONLY IF…An institution is a stable, valued, recurring pattern of behavior.
  40. 40. Example of category of economic institutions  Trust  Information  Property rights and Privatizations  Rent-seeking, Groups of pressure and lobbies  Bribe/corruption  Reputation and Values  Mechanisms of selection,  Competition and cooperation  Intermediary  Bureaucracy  Organizations  Laws and constitutions  Industrial relations 40
  41. 41. There has to be reciprocity The important conclusion  Social agents  generate,  influence  and support institutions. BUT  Institutions create social agents. A good institution must survive a dual test of “making sense” and “being fit” for its mission. 41
  42. 42. Markets require non-market institutions to work well a. Markets are not self-creating i. Property rights ii. Contract enforcement b. Markets are not self-regulating i. Regulatory authorities ii. Correction of market and coordination failures c. Markets are not self-stabilizing i. Monetary, fiscal and currency arrangements d. Markets are not self-legitimating i. Political democracy ii. Social insurance iii. Redistribution 42
  43. 43. Concluding remarks Institution formation 43
  44. 44. Ind.assnt..Quasi- Institutionalists: Joseph Schumpeter, Gunnar Myrdal, John Kenneth Galbraith Post-Keynesians  The ideas of “post-Keynesian economists” were contend that the contemporary neoclassical synthesis (synthesis between Keynesian macroeconomics and neoclassical microeconomics) is not only seriously flawed but also incompatible with Keynes’s own ideas.  Not all scholars of Keynes accepted this neoclassical synthesis. Some denied both the IS–LM interpretation of Keynes and standard microeconomics.  Chief among these post-Keynesian critics was a group of economists at Cambridge, England, including Piero Sraffa, Nicolas Kaldor (1908–1986), Joan Robinson , and Luigi Pasinetti (1930–). John K. Galbraith, Sydney Weintraub (1914–1983), and a handful of other economists contributed to this school of thought in the United States.  Many of the post- Keynesians drew heavily on the work of Polish economist Michal Kalecki (1899– 1970), who in 1933 had offered a “Keynesian-like” theory of total employment prior to The General Theory. 44
  45. 45. Cont.. The post-Keynesians are a small, yet diverse, group of economists. Some of the ideas of each individual within this paradigm differ from those expressed by others. The followings are the major basic tenets of this school. (1) Neo-Ricardian view of production, value, and distribution: According to Sraffa, the pattern of demand for various products does not affect the pattern of prices; rather, it affects only the scale of output in each industry.. 45
  46. 46.  The real values (prices) of goods depend on the shares of other commodities necessary to produce them.  Relative values (prices) and profits (if wages are given) are determined by the production techniques used to produce a composite standard commodity, which consists of the basic commodities in the economy.  (2) Markup pricing: Prices are set by oligopolistic corporations.  These firms finance investment largely from retained profits, and to achieve their desired levels of profits oligopolists set prices above current costs. 46 Cont..
  47. 47.  Prices therefore “do not reflect current demand conditions; rather they reflect the funds requirements for the planned investment expenditure.  When costs rise, firms increase their prices to maintain their markups over their costs.  (3) Endogenous money: Contrary to the view held by Fisher and Friedman, post-Keynesians regard the stock of money as being essentially endogenous to the economy, changing in response to changes in the level of wages.  The needs of trade dictate the supply of money (Keynes himself pointed).  (4) Pronounced cyclical instability: The economy is inherently unstable. Investment must grow sufficiently to keep national income and output growing at a steady rate. 47 Cont..
  48. 48. When investment is less than required to maintain the steady rate of growth, the economy recedes and unemployment rises.  (5) Need for an incomes policy: An incomes policy limits the average annual wage increase to the nation’s annual rate of productivity growth.  Similarly, firms are constrained as to how much they can raise prices.  A successful incomes policy holds down inflation, minimizes the redistribution of income from inflation, and avoids the loss of output associated with anti-inflationary fiscal and monetary policies.  According to post-Keynesians, the “class struggle” for income shares and the markup pricing by oligopolists necessitate a permanent incomes policy 48 Cont..
  49. 49. END OF CHAPTER 2 THANK YOU. 49
  51. 51.  The rate of 51
  52. 52. Iriving 52
  53. 53. Nominal 53
  54. 54.  Fisher’s) 54
  55. 55.  MV + M’V’ = 55
  57. 57. Cont…  Chamberlin: The theory of monopolistic competition P MC  The key concept is product differentiation: Assumptions - Cost curves the same - Firms charge prices greater than their marginal costs - Operate at average costs greater than minimum - Inefficiency in allocation 57
  58. 58.  Joan Robinson: Introduced the nature of monopsony market in product market and in resource market.  Monopolistic competition can only be eliminated by pure competition.  Exploitation occurs when the worker’s wage is less than the value of the marginal product of labor (VMP) Remedy by 58
  59. 59. NON MARXIAN HETERODOX ECONOMICS THE GERMAN HISTORICAL SCHOOL  Arose in 1840 with Friedrich List and Wilhelm Roscher and ended in 1917 when Schmoller died. -Like the socialists, this school is critical of classical economics. Historical Background: -Germany was divided, weak and agricultural - Nationalism, militarism, paternalism, devotion to duty and hard work, massive government intervention were the order of the day. - Germany was far behind England in industrial development - Eonomists in Germany believed government intervention 59
  60. 60.  The evolutionary approach enabled explaining the departure from laissez-faire in countries like England Lasting contribution Historical inductive method is generally accepted today. The attack on laissez faire as unrestricted free enterprise does not necessarily produce the best result. THE INSTITUTIONALIST SCHOOL (THE OLD) An American contribution to economic thought Began around 1900 and continues up to date The founder was Thorstein Veblen. Historcial Background of the school - Inspite of impressive developments of capitalism, improvements in living conditions of many workers did not match their expectations. 60
  61. 61.  Inspite of impressive developments of capitalism, improvements in living conditions of many workers did not match their expectations. Long hours of work, low housing condition, insecurity at times of sickness, unemployment, old age, higher education and job security were not adequate or accessible for most workers.  - Health and safety regulations were non-existent or inadequate - Monopoly began, conservative forces predominated every where, state and federal government were using the force of the police to solve industrial disputes, were establishing tariff protection to businesses. The doctrine that minimum government interference produces the maximum social well- being seemed untenable.  There were two methods recognized as methods of achieving 61
  62. 62. 1.Reorganize society along socialism 2. Promote trade unionism 3. Undertake social reform by ameliorating the conditions through government intervention and save capitalism There was the influence of the German historical school on American institutionalist school. Both share the inductive approach as superior over the abstract deductive approach. Despite the methodological similarity the institutionalists were not nationalists; they were more liberal and democratic in their outlook. Major tenets:- - Holistic broad perspective - the economy is like a complex organism - Focus on institutions - - economic life is regulated by economic institutions, not by economic laws. 62
  63. 63.  Whom did institutionalism benefit? - The middle-class, agrarian interests, small business and labour groups, government workers, reformers, humanitarians, leaders of consumer’s organizations, union members, were attracted to its ideas. - Non-economist academicians praised the institutionalist interdisciplinary approach.  Usefulness and correctness of the school in its time. The school challenged the rigid orthodoxy in economic thinking and helped to revise that type of theory. The school added realism to economic analysis by incorporating the institutional setting the evolutionary process and by looking at the economy as a whole. The school urged closer integration of the social sciences. The emphasis on inductive studies reduced the gap between economic theory and practice. Gathering and analysing statistical data become popular and is a monument to this method. 63
  64. 64. Lasting contributions - The broader perspective - - The reform movement - - The influence on development economics - Veblen : the founder of the institutionalist school Contributions - - The leisure class o Conspicuous consumption - Propensity to avoid useful work - Conservatism - - Attacks on Neo-classical economics - On consumer sovereignity o Static system 64
  65. 65.  Wesley Clair Mitchell The importance of empirical investigation Business cycles : conclusions - Business cycles arise in a money economy (a society where economic activities are mainly carried by making and spending money) - Business cycles are widely diffused throughout the economy - Business fluctuations depend on the prospect for profit - Fluctuation are systematically generated by the economy itself The need for social planning to overcome the worst features of business fluctuations Readings on Quasi-Institutionalists: Joseph Schumpeter, Gunnar Myrdal, John Kenneth Galbraith 65
  66. 66. The Austrian School  The new institutionalist school - Market oriented and anti-interventionsit - Emphasis on rational economic decision making on: - Various components - The role of property rights - The relationship between law and economics - Transaction costs explaining the organization and behaviour of firms - Analysis of rent seeking, interest groups, voting roles and constitutional economics 66
  67. 67.  Discovering principles for maximizing social well being  Defines welfare optimality and means of achieving it  Identify factors that impede the achievement of maximum well- being and means of removing the impediments.  Pareto- -Refined Edgeworths indifference curve notion as well as Walras’s general equilibrium analysis - Arrived at the conditions for maximum welfare Pareto optimality 67
  68. 68. cont’d  - Maximum welfare occurs where there are no longer any changes that will make some one better off while making no other worse off.  Pareto optimality implies-optimal distribution of goods among consumers, optimal technical allocation of resources and optimal quantities of outputs.  Optimal distribution of goods Optimality condition: consumers having identical marginal rates of substitution between two goods MRSxy(A) = MRSxy(B), where A and B are individuals and x & y are goods. 68
  69. 69.  Optimal technical allocation of resource -Optimality condition: MRTSLK(X) = MRTSLK (Y) Optimal quantities of output -Optimality condition: MRSXY = MRTXY Criticisms : -fails to address the issue of distributive justice, overall growth of output vs. distributive impacts - it is based on static view of efficiency Pigou: Unlike Pareto’s general equilibrium analysis Pigou relied on partial equilibrium analysis Income redistribution-greater equality of income could increase economic welfare 69
  70. 70.  Divergence between private and social costs and benefits Externalities: spill over effects lead to the divergence between social and private costs and benefit.
  71. 71.  Pigou on saving People’s telescopic faculty is defective and tend to devote too much of their resources to present use and too little to future use. Economic result is affected as a result. The creation of new capital is checked and people use up the present (existing) capital to such a degree that future advantages are sacrificed for smaller present ones. Pigou concluded that, to enhance economic welfare,  -governments intervention that strengthen the tendency to consume at present should diminish  -taxes on saving, on property, progressive taxes on income be avoided  put heavy taxes on consumption 71
  72. 72.  Pigou’s effect: real balance effect of price falls The decline in the general price level accompanying an economic down turn will increase the real value of people’s assets. With increased asset value people will save less and consume more, thus increasing demand. This will restore full employment. The idea served as explanation in macro economics why the aggregate demand is downward sloping. Pigou and price discrimination -1st degree – all consumer surplus is taken away -2nd degree – block prices charged, taking parts of the consumer surplus -3rd degree -price is charged on the basis of elasticity of demand 72
  73. 73.  Debates on Welfare under socialism versus under capitalism Ludwig von Mises: Consumer goods: -The same types of economic calculation that guide resources to their highest valued uses under capitalism must be made by the socialist planner who desires to maximize consumer welfare. - Without private owner ship of resources, free markets and entrepreneurs, such calculation is impossible to make. Capital goods: Relative prices in market economic reflect scarcities and productive values. 73
  74. 74.  Prices of capital goods change quickly in response to changes in consumer tastes, new technology, entrepreneurial expectations, etc. Under socialism no such mechanism exists.  the economy is on constant change and continuously generating new Information Entrepreneurs best suited to and have the ability to anticipate rewards.  profits and loses select those who can best fulfil wants, they smarten entrepreneurs  socialism cannot duplicable the functions of the market 74
  75. 75.  Oscar Lange: Market socialism, would result in economic efficiency and maximum social welfare.  Market socialism is characterized by a) private ownership of consumer goods a b) free choice of occupation c) state ownership of the means of production.  There are markets for goods, services and labor but not for capital and intermediate goods.  Shadow price, an index of the terms of exchange between two items, exists rather than market price.  A central planning board, through trial & error process can set the prices of capital by adjustment of price to eliminate shortages & surpluses. 75
  76. 76.  Workers are paid their market wage plus the social dividend.  The trial and error process is much the same as that which occurs under capitalism, but can work better under socialism because central planners have better access to a greater range e of information about shortages and surpluses than do individual capitalists. KENNETH ARROW -How do we know if we are socially better off as a result of policy choice? -Individual choice versus collective choice, how do they relate? - Is perfect democracy possible? - Are there rules for determining what constitutes a just distribution of income? 76
  77. 77. To ascertain the relationship between individual preferences and social choices through democratic voting, Arrow establishes four minimal conditions to be met by social choice:  social choice must be transitive : if A is preferred to B and B to C than A to C  A group decision must hot be dictated by anyone inside or outside the community  social choices must not change in the opposite direction of individual choice  A social preference made between two alternatives must depend only on preferences toward these two alternatives and not on people’s opinions of other options.  Arrow arrived at his impossibility theorem: that " perfect democracy is impossible” 77
  78. 78.  Example: suppose a community has three voters (V1, V2, and V3) and there are three alternative policies to choose from (A, B, C). 78
  79. 79.  Comparing policy A to B, by majority rule, A wins (two individuals (V1 and V3) have chosen A to be better than B). Comparing the winner A with C, C wins the majority. This choice implies that C is better than B if the social choice respects the transitivity rule. But actually B is observed to be better than C by the same majority-rule, violating the transitivity principle. Thus, decisions on the basis of perfect democracy (majority rule) do not simultaneously respect the four principles. JAMES M.BUCHANAN The public choice perspective only individuals know their utility individual have different tastes, capacities, expectations, knowledge but all possess the commonality - pursuit of self interest The pursuit of self interest leads to spontaneous order though the process of exchange. Buchanan extends the assumption of self interested behaviour to political 79
  80. 80.  the collapse of communism : Communist leaders promoted their own interest not the idealized social good  the rising of public debt in many industrial nations :Elected politicians will seek any excuse to create budget defeats to provide public goods & services so that they stay in power.  the rent seeking behaviour of business & labour groups: they attempt to persuade governments to limit competition and create special rules that enhance private profit  Bureaucracy is endemic to government and tends to beget more bureaucracy  Buchanan objects the idea in conventional welfare economics that: o advocating ( posing) government officials as agents who can identify social welfare function, and o considers them as agents who identify and correct the 'bad' produced by private sector to enhance society's welfare. The reasons for the objection are: o Utility can be known only individually; and individuals know their utility preference when presented with real world choices, which means no one can 80
  81. 81.  The government sector consists of people who act on their own interest that may not align with the social ideal, if at all that social welfare  Although Buchanan is pro- individualist he is not an anarchist. Individuals understand the need for government to constrain individual behaviour and the need for constitutional rules to constrain the state.  Mutual consent (unanimity) is desirable in establishing constitutional rules, but efficiency considerations may necessitate majority voting rule. Even majority rule is not sacrosanct. An optimal voting rule is that minimizes the sum of  (a) the costs to those opposing the proposition and  (b) Society bargaining and decision making costs associated with gaining greater consensus. 81
  82. 82. MATHEMATICAL ECONOMICS AND EMPERICAL METHODS IN ECONOMICS  Mathematical economics refers to the expression of economic principles and analyses using mathematical symbols and methods. It does not constitute a separate school of economic thought but a distinct method of expression and analysing economic theories, principles and conclusions. Algebra, geometry, calculus, difference equations, differential equations, linear algebra, topology are used in economic analysis and theorizing.  Mathematical economics was used in three general ways  (a) to derive and state economic theory  (b) to expose inconsistencies in verbally expressed theories and corrected logical errors  (c) to develop testable hypothesis  Static and Dynamic Optimization, linear programming, partial equilibrium, general equilibrium, input output analysis, game theoretic analysis, are applications of mathematics in economics. 82
  83. 83. Perpetual questions and Issues in scientific investigation - Is there any way to relate theory to reality? - - If there is a way, is there more than one way?  Assessing the reality on the ground to confirm or refute theories is known as empirical analysis. Historically the empirical methods followed to relate theory to reality were: -Common sense empiricism (arm chair empiricism) - Statistical Analysis (measurement of reality without theory) - Classical econometric analysis - - Bayesian Econometric analysis - How are Mathematical Economics, Statistics and Econometrics related in modern economic science? - Mathematical economics: - Application of maths to develop hypotheses and clarify their implications - Statistics: - Collection of numerical observations and statistical analysis, use tests derived from probability theory to gain insight into those numerical 83
  84. 84.  Econometrics: -Combination of mathematical econometrical and statistical analysis THE DEVELOPMENT OF MODERN MICROECONOMICS -Historically Cournot, Walras, Pareto, and Edgeworth unseated Marshall to become the forefathers of modern graduate microeconomics, relegating Marshallian economics to a role in undergraduate education. -Marshall focused on partial equilibrium. Modern microeconomics focused on general equilibrium that was pioneered by Walras. -Though geometry was used in Marshallian analysis to some extent, it heralded the beginning of the end of Marshallian economics. In modern microeconomic after 1930s expositions using the various geometric tools and mathematical formalizing intensified. History and institutions gave way to argumentations abstracted from any actual setting. Because many economists had acquired the requisite analytic equipment, the late 1930s and early 1940s witnessed a revolution in microeconomics, 84
  85. 85.  Formalization of economic theory went through: (1) Extending the marginal analysis of households, firms, and markets to make it more internally consistent, with the use of general equilibrium and higher mathematical analysis. (2) (2) Reformulating the questions in manner consistent with the tools and techniques available for dealing with them. (3) (3) Adding new techniques to clarify unsolved questions. This process has continued to date. These processes followed different paths 1) European roots o Generalizing and formalizing general equilibrium theory. Arrow & Debru addressing Adam Smith’s question " will the invisible hard promote social good?” 85
  86. 86.  2) The other path is that of Paul Samuelson which focussed on the implications of economic theory in the following statement "the existence of analogies between central features of various theories unifies the existence of a general theory which underlies the particular theories and unifies them with respect to those essential features“  Accordingly Equilibrium and stability conditions emerge as the two part structure underlying economic theory. The conditions of equilibrium for comparatives statics can be put in the maximization frame work. For dynamic analysis specification of the dynamic properties are required to assess the stability. -As advances in mathematical economics and general equilibrium approach relegated Marshallian approach to a subordinate level, what happened to the monopolistic competition theory, which was a departure from Marshallian 86
  87. 87.  Monopolistic competition theory failed to be embraced in the new microeconomics for reasons of difficulty in formalizing.  -Chamberlains monopolistic competition analysis was a Marshallian partial equilibrant analysis and it was not amenable to integration in the general equilibrium analysis that relied on the competitive model.  -Monopolistic competition was countered as an unnecessary appendage. It does not add to pure monopoly or to pure competition explanations as no power of prediction as the polar models. Milton Friedman and the Chicago Approach to Microeconomics Topics in modern microeconomics -Topics in Modern Microeconomics have expanded to two general areas : i.e., in terms of issues( domains) and methods (techniques) 87
  88. 88.  The domain of Microeconomics :  Microeconomics is expanding to other areas, which were traditionally considered outside the realm of economics, such as the analysis of decisions of family on the number of children, marriage, crimes, , social choice and constitutions, law and economics etc.  The techniques of microeconomics : New mathematical tool kits and inclusion of uncertainty and game theory Topics in modern micro economics in two specific areas o Demand theory: Indifference curve approach ( preference based ), Revealed preference approach ( choice based ) Critiques on the claims of the law of demand The existence of Giffen goods and the counter explanation The argument on Inadequate psychological foundation of utility maximization as a basis for demand analysis. 88
  89. 89.  Welfare economics  The fundamental theorems of welfare economics  Measures of change in consumer welfare  Consumer surplus  DEVELOPMENTS IN MODERN MACROECONOMICS  Historical forerunners of Macroeconomics - MERCANTILISTS The possibility of divergence Actual and Potential level of output as a result of : - Private interest leading to monopoly that restricts output - Individuals saving and hence deficiency of domestic demand - Imports crowding out domestic products The accumulation of Gold and silver as the measure of wealth of a country Balance of payments - The outflow of gold and silver leads to unfavourable balance of trade - The need for restriction of imports and promotion of exports - Government intervention is required to regulate domestic and foreign trade and maintain positive balance of payments 89
  90. 90.  CLASSICAL -Invisible hand would lead to attainting the potential output (under lasses faire) -A. Smith agreed with Mercantilists on the effects of monopoly but the method of removal of monopoly is not government but competition. -Mercantile unconsumption arguments were countered by “Says law -Mercantilist argument for amassing gold was countered by the idea that a countries wealth is measured not in precious metals but in real output (under free trade, & foreign competition ) -Markets (even not perfect) worked better than the alternatives -Classical thinkers’ focus of inquiry shifted from monitory and financial forces to real forces. The dichotomy between real and nominal forces was accepted -Non mainstream economist such as Karl Marx asserted that the economy had an aggregate or macroeconomic problem 90
  91. 91. NEOCLASSICAL ECONOMICS  Orthodox economics was interested mainly on one macro issuethe general price level and to some extent on business cycles. To explain the forces that determine the general level of prices, quantity theory of money in the version of equation of exchange and transaction version were developed.  The most famous theory of money, , was developed by Marshall M = kPY, where M is currency plus demand deposits PY is money income,k is the proportion households desire to hold income in the form of money , it was known as the equation of exchange version.  Irving fisher developed transaction version of the, Quantity theory of money – MV =PT, where M- Quantity of money, P- price level, V=velocity, T transaction level. Both assumed full employment.  All attempts to explain business cycle were not successful because they were based on a solid belief in self equilibrating properties of the market economy and saw aggregate fluctuation as temporary co-ordination problems. No one was able to show that equilibrium was possible at less than full employment. 91
  92. 92. Marshallean framework has problems with macroeconomics because of the partial equilibrium nature of supply and demand analysis. The only way to extend the arguments from partial to general equilibrium is to use complicated mathematics. Early neoclassical economists used little mathematics. Few Swedish economists anticipated that the problem to come. They argued that a difference between ex ante and ex post savings and investment affect the aggregate economy. These works were ignored until the great depression, after which they were reconsidered and known as disequilibrium monetary theory. British economists influenced by these events maintained that there could be temporary monetary disturbances in which the flow of savings would not equal the flow of investment. These temporary disturbances would cause fluctuations in real income. Ultimately the economy would right itself but there would be a sequence of time periods with in which the interconnected flows could be in disequilibrium. In connection with this theory it was suggested that the velocity of money could fluctuate in the short run and that there would be temporary unemployment. 92
  93. 93.  Most neoclassical economists of this period were not disequilibrium monetarist. Founded on supply and demand approach in a partial equilibrium frame work, they focused on disequilibrium in labor markets as the cause of extended unemployment. The underlying belief was that wages were above equilibrium wages due to influences of union’s power. To reduce unemployment it necessitates reducing union power. The Depression of 1930’s changed the context under which the market was seen. Economists began to analyze the aggregate economy in greater detail becoming aware of the short comings of neoclassical theory and policy prescription. 93
  94. 94. Classical school cont’d  Whom did the school benefit  Classical ideas helped to promote the political , social and economic climate that encouraged industry, trade and profit.  How was the school valid, useful or correct in its time?  It rationalized the practice of enterprising people.  It justified the overthrow of mercantilism  Reliance on competition was a timely view point  Restricting the role of wasteful and corrupt government was valid and well grounded.  It helped to remove the remnants of feudalism and enhanced investment in agriculture and industry 94
  95. 95. Classical School cont’d  Lasting Contributions Of the Classical School  The several laws are now thought as the principles of economics  The law of diminishing returns  The law of comparative advantage  The notion of consumer sovereignty  The importance of capital accumulation to growth  The market mechanism for reconciling the interest of individuals to that of society 95
  96. 96. 4.5. Precursors of Classical Economic thought • Sir William Petty as a precursor of the classical school (He Was a pioneer statistician)  Velocity of money  velocity of money can be as important as the quantity of money  Division of labor  Recognized the economics associated with the specialization of labor and division of tasks e.g. Cloth must be cheaper when one cards, another spins, and another weaves  Rent theory  Arrived at a primitive theory of rent saying that a farmer planting a corn taking out the seed out of the proceed of his harvest and also what himself has eaten and given to others in exchange for clothing and other natural necessities, the remainder of corn is the natural and true rent of the land for that year. 96
  97. 97. Sir William Petty cont’d  What were the shortcomings of this analysis?  the failure to separate the return to capital from the return to land  The failure to show rent to be a differential return arising at the intensive extensive margin of cultivation.  Petty did realize that land nearer to the market yielded a higher rent  Importance of capital  Argued that the use of tools is much productive than simple labor  Labor theory of value  The value of a bushel of corn will be equal to that of an ounce of silver if the labor necessary to produce each is the same.  Refer books for more discussions 97
  98. 98. Sir Dudley North as a precursor of the classical school  Trade is not for one side benefit  Trade’s object is not to accumulate specie  Wealth should not be measured by the stock of precious metals  What matters is not money but bread  Laissez faire in intra and inter national trade enables maximum gains  Not complete harmony in interests( this makes him different from most classical thinkers)  Disagreed that war and conquest enrich a country( in opposition to mercantilist) and undermined service and emphasized on goods production( Not akin to a classical)  Saw Industry as less important ( Not akin to a classical)  Refer books for more discussions 98
  99. 99. Richard cantillon as a precursor of the classical school  Used the concept entrepreneurship for the first time.  Predates Quesnay in recognizing the circular flow of resources  Developed the theory of value and price ( Intrinsic value and market price )  He had a theory of population growth where population growth is endogenous to the economic prosperity  Analyzed interest as a reward for risk taking in lending  Supported the export of surplus( Like the mercantilists)  Believed that gold and silver mined at home would not bring wealth rather raise domestic prices rather emphasized production of goods and selling abroad.  Stated that export surplus cannot be maintained for long  Refer books for more discussions 99
  100. 100. David Hume as a precursor of the classical school  Discussed the price-specie mechanism( like Cantillon)  Price adjustment would not take place instantaneously, it follows indirect routes)  Imbalance of trade tends to correct itself  Promoted a cooperative game in trade  Stated that international trade will not perpetuate the differences between advanced and less advanced nations  Opposed the the physiocratic idea of tax on workers getting passed to land lords  Displayed insight to the Recardian Rent theory. Refer books for more discussions 100
  101. 101. Adam Smith( 1723-1790) The founder of the classical school  The key influences on Adam Smith  The general Intellectual Climate of the time known as the enlightenment ( Enlightenment thinkers were optimists of the human progress)  His close friendship with Quesnay and Turgot during his stay in France for more than two years ( For Adam Smith Physiocracy was the “nearest approximation to the truth”  Francis Hutchison’s ( Adam Smith’s Instructor)moral philosophy and David hums philosophy and economic ideas 101
  102. 102. Important works of Adam Smith  The theory of moral sentiments ( published 17 years before the “Wealth of Nations”  The book discussed the moral forces that restrain selfishness ( Sympathy and benevolence restrain selfishness)  An Enquiry into the Nature and Cause of the Wealth of Nations  The book discussed various economic issues  The division of labor:- that the division of labor increases the quantity of output produced for three reasons.  Develops increased dexterity in performing one single task  Saves time through reduced movement  Simplifies tasks for use of machinery and increases productivity. 102
  103. 103. Important works of Adam Smith  The Harmony of interests  “It is not from the benevolence of the butcher , the brewer, or the baker that we expect our dinner but from their regard to their own interest…. By pursuing his own interest each individual frequently promotes that of society more effectually than when he really intends it.’  The action of each producer or merchant who is attempting to gain profit is restrained by the other producers or merchants who are likewise attempting to make money. Competition drives down prices and reduces profit. The pursuit of self interest restrained by competition thus tends to produce Smiths social good- maximum output and economic growth: Social good arising from the harmony of interests 103
  104. 104. Important works of Adam Smith cont’d  Limited government and laissez faire  As long as there exists harmony of interests government intrusion is unneeded and undesirable.  According to Smith governments are wasteful, corrupt inefficient and the granters of monopoly privileges to the detriment of the society as a whole. Laissez faire was promoted by Smith.  However Smith saw a significant but limited role for government involvement.  To protect society  To administer justice  To erect and maintain public works that private entrepreneurs can not undertake profitably 104
  105. 105. Important works of Adam Smith cont’d  To finance these government activities Smiths recommended Taxation. Taxes should be  Proportional to the revenue enjoyed under protection  Predictable and uniform as to the time of payment, the manner of payment and the amount of payment  Collected at minimum cost to the government  Extension of harmony of interests and laissez faire to International trade  “ If a foreign country can supply us with a commodity cheaper than we can make it, better buy it of them with some part of the produce of our own industry, employed in a way which we have some advantage.”  The law of absolute advantage in international trade 105
  106. 106. Important works of Adam Smith cont’d  The market laws of competitive economy  Value (there are two kinds of value)  Value in use ( the utility of some commodity)  Value in exchange( the power of purchasing other goods)  Smith didn’t solve the paradox of value ( why objects having high value in use may possess little value in exchange(like water) and why objects having little value in use may possess high value in exchange(like diamond)  He focused on exchange value and the source or determinant of exchange value for him was the cost of production 106
  107. 107. Important works of Adam Smith cont’d  Smith examined exchange value under two circumstances  “An early and rude state” where labor is the only scarce resource(capital and land are either non existent of free goods)  Advanced economy where capital had accumulated and land commanded a positive price.  Labor theory of value in primitive society:  In a society where labor is the only resource the relative value of a good ( exchange value) would be determined by the amount of labor necessary to produce it. This is the labor cost theory of value ( remember William Petty)  The value of any commodity to the person who possesses it , if he wishes to exchange it for other commodities,is equal to the quantity of labor which it enables him to purchase or command.This is is referred as labor commanded theory of value 107
  108. 108. Important works of Adam Smith cont’d  Labor theory of value in advanced economy:  The growth of capital invalidates the simple labor cost theory of value  The real value of commodities can no more be measured by the labor contained in them  In societies where capital investment and land resources become important goods will normally be exchanged for other goods , for money or for labor at a figure high enough to cover wages rents and profits  However the real value can still be measured by the quantity of labor which they can purchase or command  The quantity of labor that a commodity can buy exceeds the quantity of labor embodied in the in its production by the total profits and rents. 108
  109. 109. Important works of Adam Smith cont’d  For A. Smith Demand does not influence the value of commodities  The cost of production i.e., wages , rent and profits are the only determinants of value in the long run  The Implicit assumption of Smith is that production expands and shrinks at constant cost per unit output  Competition drives down prices to cost that include normal profits  Any increase in demand will not increase value because the cost of producing each unit of the good remains unchanged  Note that if the assumption was that unit cost of production changes as production increases and shrinks, then Smiths principle becomes untenable.In that case changes in demand will affect changes in production and hence changes in prices. 109
  110. 110. Important works of Adam Smith cont’d  Market price:- Smith like Cantillon makes a distinction between:  Intrinsic or natural price-( realized in the long run )  The long run price below which entrepreneurs will not sell their goods. Such prices just( exactly) cover average rates of wages, rents and profits.If they sale below these prices in a desperate situation they would not continue in their business  Market price(realized in the short run) –  The actual price any commodity is sold. It tends to fluctuate around the natural price depending on the short run supply and demand.When it happens to be above the natural price more goods come in to the market depressing prices and when lower some productive factors will be withdrawn, the quantity supplied falling and market price rising to the natural rate.  Short run demand and supply are not fundamental determinants of prices( exchange value) but are simple causes of fluctuations of the market price around the natural or intrinsic price. 110
  111. 111. Important works of Adam Smith cont’d  Smith distinguishes between Real and Nominal price.  Increases in the stock of money increases the money price of commodities  Real price of a commodity is its command over labor, not its command over money.  Wages : Smith addresses  The aggregate level of wages  The growth of wages overtime  The structure of wages  The aggregate level of wages  Average annual wage =(Wage fund)/(number of laborers)  The wage fund is a part of stock of circulating capital out of which present wages are paid. The stock consists of the the savings of the capitalists from previous production and sales. The wage fund is fixed in the short run but can expand from year to year. 111
  112. 112. Important works of Adam Smith cont’d  The minimum wage rate must be that which enable a worker with a family to survive and perpetuate labor supply  The growth of wages overtime  When demand for labor rises, wages will rise above the minimum. The rate of increase of national wealth determines the demand for labor and the wages by influencing the size of the wage fund.  Smith also laid the basis for the modern concept of economies of high wages or efficiency wage theory where high wages increase the health and strength of workers and induce more labor supply  If the wealth is stationary population and labor supply will depress wages. His emphasis is on Capital accumulation and economic growth in opposition to the low wages doctrine o0f Mercantilists  Bargaining play a role in determining wages 112
  113. 113. Important works of Adam Smith cont’d  The structure of wages  With the underlying assumption of a society with perfect liberty to choose and change occupations, advantages and disadvantages of every type of employment would be equal or tend toward equality( the theory of equalizing differences or compensating wage differentials)  According to the theory of equalizing differences or compensating wage differential theory actual wage rates for different jobs, the actual wage structure, would vary according to the five factors:  Agreeableness of occupation  Cost of acquiring the skill(Knowledge):embryonic human capital theory  Regularity of employment  Level of trust and responsibility attached  Probability or improbability of success 113
  114. 114. Important works of Adam Smith cont’d  Profit :  is a compensation for the risk of losses and a return for entrepreneurial effort ; hence, Smith argues, the lowest profit must be high enough to compensate risk of loss plus some surplus( gross profit). Net profit is the surplus alone.  In countries that are advancing rapidly in wealth, competition among businesses lowers the rate of profit.  The low rate of profit in such countries offset the effect of high wages and these countries sell goods as cheaply as those having lower wage rates.  Interest :was not treated as a separate distributive share. It was handled simply as a deduction from profit. The lowest rate of interest a little higher than the losses that sometimes occur through lending and generally lower than the rate of profit. As profits rise borrowers seek more money and interest rate rises. 114
  115. 115. Important works of Adam Smith cont’d  Rent:Smith presents several theories of rent  Rent as a component of the cost of production and constituent of price and determinant of price.  Rent as a price paid for the use of land the amount of which is determined by the price of the agricultural produce from that land.Here rent is not the component of price of agricultural produce.It is the highest price the tenant can afford to pay after deducting wages , the wear and tear of capital, average profit and other expenses of production.Rent therefore is a surplus or a residual.High prices high rents.  Rent as a monopoly return  Rent as an opportunity cost of using land for one purpose rather than another. 115
  116. 116. Important works of Adam Smith cont’d  Smith’s view on wages, profits and rents constitute an attempt to formulate a theory of factor share (functional) distribution of income.  Money:  is vital as a means of payment but does not add to the output or to the wealth of a society  Paper money would do equally well as gold and silver.  Public debt and taxes required to pay the interest were detrimental to the economy as they induce the merchants and manufacturers to invest abroad and growing debt would in the long run probably ruin great nations of Europe. 116
  117. 117. Important works of Adam Smith cont’d  Economic development  The division of labor spurs capital accumulation and increase labor productivity; capital accumulation and high wages also increase labor productivity  High wages arise from high wage fund which in turn increases with capital accumulation  Increased productivity increases national output and increased wealth of a nation. 117
  118. 118. Thomas Malthus  Influences on Malthus’s thinking  The negative impacts of the Industrial Revolution and growing urbanization were beginning to appear  Controversies on growing poverty and what to do about it  The legislation in 1795 of the latest of the series of “poor laws” that stipulated the minimum income for the poor families, and the following heated debate.  The corn laws that placed tariff on imported grain and the controversy  The growing population and the pressure on food supply 118
  119. 119. Thomas Malthus  The rising necessity to import food to England while the Napoleonic wars kept the imports of food low and the extreme prices of grains and land rent, which was favorable to English Landlords  The growing concern, after the defeat of Napoleon, of English land lords on the surge of imported grain that would depress grain prices  the urge by the landlords to lift up the floor prices of imported grains, which stood against the business interest that spoke against high tariffs  The arguments that followed to repeal Corn Laws 119
  120. 120. Thomas Malthus  The Intellectual Setting that influenced Malthus  William Godwin  A minister who turned anarchist and atheist.  He opposed all coercion by the state and all collective action by citizenry,  relied on the voluntary goodwill and sense of justice of the individual guided by the ultimate rule of reason  Believed that the human race is perfectible through continuous advance to rationality and increased well being  A person’s character depends on the social environment and perfect society will produce perfect people.  The major obstacles to progress are private property, economic inequality and the coercive state  Population growth is not a problem as humanity will refuse to propagate when population reaches its limits. 120
  121. 121. Thomas Malthus  The Marquis de Condorcet  An eminent French mathematician of an aristocratic family, who was skeptic in religion, a democrat in politics,a physiocrat in economics, and a pacifist  He welcomed and supported the French revolution  He favored universal suffrage for men and women, opposed the property qualification for voting and election to office  He was persecuted by the revolution and went hiding for nine years .  He wrote his most important work while hiding He wrote about social progress based on three fundamental principles  Equality among nations( which abolishes wars )  Equality of individuals within nations( which overcomes social evils and leads to perfections)  The perfectibility of humanity  Population would increase as a result of these beneficent reforms but the food supply would increase even more rapidly. If not birth control may have to be used. 121
  122. 122. Thomas Malthus  Malthus rebelled against these ideas of Goodman and Condorcet  He argued that misery is rooted in the prolific fertility of human race, not in evil human institutions.  Goodwin and Condorcet were promoting ideas such as the abolition of War and hunger, which are remedies of overpopulation.  Malthus’s Population Theory  was an explanation to account for much of that poverty and misery observable in the lowest classes of every nation  His law of population states  Population When un checked increases geometrically( 1, 2, 4, 8, 16,…)  Subsistence increases at best arithmetically(1,2,3,4,5,6,7,8,9,…………..)  Types of checks to population growth  Preventive checks( reduce the birth rate)  He approved Moral restraint such as postponing marriage, never marry, strict moral conduct before marriage  He disapproved what he called vice such as prostitution and mechanical birth control 122
  123. 123. Thomas Malthus  Positive checks( increase the death rate )  These include famine, misery, plague and war, which Malthus elevated to natural laws.  He promoted the idea of facilitating these unfortunate evils to increase mortality of the poor and control population  He openly discouraged benevolent people who think they are doing a service to mankind as mistaken.  There must be no government relief for the poor( abolish the poor laws)  Accordingly the poor laws were amended in 1834. The law aimed at making public assistance so unbearable that most people would rather starve quietly than submit to its indignities  Malthus ideas rendered Political economy the “dismal science” 123
  124. 124. Thomas Malthus  Malthus’s theory of market gluts  Malthus developed the theory of the potential insufficiency of effective demand  Workers’ wages < value of the production by the amount of profit  Capitalists buy some of the extra output in the form of capital goods there by increasing production but not in the habit of consuming all their profit  Investment is undertaken in the final analysis only to provide for consumption, but if the final product cannot be sold no further investment will be forthcoming  Spending by land lords and their retinue is essential to avoid the glut(overproduction ) of the market.(the need for Un productive consumption)  Rent is surplus over the cost of production and its expenditure would add to effective demand without adding to the cost of production.  The policy implications was the Retention of the corn laws, which were important to enrich the landlords and foster unproductive consumption 124
  125. 125. Thomas Malthus  Malthus’s theory of diminishing returns in agriculture  Improvements made to a fixed amount of land would provide increasingly smaller rises in yields  Appreciation of demand and supply, rather than cost of production alone, as determinants of price  Assessment of Malthus  Over rated the significance of rent  His distinction between productive and unproductive consumption is inaccurate  Over rated the significance of population growth relative to that of persistence  He underestimated the possibility of enlarging agricultural produce  Wages have been rising rather than being driven by biological subsistence  He was moralizing than analyzing the means to limit population growth  How ever his theory of population is still relevant to developing world 125
  126. 126. David Ricardo  Was a contemporary of Malthus who further developed the ideas of the classical school.  Was the leading figure in demonstration of the possibilities of using the abstract method of reasoning to formulate economic theories.  He was an outstanding example of a deductive thinker.He called his broad generalizations economic laws the operation of which in economics are as valid as the laws of physics in the natural sciences.  Although he was well acquainted with the facts of business and economic life, he did not use the inductive method of reasoning. 126
  127. 127. David Ricardo  Ricardos ideas on the currency issue  Amidst the prolonged war between France and England, when a panic induced run on gold depleted the reserves in the Bank of England, the Bank stopped paying gold on demand and people holding paper money could not redeem it for gold.  The price of gold gradually exceeded its mint parity price, a general price inflation followed and “the currency question” was an issue of worry and discussion.  In his conclusion on “the currency question” he reaffirmed the quantity theory of money. The Bank was over issuing paper currency because it no longer was checked by the requirement to pay gold on demand By increasing the money supply the Bank of England drove up prices of commodities, thereby reducing the value of currency.  The problem, according to Ricardo, was not the high price of gold, rather the low value of the pound sterling.  He suggested a return to the gold standard and after years of argument his suggestion was passed by the parliament as law. 127
  128. 128. David Ricardo  Ricardo’s theory on diminishing returns and rent  The law of diminishing returns and theory of rent developed in response to the debate on the corn laws.  Recardo was the first to use the concept of diminishing returns to develop the theory of rent  His definition of rent in perspective  Rent is that portion of the produce of the earth, which is paid to the land lord for use of the original and indestructible powers of the soil  Rent is the return on long run capital investment that are amalgamated with the land and increase its productivity.  Rent arises at both the extensive and intensive margin of cultivation 128
  129. 129. David Ricardo c ont’d  THE THEORY OF EXCHANGE AND RELATIVE PRICES  Recardo was concerned on relative( ratio of exchange between commodities) rather than absolute value.  Utility( subjective want satisfying power) or use value is not the measure of exchange value, although it essential to it.  Commodities derive their exchange value from two sources.  Scarcity  The value of non reproducible commodities( such as rare works of art, classic books, coins etc where the supply is fixed) is determined by scarcity alone. Their Value is independent of the quantity of labor originally necessary to produce them.  The quantity of labor required to obtain them  Most commodities are reproducible, and the value of reproducible commodities is determined by the labor time necessary to produce it.  Unlike Smith who stated ‘labor theory of value’ for primitive society and needed ‘labor commanded’ theory for advanced society, Recardo applied his labor theory of value to advanced economy as well. 129
  130. 130. David Ricardo  The labor time includes not only the work done in making the commodity itself but the work embodied in the raw materials and capital goods used up in the process of production.  This approach, according to Ricardo, explains the causes of changes of exchange value overtime.  Ricardo attempted to account for differences in:  capital labor ratio,  the combination of skilled and unskilled labor( labor quality differences)  Wages, profit rates and rent among producers  Two capitalists may employ the same quantity of labor in the production of their goods and yet the goods they produce differ in value because of the different quantities of fixed capital used by each. A commodity will sell at more than its labor time value if more than average capital is invested in its production.  Ricardo recognized that not all labor is of equal quality. We can simply think of the an hour of labor of a skilled labor as being double or triple of the labor time of less skilled labor  130
  131. 131. David Ricardo  Exchange value does not depend on wages, profits , what matters for exchange value is labor time required to produce the good.  Rents does not figure in to the exchange value of a commodity. Prices determine rent.  Wages and profits vary inversely  Labor does not have to receive the whole product simply because labor is the source and measure of value.  Ricardo makes a distinction between market prices and value( natural price).  Market prices deviate from the natural price due to accidental or temporary fluctuations of demand and supply.  Higher market prices lead to higher profits and attract capital , if market prices fall below the natural price capital flows out of the industry. These actions tend to equalize the rate of profit and tend to keep market prices proportional to values.  Short run prices depend on demand and supply while long run values depend on real cost of production. 131
  132. 132. David Ricardo  Ricardo on Distribution of income  For Ricardo political Economy is a subject of enquiry in to the laws which determine the division of the produce of industry among the classes who concur in its formation, rather than the enquiry in to the cause of wealth.  His concern was for understanding the forces that determine the shares of the national income accruing as wages , profits and rents.  Wages  Labor, like all other goods that are bought and sold, has natural price and market price.  The natural price of labor is that that enables workers to subsist and perpetuate themselves. It depends on the price of the necessities of life  Market price depend on supply and demand. 132
  133. 133. David Ricardo  In the long run both the natural and market prices of labor rise because of increased difficulty in producing food.  However in the long run the worker gets a minimum wage of subsistence( the Iron law of wages)  Profits  the rate of profit in different industries with in a country tend to equalize.  Higher profits come at the expense of wages and higher wages come out of profits not passed on prices.  The reason lies  In the equation of exchange and  in the international balance of payments. 133
  134. 134. David Ricardo  The long run trend for the profit rate and the share of profit from the national income would fall because of the increasing difficulty of growing food for expanding population  As population increases the increased demand for food raises it prices and poorer land goes in to cultivation and better land will be more intensively cultivated.This will raise rents, and nominal wages to maintain subsistence wage.  Falling rates of profit would curb accumulation and investment of capital and would ultimately produce a stationary state.  The stationary state would be reached when new investment ceases, population no more expands,as the limit of food production has been reached, and every available surplus goes as rent.  Ricardo saw conflict of interest between workers and capitalists and even deeper conflict between landlords and the rest of society. 134
  135. 135. David Ricardo  Policy implications of Ricardo’s theory of distribution  Wages should be deregulated( opposed the poor laws)  Tax rent would affect only rent ( agreed with Physiocrats)  Rebuff and removal of the corn laws would benefit society( opposed to Malthus)  Ricardo’s theory of comparative costs  He made a strong argument for free trade based on the efficiency gains it confers.  Even if one country is more efficient than another in producing all commodities trade between the two could be of mutual benefit ( Theory of comparative advantage)  Each Nation should produce the product for which it has a relative advantage; that is, the product for which it has the lowest domestic opportunity cost.  In formulating this theory, Ricardo assumed immobility of factors(that capital and labor did not flow between countries) 135
  136. 136. David Ricardo  He implicitly assumed that cost will remain constant as output increased.Otherwise specialization would not proceed to its fullest extent  Ricardo on unemployment  He maintained that full production and employment normally would prevail.  He raised the possibility of technological unemployment in the short run 136
  137. 137. David Ricardo  Evaluation of Ricardo  Lasting Contributions to economic analysis  The use of abstract thinking  The theory of comparative advantage  Employment of marginal analysis  The presentation on the law of diminishing returns in agriculture  Extending economic analysis to include distribution of income  Weaknesses  Overemphasis on the law of diminishing returns in agriculture and disregarded the role of technology and fast accumulation of capital ion pushing total product up[wards  Overemphasis of the idea that the land lords as a whole have no interest in increased productivity of the land.  The wrong assumption that land has only one use and has no opportunity cost, therefore is not part of cost of production. 137
  138. 138. Other important classical thinkers  Jeremy Bentham  Bentham boasted that he was the spiritual father of James mill, James was the spiritual father of Ricardo and there he was the spiritual grandfather of Ricardo  The central theme of Bentham’s thought is Utilitarianism( the principle of the greatest happiness to the greatest number of people)( Note that hedonism centers on the individual)  Money is the instrument that measures the quantity of pleasure or pain  ( cardinal utility)  Bentham argued that wealth is a measure of happiness but it has diminishing marginal utility as it increases.This idea supported the distribution of income.However the tendency towards equality by redistribution creates insecurity and loss of incentive. When ever equality and security are in opposition equality should give way.  Individuals themselves , not government, are generally the best judge of their interest and well being. 138
  139. 139. Bentham  Criticism  Economic  Pleasure and pain are subjective and is extremely difficult to make interpersonal comparison of utility and using money paid in the market as a measure is not satisfactory as what people are willing to pay are greater than what they actually pay.  Philosophical and ethical criticisms  Good life is more than the narrow definition of happiness  It is better to be a human being dissatisfied than a pig satisfied.  Happiness is not the object of life.Life has no object. Life is an end in itself. 139
  140. 140. Other important classical thinkers  Jean Babtist Say  On value , costs of Monopoly, and entrepreneurship  Opposed the labor theory of value and replaced it with supply and demand, which in turn are regulated by cost of production and utility (though more advanced thinking than Ricardo he didn’t how ever show the price and quantity schedules as A. Marshall)  Monopoly Costs are efficiency losses,( deadweight losses) plus use of scarce resources to protect monopoly interests  He emphasized Entrepreneurship as a fourth factor of production on top of the traditional factors land labor and capital  Law of markets  general Overproduction is impossible . Supply creates its own demand 140
  141. 141. Other important classical thinkers  Nassau William Senior  He wished to separate the science of political economy from all :  value judgments,  policy pronouncements and  efforts to promote welfare  ( In today’s thinking it is Known as the separation of positive and normative economics)  Senior put forward four “empirically verifiable” principles of economics from which integrated theory could be deduced  The principle of income or utility maximization  Principles of population  Principle of capital accumulation  Principle of diminishing returns  The exchange value of goods depends on supply and demand underlying the concept demand is the concept of diminishing utility of goods(a concept that was later developed by Marginalists ).Supply depends on the subjective cost of production,i.e., the sum of sacrifices required to produce goods. That were the labor of workers and the abstinence of the capitalists ( abstinence is anew term in economics lexicon contributed by Senior) 141
  142. 142. Other important classical thinkers  Senior disagreed with the distinction of productive and unproductive labor of Smith who thought producers of service were unproductive workers.  To senior the proper distinction is between productive and unproductive consumption. In the class of Unproductive consumption were the use of jewelry, tobacco, beer etc which diminish the power to produce.  Falling out from his own prescription on what an economist should do ( should not give any advice apart from telling the truth alone) he had policy positions on the :  poor laws  trade unions  Factory acts 142
  143. 143. Other important classical thinkers  John Stuart Mill(The last great Economist of the Classical school)  Production( the productive factors, labor , capital and land)  He defined wealth as all useful things that possess exchange value.Only material are included  Productive labor is the exertion that produces( directly and indirectly) utilities embodied in the material objects.  Unproductive labor is that which does not terminate in the production of material wealth.  Capital is the accumulated stock of the produce of labor.  Increase in capita depends on surplus and the disposition to save.  Every increase of capital is capable of giving additional employment to labor.  If the capitalist spend less on luxury consumption and more on investment, the wage fund and the demand for labor would rise.  If population rises the increased demand for necessities by wage earners offsets the decreased demand for luxuries by capitalists  If population rises in less proportion to capital accumulation wages would rise and luxury consumption of the workers would supplement that of employers 143
  144. 144. Other important classical thinkers  Thus the limit of wealth is never the deficiency of consumers but of producers and productive powers.  What are the limits to production?  Labor is not one of them because population increases geometrically, though population is limited by fear of want rather than by want itself.  Since the increase of capital depends on the surplus produced and the disposition to save, the greater the profit that can be made from capital the stronger the motive for accumulation. Hence the limit does not from capital.  Land and its limited productiveness is the real barrier to increases in production. There is increasing returns to scale in manufacturing while there is decreasing returns to scale in agriculture( applied the short run law of diminishing returns only on agriculture) This distinction arise from the assumption that capital can be increased indefinitely while land cannot.  The distinction between the short run concept of diminishing returns and the long run concept of returns to scale was important insight. 144
  145. 145. Other important classical thinkers, John Stuart Mill  On Distribution  The laws and conditions of production of wealth partake of the character of natural laws, but that does not hold for distribution since they are a matter of solely human intuitions  On profit: profit is composed of three parts:- interest( the reward for abstinence), insurance( rewards to risk) and wages of superintendence  Allowing for differences in risk and other reasons behind the components of profit, the profit in all spheres of the employment of capital tend to be equal. In the long run profit will tend to diminish.  On Wage Fund  Wages depend mainly on labor supply and demand  Demand for labor depends on the wage fund( capital kept aside for the payment of wages), presupposes unitary elasticity of demand for labor  Supply of labor depends on the number of people seeking work.  Minimum wage set by government above the equilibrium wage doesn’ have the effect of increasing the total wage payment 145
  146. 146. Other important classical thinkers, John Stuart Mill  Mill recognized, like Smith did, Expenditures on education partly represent present investment justified by later wage returns( human capital theory)  On Exchange  Price expresses the value of a thing in relation to money.  The value of a commodity is measured by its general power to purchase other commodities  The value of a commodity cannot rise higher than its estimated use value to the buyer  Effectual demand (desire plus purchasing ability) is one determinant of value  But differing quantities are demanded at different values  Since demand depended on value and value depended on demand it led Mill to introduce the demand schedule and this was a great leap in the theory of value. 146
  147. 147. Other important classical thinkers, John Stuart Mill  Mill understood supply schedules and elasticity of supply as well.  He classified goods in to three types  Goods absolutely limited in quantity (goods of inelastic supply where demand is of greater importance to determine value)  Goods the supply of which is perfectly elastic( the majority of goods fit in this category; value is determined by cost of production, production can expanded without limit at constant cost)  Goods where a limited quantity can be produced at a given cost( goods that fall in between the above two categories, those with a relative elastic supply; if more is wanted it has to be produced at higher costs; the value of such goods depends on the most costly portion of the supply required)  In his contribution on international trade , Mill introduced the concept of elasticity of demand to explain how the gains from trade would be divided among countries; Ricardo’s trade theory was incomplete in this respect 147
  148. 148. The Socialist thought  Historical background  The industrial revolution and advent of large factories brought to an end to the agricultural village handcraft economy  Around the factories misery was a way of life  Industrial accidents brought little or no compensation  Political rights did not exist and unions were illegal  Poverty of the great masses was dominant  It was questionable whether the mechanical invention reduced the day’s toil of human beings.  Types of Socialism  Utopian Socialism  State socialism  Christian socialism 148
  149. 149. The Socialist thought  Anarchism  Marxian Socialism( scientific socialism)  Communism  Revisionism  Syndicalism  Guild socialism  Commonalities of Socialism  Repudiation of class harmony  Opposition to laissez faire( anarchists were exceptional)  Rejection of Say’s Law( capitalism is doomed to crisis or stagnation)  Belief in the perfectibility of people and their ability to be free of selfish interest  Advocacy of collective action 149
  150. 150. Whom did socialism benefit?  The moderate groups ( utopian, Christian and Gild socialists) claimed to represent every body with emphasis on workers.  The extreme groups (Anarchists, Syndicalists, Marxists ) proclaimed class struggle against the rich, to promote the interest of the working class. 150
  151. 151. The validity of socialism in its time  The socialists concentrated on the problems that the status quo failed to address: poverty and recurring business crises .  The socialists promoted factory laws, unions, sanitary reforms, cooperative associations, workers compensation laws, pensions etc which were opposed by the classical thinkers.  Addressing these issues were valid concerns 151
  152. 152. Lasting contributions of socialism  Many of the tenets of socialism have not stood the test of time. The reorganization of society along socialist lines has not brought about the hoped for:  freedom,  increased collective activity for the common good  Better standards of morality and justice  Greater security for the individual etc  More over the predictions that the working class will be more impoverished under capitalism has not occurred  However socialist have left behind lasting economic ideas of:  the socialist economic thought of state planning and the ownership of the means of production  policy recommendations now institutionalized in capitalist countries, such as social security, workers compensation, unemployment compensation, minimum wage, overtime pay rules, etc  the analysis of the growth of monopoly power, problems of income distribution, and the reality of the business cycle 152
  153. 153. Utopian Socialists : Henri Comte de Saint Simon  He developed his socialist ideas before the working class movement took shape in France and hence didn’t appeal to the workers to rise against their employers  Made a religion of work  Suggested an industrial parliament consisting of three chambers, invention( composed of artistes and engineers), reviewing( composed of scientists), execution 9 composed of leaders of industry)  This was one of the earliest proposals for central planning  The prosperity of France can only exist through the effects of the progress of the sciences, fine arts, and professions. The Princes, the great household officials , the Bishops, marshals, the idle landowners contribute nothing directly to the progress of the sciences, fine arts and the professions, rather they hinder their progress by depriving them of what they should have been entitled.  He has enthusiasm for large scale industry 153