Handout for lecture 2: Early economic thought ( ca 800 BC – ca 1500)
1. Chronology of economics
a) Some important dates in economics
1776, Adam Smith,
An Inquiry into the Nature and Causes of the Wealth of Nations
1817, David Ricardo
Principles of Political Economy and Taxation
1848, John Stuart Mill
Some Principles of Political Economy and their Application to Social
Philosophy
1871-4, William Stanley Jevons
Theory of Political Economy; Carl Menger, Principles of Economics, Leon Walras
Elements of Pure Economics
1890, Alfred Marshall,
Principles of Economics
1936, John Maynard Keynes,
General Theory of Employment, Interest and Money
1948, Paul Samuelson,
Economics
1959, Gerard Debreu,
The Theory of Value
b) Important historical episodes in economics
Mercantilism, 13th - 16th centuries
Physiocracy, France 1750 -1789
Classical economics, first half of 19th century
Marginalism, starting late 19th century
Historical economics, late 19th century
American institutionalism, 1918 to 1940s
Rise of business cycle theory, early 20th century
Keynesian economics, 1940s onwards
Rise of econometrics and mathematical economics, 1940s onwards
Early economic thought (pre-classical economics) (8
th
century BC – 1776)
1. early pre-classical economics (Greeks, Scholasticism) (800 BC – 1500)
2. late pre-clasiccal economics (Mercantilism, 13th - 16th centuries; Physiocracy, France 1750 -1789)
(1500-1776)
Though economic activity has been a characteristic feature of human culture from the beginning, there was little
formal analysis of this activity until capitalism developed in Western Europe during the fifteenth century.
The economic studies of that time were not systematic: economic theory evolved very slowly from individual
intellectual responses to contemporary problems. No grand analytical economic systems appeared.
In thinking about this early economic thought, we have to keep in mind several points:
1) the thinkers of this period addressed limited aspects of the economy and did not expand their analysis into a
comprehensive economic system, they were not searching for grand, big, general theories.
2. The early pre-classical thinkers gave greatest attention to those kinds of non-market mechanisms of allocation
(force, authority, power, tradition). They were also in general not concerned with the problem of efficiency of
resource allocation, but rather considered the consequences of various types of economic activities for justice and
quality of life (not for economic efficiency as it is in modern economics).
Modern economies are market economies, thus modern economic theory focuses on how markets help to deal with
the problems of scarcity and gives almost no attention to the use of force, authority and tradition as mechanisms
for resources distribution in the society.
People at the time were not dependent on markets to acquire goods, but were for the most part self-sufficient.
Thus, early pre-classical economists were not interested in markets because of relative unimportance of markets in
the daily activities of people.
This is one of the most significant differences between early pre-classical and modern orthodox economics. In a
pre-market (and therefore pre-classical) setting, thinkers focused on the use of authority and power as an allocator
of resources.
In addition, we should not forget that these writers believed that it was inappropriate to separate any particular
activity – economic for example, from all other activities. In their writings, they therefore did not abstract
economic activity from all other activities, as it is in contemporary economics.
And, finally, we have to remember that early pre-classical economics (the writings of Greek philosophers and the
scholastics) was dominated by ethical, not purely scientific, considerations, the ethical, not purely scientific,
questions of justice, fairness and the morality of commerce were central to these thinkers.
For example, the pre-classical writers examined exchange and prices with the purpose of evaluating their fairness
and justice. Those kinds of considerations (the ethical ones) are almost completely absent in modern orthodox
economics, but can be find in the modern heterodox economic thought form the 18
th
century to the present (for
example in Marxism, institutionalism, radical economics and other currents).
So much for the introduction and we can turn to the Greek economic thought.
We shall now discuss the economic thought of:
1. Hesiod,
2. Xenophon,
3. Plato, and
4. Aristotle.
Hesiod,
Works and Days, c. 800 BC
Xenophon, lived in 4
th
century BC
Plato,
The Republic, c. 400 BC
Aristotle,
Politics, c. 310 BC
The ideas of Hesiod were orally presented during the eighth century BC. The most important work with economic
implications attributed to Hesiod is
Works and Days, in which he initiates a pursuit of economic questions that
continued for two centuries in ancient Greece. Being a farmer, Hesiod was interested in efficiency. Efficiency in a
household for Hesiod was the result of hard work, honesty and peace.
Economists use the concept of efficiency in a number of contexts – for example, it is measured as a ratio of
outputs to inputs. Maximum efficiency is then taken to be achieving the largest possible output with a given input.
We can also thing about a similar procedure for minimizing inputs (costs) for a given output.
Much of the writings about efficiency during the early pre-classical period concerned the efficiency at the level of
the individual producer and household. Those writers and Hesiod too were not interested in efficiency at the level
of society. This problem, efficiency at the level of society is much more difficult and complex, then the problem of
efficiency at the level of one producer or household. It is not surprising therefore that Hesiod and other Greek
thinkers were pursuing problems related to this more obvious issue of efficiency.
Beside touching on the problem of efficiency, Hesiod realized that the basic economic problem is one of scarce
resources, he also suggested that competition can stimulate production, for it will cause people to emulate each
other (that is to imitate the activities, which are profitable).
However, though those ideas of efficiency, scarcity and competition are clearly present in Hesiod’s
Works and
Days, they are not expressed in anything like abstract terms. It is just poetry, good, but only poetry. There are
economic insights, but nothing is developed very far and it is difficult to know how much significance to attach to
them.
Xenophon, writing some four hundred years after Hesiod, that is in the 4
th
century BC, took the concepts of
efficient management much farther than Hesiod and applied them at the level of the household, the producer, the
military, and the public administrator. This brought him insights into how efficiency can be improved by practicing
a division of labor.
Oikonomikos, the title of Xenophon’s work, is the origin of the words “economist” and “economics”. However, it is
better translated as The Estate Manager or Estate Management. Taken literally it means Household Management,
“oikos” being the Greek word for “household”. Xenophon’s Oikonomikos is in fact a treatise on managing an
agricultural estate. According to him, an efficient estate should be, first of all, efficiently organized. He believed
that good organization could double productivity in agricultural estate.
He also argued that the division of labor should be practiced in the household or estate in order to increase
efficiency. He observed that in a small town, the same worker may have to make chairs, doors and tables, but he
cannot be skilled in all these activities. In large cities, however, demand is so large that men can specialize in each
this task, becoming more efficient.
In Xenophon world markets and trade are still almost absent, managing the agricultural estate is as central to his
view of economic activity as it was for Hesiod’s.
Attention to the division of labor was continued by other Greek writers, including Aristotle, and later by the
scholastics. We will see that at the level of society Adam Smith gave special recognition to the influence of the
division of labor on the wealth of nations.
Next we turn to Plato. Living in the forth and third century BC.
Plato was mainly a great philosopher, but he had also some contributions to economics. In his treatise Republic,
he was trying to provide a blueprint for the ideal state, which would be free of all the vices inherent weaknesses of
democracy as well as tyranny (or monarchy). For Plato, the most important feature of society should be its
stability. Leaders in democracy in his view would not do what was right and just, but rather use their office to gain
support, while tyrants or kings, on the other hand, would use their power to further their own interests, not those
of the state as a whole.
Plato’s solution to this dilemma was to create a class of philosophers-kings, who would rule the state in the
interests of whole society. What is important from economic point of view, for the ruling class not to become
corrupt, they would be forbidden to own property or even to handle gold and silver, they would receive what they
needed to live as a wage from the rest of community. In this harsh vision, even the wives and kids in the ruling
class should be common property.
Nevertheless, returning to the economics, like other Greek thinkers Plato considered specialization in production as
a key element to efficiency.
He saw a very limited role for trade and the markets in his ideal state. Consumer goods may be bought and sold
(outside the ruling class), but property was to be allocated appropriately between citizens. There would be no
profits or payment of interest on money loans.
Therefore, what is important here is the Plato’s view that the ruling class should not possess private property but
should hold communal property, to avoid corruption and conflicts. This is a first quasi-economic argument against
private property in the history of economics.
So much on Plato.
Aristotle, living in the 4
th
century BC was a student of Plato. The influence of Aristotle on subsequent generations
was such that for many, he was simply “the philosopher”. His writings encompassed philosophy, politics, ethics,
natural science, medicine and virtually all others fields of inquiry, and it dominated thinking in these areas for
nearly 2000 years, until let’s say 15
th
, 16
th
century.
His contributions to what are now thought of as economic issues are found mostly in his work entitled Politics. He
was concerned mainly with the issues of justice, the nature of the household and the state and the status of
private property.
In the matter of private property, Aristotle believed that private property served a useful function in society and
that no regulations should be made to limit the amount of property in private hands. He argued that private
property gives incentives to efficient use of the economic resources.
This may be considered as a first quasi-economic, intuitive, not-formal, argument for private property.
Aristotle was also interested in the problem of justice in distribution and exchange. We should remember that in
his times the allocation of goods was not guided by competitive markets, but rather by authorities. In addition, the
prices of goods were highly regulated. The question of how justly distribute goods and what is the fair price were
therefore important.
When dealing with these problems of distribution and exchange Aristotle distinguished between three types of
justice: distributive justice, rectificatory justice and commutative justice (or justice in exchange).
The first concept applies to the distribution of goods. It is said by Aristotle that goods are distributed justly in this
sense if they are supplied to people in proportion to their merit (goodness, virtue, quality of character,
contributions to the prosperity of state). It was a very elastic notion, for merit can be defined in different ways in
different settings.
Second type of justice is rectificatory justice, that is putting right previous injustice by compensating those who
had lost something. It is not interesting from our point of view.
Finally, there comes commutative justice, justice in exchange.
If two people exchange goods, how do we assess whether the transaction is just? We could say that if exchange is
voluntary, than it must be just. Aristotle recognized however, that in such exchanges justice does not determine a
unique price, but merely a range of possible prices in between the lowest price the seller is prepared to accept and
the highest price the buyer is prepared to pay. There is therefore a scope for a rule to determine the just price
within this range.
His answer was the harmonic mean of the two extreme prices, which is given by the formula:
2/[1/p
1
+1/p
2
],
Where, p
1
and p
2
are the relevant prices.
The harmonic mean has the mathematical property that if the just price is, say 40% above the lowest price the
seller will accept, it is also 40% below the highest price the buyer is prepared to pay.
This is Aristotle’s concept of justice in exchange.
We should remember – he was not dealing with exchange in competitive markets, where there is a unique price,
for in his times the role of markets was limited.
Aristotle also developed a distinction between economics – the science of household or estate management, and
the science of wealth getting, which is called
chrematistics (that is wealth-getting, accumulating wealth).
Aristole distinguished between two kinds of chrematistics – natural and unnatural one. The first one, natural
chrematistics is a part of economics (that is household management), for a person should know whether to
engage in planting wheat or bee keeping, or should know where to go fishing or hunting. These were natural ways
in which to acquire, to get wealth (barter exchange was also part of natural chrematistics).
In contrast, the second type of chrematistics is getting wealth through exchange using the money. It is according
to A. unnatural, for this could involve making a gain at someone else’s expense. Unnatural ways to acquire wealth
included commerce by the use of money and usury (lending money at interest). This kind of chrematistics is not
included in economics and should be condemned as unnecessary and evil, morally bad.
What does it mean that for A. commerce and exchange were unnatural and therefore morally bad?
In Aristotle’s vision, people should aim at a good life. To do this they needed material resources, provided by their
estate. These could be obtained by means of natural chrematistics or by trade and exchange (unnatural, bad kind
of chrematistics). However, according to Aristotle a characteristic feature of a good life is that human needs are
limited and high levels of consumption are not part of a good life. Therefore, there is a limit to the natural
acquisition of wealth – that is fulfilling your basic needs.
What disturbed Aristotle about commerce was that it offered the prospect of an unlimited accumulation of wealth,
far beyond the needs of the household. He thought of money exchange rather as an attempt to satisfy unlimited
desires of human beings. While satisfying the desires was not a part of Greek notion of a good life.
So therefore, according to Aristotle, market exchange with the medium of money, suggests that a person want to
make a monetary gain through the exchange and satisfy the unlimited desire for money and wealth. These
activities do not lead to a good life and as such, unnatural chrematistics should be considered as morally bad.
So much on Aristotle’s economic views.
He had enormous impact on economic ideas during the period of scholasticism. It was Aristotle’s views that St.
Thomas Aquinas and other churchmen developed further in the 13
th
and 14
th
century.
One last remark. The ancient world was dominated by self-sufficiency and isolated (non-market) exchange.
However there was no market economy in the modern sense, commercial activity were sufficiently developed to
provide a big challenge to the thinkers.
Overall, the thinkers whose views are known to us were rather suspicious of commerce and exchange. The
two subjects dominated discussions of economic issues right up to the 17
th
century – justice and the morality of
commerce and exchange. Only by 17
th
century, the existence of market economy and commercial mentality had
come to be accepted.
The Middle Ages and the so-called scholastic economic doctrine.
Some general remarks on the scholasticism.
The scholastics were educated monks, who tried to provide religious guidelines to applied to secular (for example
economic) activities. Their aim was not so much to analyze economic activity taking place during their times, as to
prescribe rules of economic conduct compatible with religious dogma. The economic insights they produced,
usually referred to as “scholasticism” or scholastic economics, were concerned primarily with ethical connotations
of economics.
The most important of scholastic writer was St. Tomas Aquinas,
Summa Theologica, c. 1273, lived in 13
th
century.
Few words about the economy during the Mddle Ages.
Although the production of goods for sale in a market increased throughout the period, it did not play a dominant
role in everyday life. The feudal economy of the middle ages consisted mainly of agriculture in a society bound
together not by a market but by tradition, custom and authority. The society was divided into 4 groups: serfs,
landlords, royalty and the church. All land was fundamentally owned by the Roman Catholic Church or the king.
Use of the land owned by the king was given to the lords, who in exchange had certain obligations to the central
authority. The relationship between lord and serf was also dictated by custom, tradition and authority, the serf was
tied to the land by tradition and paid the lord for use of the land with labor, corps and sometimes money. What is
also important, the church as a largest landholder in Western Europe had significant secular influence in society.
The scholastics essentially addressed the same economic issues as ancient Greeks: that is the institution of private
property and the concepts of just price and usury. We may risk a judgment that scholastic literature is an attempt
to reconcile the religious teachings of the church with the slowly increasing economic activity of the time.
Scholastic writings represent a gradual acceptance of certain aspects of economic activity as compatible with
religious doctrine. The significance of Aquinas ideas lies in his fusion of religious teachings with the writings of
Aristotle, which provided scholastic economic doctrine with much of its content.
To reconcile religious doctrine with the institution of private property and with economic activity, Aquinas had to
challenge numerous biblical statements condemning private property, wealth and the pursuit of economic gain.
As you know, we can find in the Bible the following statements:
And Jesus said to His disciples, 'Truly I say to you, it is hard for a rich man to enter the kingdom of heaven.
Or: 'And again I say to you, it is easier for a camel to go through the eye of a needle, than for a rich man to enter
the kingdom of God.'
Based upon the New Testament early Christian thinkers held also that communal property is the natural state of
the world.
St. Thomas using Aristotle’s thought were able to argue in a convincing way that private property is not contrary to
natural law or religious beliefs. Although he agreed that under natural, god’s law, all property is communal, he
maintained that the private property was an addition, not a contradiction, to natural, god’s given, law. The nature
of this argumentation was religious, not economical, but the implications of Aquinas reasoning were powerful and
extremely beneficial for the economy.
Aquinas was also concerned with another aspect of economic activity, that is the price of goods. Unlike modern
economists, he was not trying to analyze the formation of prices in an economy or to understand the role that
prices play in the process of resource allocation.
He focused on the ethical aspect of prices, raising issues of justice in exchange. Mainly, he was asking - What is a
just price?
Historians of economics differ in their interpretations of the Aquinas notion of just price. Some of them argue that
a just price of a commodity according to Aquinas is an equivalent to the cost of the labor embodied in the
commodity.
Others, that is an equivalent in terms of the utility, and others that the just price is an equivalent in terms of total
cost of production.
The most popular interpretation is, however, that for Aquinas just price meant simply the market price.
If this is correct – we should stress that it is not useful solution, since Aquinas had no economic theory explaining
the forces that determine market price.
Scholastic thinkers, following Aristotle, were also in the early middle ages prohibiting the usury, that is taking the
interest on money loans, but later in the period they accepted it, at least if money was lent on business purposes.
St Thomas Aquinas was a complex and interesting thinker. On the one hand, he held back economic thinking by
emphasizing ethical issues and focusing on moral aspects of economics; on the other hand, he advanced
economics by his use of little more abstract thinking than writers before him.
So much on Aquinas.
Short summary of early pre-classical economics.
Pre-classical thinkers did not pursue economics as a separate discipline; they were interested in much broader,
more philosophical issues. Moreover, since the economic activity they observed during those early times was not
organized into a market system as we know it, they concentrated not on the nature and meaning of the price
system but on ethical questions concerning justice and fairness.
The Greeks studied the administration of resources at the level of the household and producer and pursued the
ideas of efficiency and division of labor. They examined the role of private property, different notions of justice and
the distinction between human needs and wants.
Later, scholastic doctrine did not attempt to analyze the economy, but rather to set religious standards by which to
judge economic conduct. Nevertheless, the scholastic doctrine helped to form a base for the development of a
more analytical, abstract approach to economics.
Handout for lecture 3
Mercantilism and the Physiocracy
Early economic thought (pre-classical economics) (8
th
century BC – 1776)
1. early pre-classical economics (Greeks, Scholasticism) (800 BC – 1500)
2. late pre-classical economics (1500-1776)
•
Mercantilism, 16th - 18th centuries;
•
Physiocracy, France, 1750 -1789
Late pre-classical economics spans from circa the year of 1500 to 1776. We can distinguish two main currents of
economic thought in this period: Mercantilism, active in the whole Europe from 13
th
to 16
th
century and
Physiocracy, a French school of economic thought, active from about 1750 to 1789. We discuss them in turn.
Important writers of this period (late pre-classical economics)
Thomas Mun,
England’s Treasure by Foreign Trade, 1664
William Petty,
Political Arithmetic, 1690
Bernard Madeville,
The Fable of the Bees, 1714
David Hume, Political Discourses, 1752
Richard Cantillon,
Essay on the Nature of Commerce in General, 1755
Francois Quesney,
Tableu Economique, 1758
The period between 1500 and 1750 was characterized by an increase in economic activity. Feudalism was giving
way to increasing trade. Individual economic activity was less controlled by the custom and tradition of the feudal
society and the authority of the church. Production of goods for market became more important and land, labor
and capital began to be bought and sold in markets.
This laid the groundwork for the Industrial Revolution in the second part in the 18
th
century. However, we have to
remember, that still we are talking about pre-industrial world, where agriculture is the most important sector of the
economy.
During this period from 16
th
to the half of 18
th
century, economic thinking developed from simple applications of
ideas about individuals, households and producers to a more complicated view of the economy as a system with
laws and interrelationships of its own.
Mercantilism.
Mercantilism is the name given to the economic literature and practice in Europe of the period between 1500 and
1750. Although mercantilist literature was produced in all the developing economies of Western Europe (and I
should add some Eastern European, for example in Poland, economies too), the most significant contributions
were made by the English and the French.
Whereas the economic literature of scholasticism was written by medieval churchmen, the economic theory of
mercantilism was the work of secular people, mostly merchant businessmen, who were privately engaged in selling
and buying goods. The literature they produced focused on questions of economic policy and was usually related
to a particular interest the merchant and writer (in one person) was trying to promote.
For this reason, there was often considerable skepticism regarding the analytical merits of particular arguments
and the validity of their conclusions. Few authors could claim to be sufficiently detached from their private issues
and offer objective economic analysis. However, throughout the mercantilism, both the quantity (there were over
2000 economic works published in 16
th
and 17
th
century) and quality of economic literature grew. The mercantilist
literature from 1650 to 1750 was of distinctly higher quality, these writers created or touched on nearly all
analytical concept on which Adam Smith based his Wealth of Nations, which was published in 1776.
The age of mercantilism has been characterized as one in which every person was his own economist. Since the
various writers between 1500 and 1750 held very diverse views, it is difficult to generalize about the resulting
literature. Furthermore, each writer tended to concentrate on one topic, and no single writer was able to
synthesize these contributions impressively enough to influence the subsequent development of economic theory.
Secondly, mercantilism can best be understood as an intellectual reaction to the problems of the times. In this
period of the decline of feudalism and the rise of the nation-states, the mercantilists tried to determine the best
policies for promoting the power and wealth of the nation, the policies that would best consolidate and increase
the power and prosperity of the developing economies.
What is especially important here is the mercantilistic assumption that the total wealth of the world was fixed and
constant. These writers applied the assumption to trade between nations, concluding that any increase in the
wealth and economic power of one nation occurred at the expense of other nations (the rest of the world). Thus,
the mercantilists emphasized international trade as a mean of increasing the wealth and power of a nation.
Using some modern game-theoretic language, we may say, that they perceived economic activity and international
trade in particular as a zero-sum game, that is a game, where it is impossible for both players to win (In a two-
person zero-sum game, the payoff to one player is the negative of that going to the other player). So according to
mercantilists, it is impossible to increase a global wealth of the world in effect of international trade. It is a very
sad assumption, and modern economists do not share it.
The goal of economic activity, according to most mercantilists, was production, not consumption, as classical
economists would later have it.
They advocated increasing the nation’s wealth by simultaneously encouraging production, increasing exports and
holding down domestic consumption. Thus, in practice, the wealth of nation rested on the poverty of the many
members of society. One again, they advocated high level of production, high level of export and low domestic
consumption.
In addition, they proposed low wages in order to give the domestic economy competitive advantages in
international trade. Most of the mercantilists held that wages (of the workers) should be set on the subsistence
level, allowing workers to preserve their lives, but not to consume more than it is required to continue their lives.
Higher wages would cause laborers to limit their work supply and national output; national wealth would fall,
according to mercantilists.
Thus, when the goal of economic activity is defined in terms of national output and not in terms of national
consumption, poverty for the masses benefits the nation. This is another sad consequence of mercantilist
economic theory.
Third general point about mercantilism is their insistence on the notion of balance of trade.
Balance of trade figures, also called net exports, are the sum of the money gained by a given economy selling
exports, minus the cost of buying imports.
A positive balance of trade is known as a trade surplus and consists of exporting more (in financial terms) than
one imports. A negative balance of trade is known as a trade deficit and consists of importing more than one
exports.
As we know today, neither positive nor negative balance of trade is necessarily dangerous in modern economies,
although large trade surpluses or trade deficits may sometimes be a sign of other economic problems.
According to mercantilists a country should increase exports and discourage imports by means of tariffs, quotas,
subsidies, taxes and the like in order to achieve a so-called favorable or positive balance of trade.
Production should be stimulated by government interference in the domestic economy and by the regulations of
foreign trade.
Protective duties should be placed on manufactured goods from abroad; and the state should encourage the
import of cheap raw materials to be used in manufacturing goods for export.
Why did the mercantilists argued for a positive balance of trade?
It is not an easy question to answer.
Many early mercantilists defined the wealth of nation not in terms of nation’s production or consumption, but in
terms of its holdings of precious metals such as gold or silver. They argued for positive balance of trade because it
would lead to a flow of precious metals into the domestic economy to settle the trade balance. Remember here
that later or most eminent mercantilists equated the wealth of nation with the overall production of the nation.
While for early mercantilists the wealth of nation consisted of the precious metals accumulated in the domestic
economy.
The first mercantilists argued that a positive balance of trade should be struck with each nation. A number of
subsequent writers however argued that only the overall balance of trade with all nations was significant. Thus,
England might have a trade deficit with India, but because it could import from India cheap raw materials that
could be used to manufacture goods in England for export, it might well have a positive overall trade balance with
all nations.
A related issue concerned the exports of precious metals or bullion (that is gold or silver in bars).
Early mercantilists recommended that the export of bullion be strictly prohibited. Later writers suggested that
exporting bullion might lead to an improvement in overall trade balances if the bullion were used to purchase raw
materials for export goods.
So much on the mercantilist concept of positive trade balance.
One more point about mercantilist theory concerns money.
The early mercantilists equated the wealth of nations with the stock of precious metals internally held in the
country. They were very impressed with the significance of the tremendous flow of precious metals into Europe,
particularly into Spain, from the New World, from America. It is therefore not surprising that they became to
identify the wealth of nations with gold and silver.
However later mercantilists subscribed to a more sophisticated view and identified the wealth of nation with the
nation’s overall production. They were able to develop useful analytical insights into the role of money in an
economy.
A central feature of this late mercantilist literature is the conviction that monetary factors, money supply, rather
then real factors (such as quantity of labor, capital goods and the like), are the chief determinants of economic
activity.
They maintained that an adequate supply of money is particularly essential to the growth of trade, both domestic
and international. Changes in the quantity of money, they believed, generate changes in the level of real output.
Therefore, in this view a positive balance of trade, which would effect in a flow of money into the domestic
economy, would increase the production, the real output and therefore contribute to the increasing wealth of
nation.
Classical economists and Adam Smith radically rejected this view, that monetary factors are main determinants of
economic activity and economic growth in the second halt of 18th century.
Classical economists held that the level of economic activity and the rate of growth depend upon a number of real
factors: the quantity of labor, natural resources, capital goods and the institutional structure of the society. Any
changes in the quantity of money according to classical economists would not influence the level of neither output
nor growth, but only the general level of prices.
Mercantilists held that money supply (not any non-monetary, real factor) was the main factor contributing to the
wealth of nation.
So much on the assumptions of the mercantilistic economic doctrine, and we can move to the discussion of its
contribution to the economic theory – theoretical contributions of mercantilists.
Probably the most significant accomplishment of the later mercantilists was the explicit recognition of the
possibility of analyzing the economy. As we remember, the ancient and medieval thinkers were mostly engaged in
moral, ethical analysis of the economy. It is just in mercantilistic writings, that economy becomes an object of a
purely scientific, not moral analysis. They started to think about an economy as a subject of science, they realized
that the laws of economy could be discovered by the same methods that revealed the laws of physics and other
sciences. This was extremely important step toward subsequent developments in economic theory.
Many mercantilists saw an economy as a mechanical system and believed that if one understood the economic
laws governing the economy, one could control the economy. Wisely proposed legislation could, in this view,
positively influence the course of economic events and economic analysis would indicate what forms of
government intervention would help the economy.
They however realized that government intervention must not be in contradiction with some basic economic truths
such as the law of supply and demand.
Some of them correctly deduced, for example, that price ceilings set below the equilibrium prices lead to excess
demand and shortages.
In addition, the later mercantilists frequently applied the concepts of economic man and the profit motive in
stimulating economic activity – they said, that government cannot change the basic nature of human beings, and
especially their egoistic drives. Therefore, politicians have to take these factors as given (that humans are egoistic
and driven by profit motive) and try to create a set of laws and institutions that will channel these drives to
increase the power and prosperity of the nation.
Many of the later mercantilists became aware of the serious analytical errors of their predecessors (that is early
mercantilists). They recognized, for example, that stock of gold and silver is not a measure of the wealth of a
nation, that it was not possible for all nations to have a positive balance of trade, and also that no one country
could maintain a positive balance of trade over the long run.
What’s more, some of them realized that trade can be mutually beneficial to nations and that advantages will
occur in those countries that practice the division of labor in production.
An increasing number of writers recommended a reduction in the amount of government intervention, anticipating
the prescriptions of Adam Smith and other classical economists.
We have to remember however, that none of these writers was able to present an integrated view of the operation
of a market economy – the manner in which prices are formed and scarce resources are allocated. This was
eventually achieved by Adam Smith and classical economists in the second half of 18
th
century and in 19
th
century.
The popular explanation of this failure of mercantilists to produce a systematic account of a market economy is
that the mercantilists believed that there was a basic conflict between private and public interests or between
private and public welfare.
Therefore, they considered it necessary for government to channel private self-interest into public benefits.
Classical economists, on the other had, found a basic harmony in society between private, egoistic drives of
individuals and social welfare. Even the later mercantilists who advocated market policies lacked sufficient insights
into the operation of market to make an adequate argument linking private self-interest and social welfare.
Still, the writings of the later mercantilists were used by Smith to develop his analysis, and this is another
significant contribution of the mercantilists.
So much on the analytical contributions of mercantilists to the economic theory.
The thought of some influential mercantilist writers.
Thomas Mun (1571-1641), director in one of the most important English trading companies, his most important
book was
England’s Treasure by Foreign Trade, published after his death in 1664.
Mun was a typical mercantilist, he was a proponent of governmental policies that benefited a particular business
interest. It is often said that his book is the classic example of English mercantilist literature.
Mun asserted in the tile of the book that England’s treasure (the wealth of England) was gained by foreign trade.
His thinking was typically mercantilistic in that he confused the wealth of nation with its stock of precious metals
and therefore argued for a positive balance of trade and inflow of gold and silver to England.
He believed that government should regulate foreign trade to achieve a positive balance, encourage importation of
cheap raw materials, encourage exportation of manufactured goods, use protective tariffs on imported
manufactured goods and take other actions to increase population and keep wages low and competitive.
These are all classic mercantilistic policies.
But Mun also has refuted some of the cruder mercantilistic notions, such as a view that England should have a
positive balance of trade with each country; he argued that the really important thing is to have a positive balance
of trade with all countries.
So much on Mun’s book.
Another mercantilist thinker, William Petty (1623-1687), was a sailor, physician, inventor, and what is most
important for us, the first economic writer to advocate the measurement of economic phenomena.
His economic writings were not general treatises; they were the result of his practical interests in matters such as
taxation, politics, money, and measurement.
His most important economic work,
Political Arithmetic, was published after the death of the author in 1690.
Petty was apparently the first to explicitly advocate the use of what we would call statistical techniques to measure
social and economic phenomena. He tried to measure population, national income, exports, imports, and the
capital stock of England. His methods were very crude or simple indeed, but the tried to express economic events
in terms of numbers, weight, and measure, which is a characteristic feature of modern economics. So we could
say, that Petty is a precursor of contemporary methodological position of mainstream economics, which aims at
statistical and econometric testing of theoretical propositions.
Later Adam Smith rejected Petty’s political arithmetic because of the simplicity of Petty’s methods and the
problems of obtaining reasonably accurate data, and the process of quantification of economic analysis has
stopped for nearly 100 years until the second half of 19
th
century.
Another mercantilistic thinker Bernard Mandeville (c. 1670-1733) wrote a satirical poem entitled
Fable of the Bees,
or Private vices, Public Benefits (1714), which drew interest not only from economists but also from philosophers,
psychologists, and other scientists.
In the poem, Mandeville argued against some widely shared at the time views about morality. According to these
views, good society and accordingly good economy requires that people behave virtuously, that is altruistically for
example. In other words, the popular opinion at the time was that people should care not only for their own good,
but also for the good of other members of society, if you want to have a prosperous society with high standard of
social welfare.
Mandeville argued that egoism and selfishness is a moral vice, but that social good, public benefit could result from
selfish acts if these actions were properly channeled by government. On the other hand, if you would try to
change people by moral persuasion, and try to build a society where people are driven by private virtues (not
private vices as in the real societies) you would end up with much lower level of economic output, unemployment
and economic depression. So private vices produce public benefits.
So, according to Mandeville, one should accept men and women as they are and not try to moralize about what
they should be. It is the role of government to take imperfect humankind, full of vice, and by rules and regulations
channel its activities toward the social good.
As a mercantilist, Mandeville had no concept of natural harmony, where the so-called “invisible hand” of the
market, within appropriate institutional setting and without the need of government intervention, makes individual,
egoistic actions also profitable for the whole society. Such a concept was later developed by Adam Smith.
He still insisted that government should regulate much of the economic activity, for example, regulate the foreign
trade in order to create employment and to undertake various projects to provide employment for the poor. In
Mandeville thought mercantilist ideas thus coexisted with his recognition of the importance of the beneficial effects
of the markets.
David Hume (1711-1776).
He is now best known for his philosophical writing, but he also contributed to economics. He was a close friend to
Adam Smith; his economic views are contained in nine essays published in 1852 as a part of a volume of
Political
Discourses.
Like many of his contemporaries Hume could be called a liberal mercantilist, he had one foot in mercantilism, but
with the other stepped forward into classical political economy.
His most important contribution is known in international trade theory as the price specie-flow mechanism,
where
specie is simply the money in the form of coins rather than notes.
Hume pointed out that it would be impossible for an economy to maintain a favorable positive balance of trade
continuously, as many mercantilists advocated.
A positive balance of trade would lead to an increase in the quantity of gold and silver (that is specie) within an
economy (let’s say English economy).
An increase in the quantity of money would lead to a rise in the level of prices in the economy with the positive
balance of trade (English economy).
If England has a positive balance of trade, some other country or countries must be having negative balance, with
a loss of gold or silver and a subsequent fall in the general level of prices in those countries.
Exports in England will decrease and imports will increase because its prices are relatively higher than those of
other economies.
The opposite tendencies will prevail in an economy with an initial negative balance of trade.
This process will ultimately lead to a self-correction of the trade balances in all countries.
Thus, according to this theoretical, beautiful argument of Hume (price specie-flow mechanism), mercantilistic
policy of advocating a positive balance of trade is self-defeating, it is impossible to have a positive or negative
balance of trade in the long run.
It is a very strong, defeating argument against mercantilistic policy.
However, other mercantilists unfortunately paid little attention to Hume’s argument, and they still held the view
that a nation in the first place should care about its balance of trade.
But we still name Hume as a mercantilist because he believed that gradual increase in the money supply would
lead to an increase in real production, real output, while it is characteristic feature of classical economists’ thought
that they maintained changes in money supply would change only the general level of prices.
Therefore, Hume was at least half-mercantilist.
A short summary about mercantilism.
Mercantilists made useful contributions to economic theory, the most important of which was their recognition that
the economy could be formally, scientifically studied. They developed also some abstract models (such as Hume’s
price specie-flow mechanism) to discover the laws that regulated the economy. Along with Physiocrats they can be
regarded as the first economic theorists.
The Mercantilists achieved the first insights into the role of money in determining the general level of prices and
into the effects of foreign trade balances on domestic economic activity.
They also perceived exchange, especially international trade as a process in which one party gains at the expense
of another. Therefore, they advocated intervention in the economy by the government.
Finally, the argument by David Hume, price specie-flow mechanism, put a final nail in the coffin of mercantilist
economic theories, so to speak.
We should however remember that mercantilism could be interpreted not as an attempt to build an economic
theory, but as a sort of rent-seeking activity.
The mercantilists according to this interpretation were driven not by the desire to discover the truth about the
economy, but rather by profit motives to use government to gain economic privileges for themselves. They were
generally merchants who favored government granting of monopolies that would enable the merchant-monopolists
to charge higher prices.
This is only a suggestion, but there may be some truth in this interpretation also.
Physiocracy, France, 1750 -1789
Although mercantilism was a predominant economic school in 18
th
century France, a new but short lived
movement called Physiocracy (or Physiocratic school) began there, in France around 1750.
It provided significant analytical insights into the economy, perceived the interrelatedness of the sectors of the
economy and analyzed the working of non-regulated markets. Thanks to these achievements, the influence of
physiocracy on subsequent economic thought was considerable.
Historians of economics often arbitrarily group thinkers with divergent ideas into a school of thought, usually
because of a single similarity in their thought.
However, the writings of physiocratic school express remarkably consistent views on all major points. There are
three reasons for this, and thus these are three reasons for calling physiocracy – the school of economic thought.
We shall not call mercantilism a school of economic thought, since mercantilistic writings were extremely diverse
and widely scattered in time and space. Mercantilists were united by the insistence of the balance of trade as an
indicator of country opulence, of country prosperity, but in many other aspects of their works their views were
incoherent, inconsistent or simply opposing to one another. So mercantilism was rather a deeply internally diverse
movement in the history of economics, than a school of economic thought
First reason for calling the physiocratic movement school of economic thought is that physiocracy developed
exclusively in France. There were no physiocratic writers in other countries.
Second reason, is that ideas of physiocrats were presented over a relatively short period, from about 1750 to
1780s. Somewhat ironically, we may say that no one was aware of physiocratic ideas before 1750 and after 1780,
only a few economists had heard of them.
Finally, third reason is that physiocracy had an acknowledged, charismatic intellectual leader, Francois Quesnay
(1694-1774), whose ideas were accepted virtually without question by his fellow physiocrats. There was no such
leader in mercantilist movement for example. The writings of other physiocrats were mainly designed to convince
the reader of the merits of Quesnay’s economics.
So physiocracy was a school of economic thought because it was a movement quite limited in space (that is
geographically), time and the diversity of their ideas, it was a closely knit group of followers to spread the
doctrines of the master – F. Quesnay.
The term “physiocracy” means “the rule of nature” or “the regime of nature”, “the authority of nature” and the
like.
In 18
th
century France many feudal institutions still remained, many more than for example in 18
th
century
England, and the king possessed absolute power. Economic policy in the early 18
th
century was mainly
mercantilistic, there were attempts to increase exports and reduce imports, thereby both achieving national self-
sufficiency and accumulating the treasure. In addition, there were attempts to increase the population and to keep
wages low, thus forcing people to work hard. Immigration of skilled workers was encouraged through subsidies.
Trade, internal trade, was carefully regulated and new industries were set up, sometimes with foreign workers.
France in the 18
th
century faced severe financial and economic problems. It was not until much, much later that
deaths from famine, from hunger, from starvation, became outdated.
Throughout the century, the 18
th
century, shortages of food were common.
The government resorted to numerous measures in order to deal with the problem, including price fixing,
prohibiting speculation, and direct regulation and coercion of food producers. The main reason for shortages of
food was the lack of internal movement of food, since there were some surpluses of food in some parts of the
country and at the same time, shortages in others. The markets for food were very limited, in large part because
of the governmental taxes and barriers.
The government also faced chronic financial difficulties, these being due to military expenditures incurred by
French kings, Louis XIV and his successors.
The state was continually on the verge of bankruptcy. The clergy (that is people ordained for religious duties in the
church), and the nobility (the aristocracy), who owned most of the nation’s wealth, were largely exempt from
direct taxation, and among those who were liable the burden of such taxes was very uneven. Collection of taxes
was arbitrary and unjust.
A major reason for this was that the state did not have the administrative apparatus to collect them itself, but
farmed the job out to private companies. These would pay an agreed sum to the state in return for the right to
collect taxes, this process was inefficient and unjust methods of collection of taxes were often used.
Physiocratic ideas were developed mainly by Francois Quesnay in 1750s and 1760s.
By the time Quesnay turned to economics (he was in his 60s), he had gained a considerable reputation as a
doctor, surgeon and physician. His position in the French court was as physician to Madame de Pompadour,
mistress of Louis XV, and it was for his medical services that he received an aristocratic title and considerable
wealth. After a few years, his interest in economics stopped and toward the end of his life he turned to
mathematical investigations.
His medical background is important as it influenced his perspective on economics.
In turning to economics, Quesnay sought to analyze the pathology of society and to propose remedies. He focused
on the circulation of money, a clear analogy with the circulation of blood within the body. It is tempting to suggest
that the term “Physiocracy”, meaning the rule of nature, reflected the attitude of an experienced physician,
medicine doctor, who knew the importance of working with nature in discovering a cure for a disease in the
society and the economy.
Beside focusing on the circulation of money, equally significant, the Physiocratic system rested on a clear analysis
of the structure of French society.
The main components of physiocratic thought:
•
Concept of the “natural order”
•
Concept of “net product”
•
The theoretical model of the economy
•
Policy implications and proposals
The concept of natural law or natural order.
The physiocrats like the later mercantilists developed their economic theories in order to formulate correct
economic policies. Both groups believed that the correct formulation of economic policy required a correct
understanding of the economy. Economic theory was therefore a prerequisite of economic policy.
The physiocrats’ unique idea concerned the role of the so-called natural law in the formulation of policy. They
maintained that natural laws governed the operation of the economy and that, although these laws were
independent of human will, humans could objectively discover them – as they could the laws of natural sciences.
Those natural laws, which are independent of human will, but also objectively manageable to discover, made up
the natural order. The natural order is, according to Quesnay, the one being made up of beneficial and self-
evident, created by God, rules that govern the operation of society and the economy. The example of such a
natural law would be in Quesnay’s views:
- right to acquire property through labor
- the right to pursue one’s own interest
- the right to survival
- Duty to respect other persons and property of others
- the right to voluntary exchange, etc.
Following these laws will ensure the happiness of mankind, Greatest possible abundance of goods, greatest
possible liberty to make use of these goods, and harmony of interest between social classes as physiocrats
thought.
Quesnay made a sharp distinction between the natural order as defined above and the positive order in the nature
and society.
A positive order was human legislation, laws created by people, by governments.
What is important here, physiocrats held that where the positive order (human legislation) deviates from the
perfect, created by God, natural order, the beneficial effect of the natural order will not come into full play.
However, if the government in enlightened by reason, positive laws that are harmful to society will disappear. So
this was the task that physiocrats were trying to perform – to advice the government, the king, to implement the
kind of positive order, the state legislation, which is consistent with eternal, created by God, natural order.
The concept of “net product” and the theoretical model of the economy
Even though physiocratic theory was deficient in logical consistency and detail, the physiocrats did determine the
necessity for building theoretical models by abstracting and isolating key economic variable for study and analysis.
So they were early proponents of abstract model building in economics, their work was analytical, it was not some
kind of story telling, but they tried to work scientifically by building models, very simple models, but nevertheless
scientific models.
Using this procedure (modeling) they achieved significant insights into the interdependence of the various sectors
of the economy on the levels both
The major concern of the physiocrats was with the macroeconomic process of development. They recognized that
France was lagging behind other countries, and especially England in applying new agricultural techniques. Most of
France was maintaining its old agricultural techniques in production, and while some areas of France were
introducing advanced techniques, in overall the country was developing very unevenly.
To cope with this problem, the physiocrats like mercantilists wished to discover the nature and the causes of the
wealth of nations and policies that would best promote economic growth. Physiocracy was an intellectual reaction
to the widespread regulation of the economy that was promoted in 18
th
century by French mercantilism.
The physiocrats focused not on money (as mercantilists did), but rather on the real forces leading to economic
development. In reaction to the mercantilistic notion that wealth was created by the process of exchange
(international exchange), they studied the creation of physical value and concluded that the origin of wealth was in
agriculture or nature.
That is a fundamental conclusion of physiocratic thought – the origin of nation’s wealth is in agriculture.
In the economy of 18
th
century, more goods were produced than were needed to pay the real costs to society of
producing those goods. Therefore, a surplus was generated. The physiocratic search for the origin and size of this
surplus led them to the idea of natural or net product.
The agricultural production process provides a good example of a net product.
After the various factors of production – seed, labor, machinery, and the like – are paid for, the annual harvest
provides an excess, a surplus. The physiocrats regarded this as resulting from the sole productivity of nature.
Labor, according to them, could produce only enough goods to pay the costs of labor, and the same held true for
the other factors of production, with the exception of land.
So all other factor of production, beside land, are not productive, they do not produce any surplus over the costs
of their use. Only land is productive factor of production and only agriculture is a productive sector of the
economy. All other sectors (trade, manufacturing) are therefore not productive; they are sterile. They are (other
factors of production and other sectors of the economy), but they are essential for other purposes in the economy,
they are necessary in the economy, but they do not produce wealth.
Manufacturing covers subsistence and the costs of the inputs used up but does not produce a surplus. Land is
productive in physiocratic meaning of the term, in that that it produces a surplus over the necessary costs of
production, only land and agriculture yield a net product, a surplus.
Once more, production from land created the surplus that the physiocrats called the net product. Manufacturing,
trade and other nonagricultural economic activities were considered non-productive, because they created no net
product.
The belief that only agricultural production was capable of returning to society an output greater than the social
costs of that output (cost of production) may seem very strange today.
We know today that other factors of production (capital, labor and others) are productive in the sense also.
The physiocratic view about the unique productivity of land may be explained by the fact that the physiocrats
focused on physical productivity (that is a measure of physical quantity of output produced) rather than value
productivity (a measure of money equivalent of the products). And physical productivity is best physically visible in
agriculture, where plants grow, animals are raised and the like.
In addition, because large-scale industry had not yet developed in France in the middle of 18
th
century, the
productivity of industry was not apparent in the economy of the physiocrats.
The small employer with only a few employees did not seem to be making any surplus of revenues over the costs
of production, and his standard of living was not significantly higher from that of his employees. Therefore, they
could not see that the industry was productive in the same sense as agriculture was.
Having established that the origin of the net product was in land, the physiocrats concluded that land rent (rent
derived from land) was the measure of the society’s net product, society’s wealth.
The relationship between agriculture and net product was explained by Quesnay in several versions of his main
economic work,
Tableau economique, the first version published in 1758.
Quesnay presented the creation of net product in the economy by means of quite complicated diagram. The
simplification of the diagram shows the essence of the physiocratic analysis, their model of the economy.
The diagram shows three sectors of society: farmers, landowners (lendołners, king, aristocracy, the church) and
artisans (craftsmen, skilled workers, mechanics, technicians).
There is no foreign sector, government sector or manufacturing sector above the artisan level. So the model is
very abstract and simple.
The physiocratic analysis began with a net product at the beginning of the economic period of let’s say 2 million
pounds held by landowners.
This net product was paid to the landowner class as rent from economic activity in the previous period.
The physiocrats assumed that only land could produce an output greater than its costs of production and every
year accumulated capital generates a gross production worth 5 million pounds. The costs of production in
agriculture are 3 million pounds – 1 million is annual depreciation of fixed capital (agricultural machines) and 2
million is circulating capital (wages for agriculture workers, money for buying manufactured goods to agricultural
production).
The circulating capital is shown as the number 2 in the farmers’ column on the diagram.
So the net product is 2 million pounds at every year – since the annual production is worth 5 million and the costs
of production are 3 million.
The net product it is paid as a rent from farmers to landowners – two millions go to the landowners, this is market
by the number 2 in the central column.
Activities of artisans’ results in products produced and the payments to factors of production in artisan production
equal exactly the value of the goods produced.
These activities are not productive in the Quesnay'’s meaning of the word ‘productive’.
The sterile class, artisans have one million pounds of circulating capital (this is shown as number 1 in the artisans’
column).
Starting at the top center of the Quesnay’s economic table, the landowners spend last year's net product of 2
million pounds by buying agricultural goods (food) from farmers for 1 million pounds and buying luxury goods from
artisans (and paying another 1 million pounds for them)
This is represented by the lines A and B from the landowner column of the diagram, toward the columns
representing the farmers and the artisans.
Thereafter, artisans buy food from the farmers for 1 million. This is represented by line C.
Farmers reconstitute their capital by buying manufactured goods from artisans for 1 million (remember, we said,
that the fixed capital of the productive class is depreciating 1 million each year). This is line D.
Farmers
Landowners
Artisans
(sterile class)
2
2
1
1
1
1
1
1
A
B
C
D
E
5
Finally, artisans spend this 1 million received from farmers buying agricultural products (and paying 1 million) in
order to reconstitute their circulating capital – this is shown by the line E. (remember that at the beginning of the
period artisans had 1 million of circulating capital).
Summing up, the landowners, landlords, have spent all the money received as rent in order to consume food and
luxury goods from the artisans.
The artisans have sold manufactured goods for two million pounds (units of money) and spent two millions in
order to buy food and to reconstitute their capital.
The circulation process in the economy has allowed these two classes in the end to get what they had in the
beginning (landlords spent all the money, and in the next period they will receive another rent form farmers, and
artisans have one unit of circulating capital).
What about the productive class - the farmers? They have sold agricultural goods for 3 million (goods worth one
million for landlords and worth two million for artisans).
In addition, they have still agricultural goods worth 2 million to reconstitute their circulating capital (wages for
workers).
They have also bought the necessary manufactured goods in order to reconstitute their fixed capital (which is
depreciating every year for 1 million).
Finally the money capital is reconstituted as well, since the farmers have 2 million pounds (they got 3 million
pounds lines A, C, E) and spend 1 million (line D).
Every form of capital is thus reproduced in the economy, the process of circulation of goods and money
reproduced the initial conditions of production.
And another year the process repeats itself reproducing the net product and capital.
This is the nature of the tableau economic by Francois Quesnay - a bold, creative conception of the
interrelatedness of macroeconomic sectors with great simplicity.
The table presents how the natural product is generated in the economy, and how goods and money circulate
between different sectors in the economy.
They made few efforts to develop a theory of the microeconomic theories of the markets and these cannot be
considered as successful microeconomic theories.
The physiocrats considered Quesnay's tableau, the diagram, to be their main theoretical achievement. It gave a
crude, simple, but clear representation of two main things.
First, it represents the flow of money incomes between the various sectors of the economy.
Second, it shows the creation and annual circulation of the net product throughout the economy.
The tableau economic, Quesnay's can be considered as first, very simple, macroeconomic model of the economy in
the history of thought. It is a major methodological advance in the development of economics - a grand attempt to
analyze economic reality by means of abstraction.
The tableau, table, was not only an abstract model to analyze the relationships between various sectors in the
economy. The physiocrats also attempted to quantify the sensitivity of the economic system to various changes.
For example by the use of the tableau, Quesnay showed that if a tax of 25 000 pounds were imposed on both
sectors (that is on farmers and artisans), the result would be a decline in the annual product in agriculture from 2
million to 1 million 950 thousand pounds. The net product would decreased by 50 000 pounds in effect of taxes of
25 000 pounds. The result would be then economic decline, for less output would be produced the following year.
Similarly, he showed that a fall in the productivity (due to government intervention) would reduce output. So, the
physiocrats also tried to quantify the effects of different changes in economic system on the national wealth,
national output.
So much on the theoretical contribution of the physiocracy.
A few words on physiocratic economic policy.
The physiocrats thought that free competition led to the best price and that society would benefit if individuals
followed their self-interest. Furthermore, they believed that the only source of a net product was agriculture; they
concluded that the burden of taxes would ultimately rest on land as the sole productive factor.
For example, a tax on labor would be shifted to land because competition had already ensured that the wage of
labor was at a subsistence level, the lowest possible level.
Because the physiocrats believed that a natural order existed that was superior to any possible human design, they
conceived of the economy as largely self-regulating and thus rejected the controls imposed by the mercantilist
system.
The proper role of government was to follow a policy of laissez-faire – which means to leave things alone, allow to
do, in French. A laissez-faire policy demands that a government do not interfere into in the working of the free
market at all.
In the hands of Adam Smith and classical economists this idea of laissez-faire policy, was of tremendous
importance in shaping the ideology of Western civilization. We will talk about this laissez-faire policy many times in
the following lectures.
Returning to some details of physiocratic economic policy, they maintained that the primary obstacles, barriers, to
economic growth proceeded from the mercantilist policies regulating domestic and foreign trade. They objected
particularly to the tax system of the mercantilists and advocated that a single tax should by levied on land. All
other taxes should be abolished.
The most unfortunate of the many governmental regulations according to the Physiocrats, was the prohibition on
the export of French grain, the seeds of wheat or rice, for example.
For physiocrats, it kept low the price of grain in France and in their view was therefore an obstacle to agricultural
development. In the absence of the prohibition, if laissez-faire policy were introduced, the small-scale agriculture
would be replaced by large-scale agriculture and the wealth and power of France would be increased. Laissez faire
policy would lead to increased agricultural production and greater economic growth.
However, we may add, physiocrats did not foresee that soon, at the end of 18
th
century in the effect of industrial
revolution, the agricultural sector would start to lose its central role in the European economies and that the
manufacturing and industry would start to be the most important sectors in the economy.
So to sum up the physiocratic economic policy, I will stress following points
First, they tried to Encourage Agriculture--Improve agricultural management and technique.
2
nd
, they tried to Dismantle restrictive laws and regulations and to introduce the policy of laissez-faire
Third, they wanted to end artificial encouragement of manufacturing by the government.
4
th
, they proposed to reform the tax system and to implement a single tax on the net product derived from
land.
5th, they encouraged the domestic consumption as a mechanism to maintain income flows between the
classes in the society.
And finally, they praised the free international trade, particularly in agricultural goods.
So much on the physiocracy.
The most important contribution of physiocracy was their recognition that the economy can be formally studied, by
means of models, by means of abstract reasoning. Along with mercantilists, they were the first model builders in
economics.
Their most abstract model, the economic table,
tableau economique, shows the interrelatedness of various sectors
of the economy, the process of generating the net product, and circulating of money between different classes of
the society.
We should also stress that they are first advocates of a free market economy, they called not for intervention in
the economy, but for laissez faire, a policy of not intervening in the working of the economy.
Lecture 4
Classical Economics: Adam Smith
What is generally called the classical economics or classical political economy covers more than one hundred years
from about 1776 to circa 1890. Classical economics was almost exclusively produced in Britain.
The three major treatises, economic masterworks of the classical period were:
1. Adam Smith (1723-1790),
Inquiry into the Nature and Causes of the Wealth of Nations, 1776 (we shall use the
shorter version of the title, the
Wealth of Nations; almost nobody uses the full title).
2.
On the Principles of Political Economy and Taxation by David Ricardo (1772-1823), 1817.
3.
Principles of Political Economy by John Stuart Mill (1806-1873), 1848.
Smith, Ricardo and John Stuart Mill ruled economic thought from 1776 until almost the end of 19
th
century; Smith
from 1776 until about 1820, Ricardo from roughly 1820 to 1850s, and Mill from 1850s until the 1890s.
There were of course many other minor thinkers, who belong to classical economics, but these three authors are
the representative economists of the period.
There are two main characteristic features of the classical economics.
First, classical economists found in the economy a basic harmony; they had a positive attitude to the economic
phenomena, which were induced by natural forces in the economy. They held a view that markets automatically,
at least in the long run, bring a harmony in the economy and the society, that markets harmoniously resolve
conflicts over the scarcity of economic resources, that markets always operate at or near full employment, that
economic depressions are short-lived and that the markets automatically recover from slumps and the like.
This led them to advocate a governmental policy of laissez-faire, policy of governmental non-interfering in the
economy. This was a very optimistic view about the functioning of the markets.
The second widely shared assumption or interest within classical economics is that classical economists were
mainly interested in dynamic issues, long-term, long-run economic processes. The classicals were very interested
in the forces determining the economic growth and the distribution of income over time. Adam Smith focused on
the economic growth, while David Ricardo was interested in long-run changes in the distribution of income that
would take place under capitalism.
After the decline of classical economics in 1870s, the long-term economic problems like the economic growth or
the distribution of national income over time disappeared from economic theory for about 80 years in case of
economic growth (the interest in growth reappeared in 1950s) and about 100 years in case of distribution of
income over time (the interest in this problem has been brought back to economics only in recent let’s say 20
years).
The interest in long-run economic processes is the second characteristic feature of classical economics.
Two other seminal thinkers of the period deserve mention in this introduction to the classical thought.
Thomas Robert Malthus (1766-1834) and Karl Marx (1818-1883) were in part classical economists, they shared
some views of Smith and Ricardo, but they should be considered as serious and important critics of classical
economics.
Malthus formulated first population theory in the history of ideas, which is in accordance with classical economic
theory. But he deviated significantly from the orthodox classical economics in his analysis of certain
macroeconomic aspects of the economy.
A little digression here, classical economics and its reformulation neoclassical economics, which followed classical
economics, is often called orthodox economics – as the views of classical and neoclassical economics were
accepted as right or true by the most economists during the 19
th
and 20
th
century.
In accordance with this view, we have many heterodox economic currents or schools, Marxian economics,
institutional economics, historical school of economics, Austrian economics and many others. Everything beside
classical and neoclassical economics is non-orthodox, unorthodox or heterodox economics since it differs from the
economics, which is considered right or true.
Malthus claimed that the market economy has no ability to automatically achieve full employment of resources.
According to Malthus there are considerable difficulties in maintaining full employment of resources in the market
economy,
Classical economists, Smith, Ricardo, thought that the underemployment of resources in market economy can
happen only during relatively short periods and that in the long run there is an automatic tendency to a full
utilization of resources.
Malthus’ claim to heterodoxy was his macroeconomic belief that there is no inherent, essential stability in market
economy.
Karl Marx borrowed some elements from classical economics but he reformulated them completely and drew
radically different theoretical conclusions and implications for economic policy.
We should add here that it was Karl Marx who coined the term ‘classical economics’.
Marx incorporated into his analysis several classical ideas – the so called labor theory of value, for example, and in
the first place the interest in dynamic questions, especially the questions of the distribution of income over time in
capitalism, the course of the rate of profit over time, and the prospects for the level of well-being, welfare of the
labor class over time in capitalism.
So Marx can be considered as classical economist on the methodological level, he used the scientific tools of
classical economics, but for completely different purposes.
While classical economists found that the profit motive of the capitalists led to an efficient allocation of capital in
the economy and to savings, which promoted growth, Marx saw the activities of capitalists as harmful to the labor
class and the society, he thought that labor class was exploited in the capitalism, that capitalism is unjust
economic system and that it is doomed to failure.
Classical economists were the advocates of capitalism; Marx was a harsh critic of capitalism.
So much on the introduction to the classical economics and we can start with the discussion of Adam Smith’s
economics.
Adam Smith was born in 1723 and died in 1790. He came from an influential Scottish family.
Smith was typical of early economic writers in that he was not exclusively an economist. He was an academic, and
this allowed him a degree of detachment from various particularities and objectivity that was lacking in the
mercantilist writers, who were generally businessmen.
As a professor of Moral Philosophy at Glasgow University from 1752-1764, he was giving a series of courses that
encompassed what we now call the social sciences and humanities. He was interested in Moral Philosophy, which
has many connections with his economics.
Smith was not a narrowly technical theoretician but a careful scholar with a grand vision of the interrelatedness of
the society and the economy. Although we pay particular attention to his vision of the interrelatedness of the
economy, Smith dealt with the important connections across many areas of society – things that are today studied
by economists, political scientists, sociologists and philosophers.
Smith was influenced by his teacher Francis Hutcheson (1694-1746) and by his friend philosopher-economist David
Hume (1711-1776). We touched on some views of Hume, while discussing mercantilism; we said that Hume was
half-mercantilist, half-classical economist.
We discussed Hume’s famous argument, price-specie flow mechanism and concluded that Hume did not believed
that single rise in money supply could contribute do the economic growth. Smith shared this view of Hume.
In case of Hutcheson, Smith shared Hutcheson’s strong disapproval of the mercantilist ideas of Bernard Mandeville.
We discussed Mandeville’s views some weeks ago.
Mandeville, in his poem
The Fable of the Bees, claimed that pursuit of individual self-interest by the members of
society would generate many undesirable social and economic consequences and therefore there is a case for
government intervention in the economy.
Hutcheson and after him Smith argued that egoistic actions do not necessarily lead to bad outcomes for the
society, so the government do not have to undertake actions to channel private activities for good public effects.
Many of the attitudes toward knowledge and science during Smith’s time differ sharply from those of today.
First, no clear distinctions between various areas of inquiry existed: philosophy, science, social science and ethics
were treated not as separate disciplines, but as a single body of knowledge. Smith wrote not only on economics,
but also on rhetoric, law, and even on astronomy.
One of the consequences of this interdisciplinary approach was that Adam Smith believed that the scientific rigor
of natural sciences, and especially of physics, could also be attained in social sciences, and in economics also.
He believed that just as Isaac Newton through rigorous scientific analysis had found order and harmony in the
physical world, so he may discover the natural laws governing society and the economy.
This Smith’s preconception enabled him, when he examined the economy, to see not chaos but harmony and
order, produced by individual self-interests interacting in competitive markets.
Smith has often been called the father of economics. Although each of the precursors of classical economists, that
is mercantilists and physiocrats writers, saw bits and pieces of the puzzle (puzzle of how market economy is
functioning), none had been able to integrate into a single volume an overall vision of the forces determining the
wealth of nations, the appropriate policies to foster economic growth and the way in which millions of economic
decisions are effectively coordinated by market forces.
Smith is called often the father of economic not because he discovered independently some important economic
laws, but because he was able to synthesize his and previous developments into one, coherent, integrated system,
explaining how markets work and how economic growth operates.
Smith’s major economic work is titled
An Inquiry into the Nature and causes of the wealth of nations, published in
1776, the year of the American Declaration of Independence also.
In Smith’s lifetime, however, his reputation as a scholar was based not on this book, but on
The theory of Moral
Sentiments, published in 6 editions between 1759 and 1790.
Smith regarded both books as part of his broader inquiry into social science.
The main concern of the theory of moral sentiment was with the criteria on which moral judgments can be based -
so this is the book on philosophy and ethics. However, since it creates a context for the Wealth of Nations, few
words on the Smith’s theory of moral sentiments.
In this work, Smith was exploring the question of what makes it possible for people to live in society. How it is that
selfish by nature people can be restrained in order to prevent form injuring one another?
Smith answer was that people are held together by mutual affection that is desire to please others because of the
ability to see things from someone else’s point of view (they feel sympathy for each other). Nevertheless, this
feeling is not strong enough for the society to flourish, to be peaceful and prosperous.
Further guidance for people is needed and this is provided by moral rules, generalizations from our experience of
what types of action are approved of and disapproved of. Still moral rules are in themselves insufficient and need
to be backed up, in some cases, by positive, legal laws.
So, in general, feelings of mutual love or affection, moral rules and positive laws are needed for society to flourish,
to be prosperous.
However, Smith argued that sympathy and feelings of mutual love, affection, or friendship are not necessary for a
commercial society. A commercial society can flourish, be prosperous, even though people do not have strong
affections for each other.
This is the context for the
Wealth of Nations – in this book Smith is exploring how a commercial society can
prosper, even though men and women are pursuing their own interests.
What is important here, he assumes a framework of justice; people are assumed to be guided by morality (but not
by love or sympathy for others) and restrained by a just legal system. Without such a framework of justice, society
would be destroyed.
Within this framework, Smith in Wealth of Nations explains the benefits that arise from a system of liberty, where
government is severely limited and people are allowed to pursue their self-interest.
As the title of his main economic work suggests, Smith was interested in explaining the nature and causes of the
wealth of nations that is, using modern language, he was interested in macroeconomics, and tried to discover the
forces of the economic growth. But the forces that Smith examined were much broader than those studied in
modern economics, and he filled his economic model with political, sociological and historical material.
He gave some attention to the microeconomics, to the determination of relative prices, but his main interest was in
the theory and practice of promoting economic growth.
A few statements on Smith’s methodology.
He used a combination of deductive reasoning and historical description.
Deductive reasoning is inference in which the conclusion is of lesser or equal generality than the premises, as
opposed to inductive reasoning, where the conclusion is of greater generality than the premises. In deductive
reasoning if the premises are true, it would be
impossible for the conclusion to be false. For this reason, deductive
arguments are usually limited to inferences that follow from definitions, mathematics and rules of formal logic
Smith did not use mathematical expressions, he used deductive reasoning in informal mode, descriptively.
His models, if we can use this word, lack rigor and elegance, but his descriptions of interrelationships within the
economy are unmatched in history.
A modern mathematical economist could condense the theoretical propositions contained in the nine hundred
pages of the Wealth of Nations into a very short paper, probably a few pages long paper. However, the Smith’s
times were different and the modes of scientific reasoning were at the time different too.
We will now examine the overall theoretical structure of the
Wealth of Nations and the policy conclusions that flow
from Smith’s theory. After that, we will discuss some specific theoretical Smith’s achievements.
We start with the overall look at the Smith’s theory and its’ policy conclusions because we was not an economist in
the narrow sense of the word, but rather a philosopher who pointed the way toward economic development and
affluence. Smith is still read today for his insights in economic policy, not for his contributions to the technical part
of economic theory.
So, let’s start with smith’s economic policy.
Smith’s economic policy from a methodological point of view is often called contextual economic policy. This means
that his conclusions in economic policy were not only based on abstract, non-contextual, theoretical arguments,
but that they were contextual, that is, they are based also on Smith’s observations of the existing historical,
political and institutional circumstances.
Non-contextual economic policy is based only on abstract economic models; an example of non-contextual
reasoning would be argument that laissez-faire, not intervening in the economy is the best policy, because in the
long-run firms produce at the lowest possible average cost. There is a single, theoretical, separated from historical
or institutional context reason for promoting laissez-faire in this reasoning.
Smith also used theoretical arguments in guiding economic policy, but his advocacy of laissez-faire is rooted in a
methodological approach that asks the following question: Does experience, historical observations show that
government intervention will produce better results than will the free working of the markets?
He advocated laissez-faire not only because of the theoretical, abstract arguments, but also he believed that in the
context of history and the institutional structure of the England of his time, markets usually produced better results
than did government intervention.
So he formulated contextual economic policy.
Later economists varied in their approach.
David Ricardo advocated laissez-faire policy based on abstract, non-contextual, ahistorical model. He did not used
mathematical notation, but he formulated very abstract, non-contextual model of the economy.
Ricardian approach, the approach of David Ricardo, that is building abstract economic models and drawing policy
conclusions from these models, became very influential in economics, especially in the 20
th
century with the rise of
mathematical economics.
However, we should remark here, recently there are many new currents in economics which for the purposes of
giving policy advice at least, are moving away from abstract theorizing, and examine how governments and
governmental policies actually work in historical and institutional context. Public choice school in modern
economics is one example of such a school.
Returning to Smith. What are his main policy prescriptions?
Let’s start with the assumptions of his analysis. He assumed that human beings are rational and calculating and in
their economic matters are largely driven be economic self-interest.
He also assumed that, for the most part, competitive markets exist in the economy, and that within these markets
the factors of production move freely to advance their economic advantage, he assumed free movement of the
factors of production.
He also claimed that there is a natural process at work in the economy, which can resolve conflicts more
effectively than any arrangements devised by human beings.
Smith expressed the nature and the effects of this beneficial process in market economy in the following passage
from the
Wealth of Nations (it deserves to be quoted at length):
As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic
industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily
labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to
promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that
of foreign industry, he intends only his own security; and by directing that industry in such a manner as its
produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases,
led
by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for
the society that it was no part of it. By pursuing his own interest he frequently promotes interest of the society
more effectually than when he really intends to promote it. I have never known much good done by those who
affected to trade for the public good.
The reasoning in this passage is very simple.
Humans are rational, calculating, and driven by self-interest. If left alone by the government, each individual will
follow his or her own self-interest, and thanks to the so-called invisible hand, in promoting self-interest he or she
unintentionally promotes the interest of society.
Government should not interfere in this process and should therefore follow largely a policy of laissez-faire.
Private self-interest by means of invisible hand will lead to the public good in a non-regulated market economy.
However, what is this natural process – an invisible hand – which leads from private interest to public interest?
“Invisible hand” is Adam Smith’s famous metaphor, which is present in the economic, scientific and public
discourse from his times until today. This is probably the most famous, most well known, economic metaphor and
idea of all times, invisible hand, invisible hand of the market.
In the most popular interpretation by the invisible hand, Adam Smith meant the mechanism of market competition.
Free competition allows turning private self-interested actions into public interest, into general welfare of the
society.
How the process of competition proceeds?
Capitalists are driven by desire to make profit, not by altruistic motives, and in order to increase revenues, they
produce the commodities that people desire.
Competition among capitalists will result in these commodities being produced at the minimal cost covering
opportunity costs of the various factors of production.
If profits above a normal rate of return exist in any sector of the economy, other firms will enter these industries
and force down prices until there are no excess profits.
Competition among capitalists also will result in productive factors being moved into those activities where they
were most needed, where their efficiency is greatest.
On the other hand, changes in consumer’s desires will produce changes in relativee prices of final goods and
consequently changes in the profits in different firms or industries.
So, the market competition, without planning or governmental direction, leads to the satisfaction of consumer
desires at the lowest possible social cost, Smith concluded.
In modern language, he claimed that in competitive markets without government intervention an optimal
allocation of resources occurs.
Of course Adam Smith did not prove rigorously all these steps in this reasoning, but he described some of them.
He proved that price resulting from competition would in the long run equal the cost of production
He also proved that the competition would equalize the rate of profits, the rate of wages and the rate of land rents
among the various sectors of the economy.
He did not prove, for example, that the producers employ the optimal combination of productive factors or that the
consumers buy the optimal bundle of goods in the market economy.
Smith only partially and not rigorously deduced that in the absence of governmental intervention free competition
leads to the optimal allocation of resources in the market economy.
He opposed monopoly, which in his days was normally the result of privileges granted by the government to the
businessmen. He was not able to specify what the monopoly price would be, but he recognized that monopolists
would charge higher price by restricting output produced.
Therefore, arguing against government intervention in the economy, Smith used a theoretical argument,
metaphorically called the invisible hand, which claims that free competition leads to beneficial results for the whole
society.
However, as we said he used also other arguments, non-theoretical, contextual arguments.
He reviewed many of the historical mercantilist regulations of domestic and foreign trade and showed that they
resulted in non-optimal allocation of resources (that is the allocation less desirable than the allocation produced by
competitive market forces).
He showed that many of governmental regulations were on purpose introduced not for the public good, but
directly for the purposes of particular merchants. Therefore, he looked at the policy of regulation in the context of
the economic and legal institutions of his time.
However, Smith was not arguing for complete laissez faire, his advocacy of laissez faire was qualified, he saw an
important role for government. He believed that some government interventions in the context of the historical,
political and institutional structure of his time, was necessary.
The main reason why government was needed was that the arguments of the Wealth of Nations presupposed a
system of justice, as we said before. Without justice, men and women would be insecure, so spending on the legal
system and on the armed forces was essential for the economy and the society to work.
For Smith, to maintain law and order was therefore the first duty of the authority. It is worth noting here that this
involved some significant exceptions to the principle of laissez faire. For example, although he was generally
against the regulation of international trade, he made exception if national defense would be weakened by a policy
of perfectly free international trade.
The third duty of government (beside defense and justice) according to Smith was that of provision of goods that
have great social benefits but that are not supplied by the private market because supplying them would not be
sufficiently profitable.
In modern language, this kind of goods would be classified as public goods or goods with positive external effects.
For example, the social benefits of education are very great, but the profits to be realized from the private
provision of education (in Smith’s times) were so small that, if market were left alone, less education would be
supplied than is socially desirable. Smith argued that public primary education should complement private primary
education.
Other examples of this kind of exceptions to the laissez faire include transport, bridges and roads.
These qualifications of the laissez faire principle in Smith’s thought are an index, a sign of his scholarship and
intellectual honesty. They did little, however, to diminish the significance and vigor of his laissez faire creed and
most economists forget about them while discussing his views. Most people perceive Smith as unqualified defender
of laissez faire and as a opponent to every kind of government intervention.
However, as we have seen, he saw important exceptions to laissez faire policy.
Therefore, the great achievement of Smith in the field of economic policy was his brilliant analysis of how markets
work and what the process of competition is.
Now, still talking about Adam Smith economic policy we should say some things about his attitude toward capital
and the class of capital owners, capitalists.
Smith held that capital plays a very important role in the economic growth, namely that economic growth depends
upon capital accumulation. We will see this in detail when I talk about Smith’s theory of economic growth.
If growth depends on capital accumulation, then capitalists play the key role in the functioning of the economy.
Their pursuit of wealth and profits directs the economy toward development and growth.
What is important here is that Smith believed that only capitalists in the society could accumulate capital, labor
class could not, because the level of wages permitted only the satisfaction of basic consumption needs of the labor
class. The wages were so low that labor class could barely survive. Therefore, they could not accumulate capital.
In addition, the landowners could not accumulate capital because they spent their incomes on luxury goods and
services since, according to Smith, landowners had desires for high living, for unproductive expenses to maintain
their high standard for living. Therefore, the landowner class also did not accumulate capital.
Only the capitalists, striving for profits, striving to increase their wealth, trough savings and investment, are able
and willing to accumulate capital and therefore to contribute to economic growth. Therefore, they are the most
important class in the society, at least from the economic point of view, according to Smith.
In addition, we should indicate here, that the special role of the capitalists in the society of Adam Smith, demands
that there be quite unequal distribution of income and wealth in the society in favor of capitalists. Because without
an unequal distribution of wealth, economic growth is not possible, for the whole of the yearly production will be
consumed, there will be no savings and accumulation of capital.
So according to Smith an unequal distribution of incomes and wealth in capitalism is a good thing because it leads
to increased economic growth and possibly to higher standards of living for each class of the society in the long-
run.
So much on the attitude of Smith to capitalists and on the Smith’s prescriptions in the area of economic policy.
We can say a few words on the influence of Smith’s views in subsequent thought and practice of societies and
governments.
Thanks to his illuminating theoretical analysis and the body of descriptive and historical material contained in the
Wealth of Nations he was able to exert an influence on English economic policy and give support to the
increasingly favored in the 18
th
and 19
th
century view, that the wealth of England would be best promoted by a
government policy of laissez faire.
He had enormous impact on the practice of economic policy in England and whole industrialized world form 19
th
century on, especially in the United States.
The policy of laissez faire, policy of government not intervening in the economy, has become the economic
ideology of the American society, and it was promoted in other areas of the world. It is possible that no other idea,
at least economic idea, and no single author than Smith have had more influence on the development of American
and other free-market economies.
This practical contribution, and not his theoretical contributions, is probably his greatest and most lasting
achievement.
Now, after discussing Smith’s economic policy we can turn to the economic theories presented in the Wealth of
Nations. we will discuss in turn his:
- theory of economic growth
- theory of international trade
- value theory
- distribution theory
Smith’s theory of economic growth.
As the title of his book suggests Smith was interested mainly with the nature and causes of the wealth of nations.
So what is wealth of a nation in general?
For Smith the wealth of a nation was an annual flow of goods.
We should notice here the difference between Smith’s view on wealth and the view of mercantilists. Mercantilists
assumed that the wealth of a nation was a stock of precious metals, stock of gold and silver.
Smith’s conception of the wealth of nations – an annual flow of goods – has a similarity with the modern notion of
national income. However, there is one important difference on which I will elaborate later.
Smith also argued, against mercantilist views and according with modern views, that the final purpose, final aim of
economic activity is not the production, but the consumption.
His views of wealth were also different from those of physiocrats, because as we remember physiocrats thought
that the land is the only source of wealth. While Smith believed that labor and capital are the most important
sources of wealth.
Smith went as far as to suggest that the wealth of nations should be measured in per capita terms, that is in
relation to people taken individually. In this respect his views on nation’s wealth were also very similar to modern
ones.
So much on the nature of wealth – it is an annual flow of goods measured in per capita terms.
What are the causes of the wealth of nations?
Smith held that in the first place the wealth of nation depends upon two factors:
- the productivity of labor;
- the proportion of laborers who are usefully of productively employed (or ratio of productive and unproductive
labor).
Smith stated that the productivity of labor further depends upon the division of labor.
We have already met this idea of division of labor in the writings of ancient Greek philosophers, who argued that
division of labor is the best mean to the efficient management of a household.
It is today a very well known fact that a division of labor and specialization increase the productivity of labor.
Smith illustrated the advantages of the division of labor with the example of factory producing pins, strait pins –
short thin pieces of metal with a round head at one end and a sharp point at the other.
When there is no specialization, no division of labor in pin factory, the productivity in Smith’s example is very low –
that is if every worker performs each of 18 distinct operations leading to producing a complete pin, each worker is
able to produce about 20 pins a day – so the productivity without the division of labor is 20 pins per worker.
But if specialization is introduced, and every worker is performing repeatedly only one operation for the whole day,
than the productivity increases to 4800 pins per worker, that is productivity with the division of labor increases
about 240 times.
In this very simple example, the increase in productivity thanks to division of labor is very great, even enormous.
We have to stress here however, that Smith also noticed that although the division of labor is economically
beneficial for the society, it involves also some serious social costs. The most important social disadvantage of the
division of labor is that workers are given repetitive tasks that soon become boring, monotonous, human beings
become machines tied to a production process and are dehumanized by this simple, boring, repetitive tasks they
perform.
These are all very serious negative consequences of the division of labor, but in overall Smith had no doubt that
the welfare of the society on balance increased by the division of labor. Especially the welfare of other than labor
classes we may add.
The division of labor in turn depends upon two other factors: 1) what Smith called the ‘extent of the market’ and
2) the accumulation of capital.
With respect to the extent of the market – the larger the market, the greater is the volume that can be sold and
the greater the opportunity for division of labor. A limited market on the other hand permits only limited division of
labor.
Moreover, the division of labor is limited by the accumulation of capital because the productions process it time-
consuming – there is a time lag between the beginning of production and the final sale of the finished final
products.
In this period between the beginning of production process and the sale of final products, the capitalist has to
provide the means for laborers to survive. Therefore, he has to accumulate capital to pay the wages for laborers,
and the more capital he accumulated the more the division of labor can be used in his factories.
The second basic factor of economic growth is the ratio of laborers employed productively to laborers employed
unproductively.
Labor employed in producing physical objects, goods which can be touches physically and sold in the markets is
productive labor, whereas labor employed in producing a service (service is not a physical object) is unproductive.
Smith did not include services in his definition of national wealth. Only real goods, physical objects contributed to
the wealth of nation. This is the main difference between his concept of the wealth of nation and today’s concept
of national income, where the value of services is also included.
However, Smith thought that landowners mostly used services and that the expenditures on services were
wasteful since they did not produce an increased output of real, physical goods and therefore did not contribute to
the economic growth.
So for Smith, the larger the share of the labor force involved in producing tangible, touchable, visible, physical,
concrete, real goods, the greater the wealth of the nation.
Capital is here required to pay for the work of productive labor force, therefore the greater the capital
accumulation, the larger the proportion of the total labor force involved in productive labor – capitalist do not pay
for the unproductive labor according to Smith, they do not spend money for services.
OK, now we have discussed all major factors contributing to growth in Smith’s theory.
What determines the wealth of a nation?
The immediate causes are the productivity of labor and the ratio of productive and unproductive labor. On closer
examination, we see that the main, ultimate factor contributing to growth is the capital accumulation. Both of
these immediate factors of wealth depend in the end on capital accumulation – so capital is the chief determinant
of the economic growth.
The larger the proportion of capital accumulation to total wealth of a nation, the greater the rate of economic
growth.
What is required if we want to have the greatest possible accumulation of capital in the country? So what is the
best policy to promote economic growth?
According to Smith, we should have free markets with private property, governmental policy of laissez faire, and as
we remarked earlier, an unequal distribution of wealth in the society.
So much on the Adam Smith’s theory of economic growth.
Now, we will take a closer look at his theory of international trade.
One of the major aims of Smith’s Wealth of Nations was to demonstrate the falsity, inaccuracy of mercantilist ideas
concerning governmental regulations of international trade.
As we remember mercantilists argued that these regulations were necessary in order for a country to have a so-
called positive balance of trade, and therefore to increase the quantity of gold and silver held in the country.
Smith on the contrary argued for unregulated, free foreign trade, reasoning that if England can produce a good at
lower costs than France can for example, and if France and produce another good at lower costs than England,
then it is beneficial to both parties to exchange these goods.
In language of modern economics, this became known as the absolute advantage argument for foreign trade and
the theory is called absolute advantage theory of international trade.
This theory was soon superseded by the comparative advantage theory, developed by David Ricardo, the next
great classical economists. You should know both theories from other courses.
The proper governmental policy toward international trade, Smith held, should be the same as that toward
domestic trade, laissez faire policy, to let voluntary exchanges take place in free unregulated international markets.
A policy of laissez faire, he believed, would lead to ever-higher levels of well-being in all countries.
However, he did not asked how these benefits from trade would be divided between the trading countries.
Smith’s arguments in favor of a free international trade were very simple and the theories of international trade
were developed more thoroughly later in the writings of other classical economists David Ricardo and John Stuart
Mill.
Value theory of Adam Smith.
What are the questions posed by value theory, what is this theory about?
This is probably the most complicated theory in the history of thought and it is often not easy to present various
theories of value, given the complexity of writings devoted to this issue. Especially the value theories of David
Ricardo and Karl Marx are quite difficult, confused and tricky, but we will try to present them in simplified versions.
For example, value theory tries to answer the following questions:
What determines the price of a good, what determines the relative prices of goods in the economy?
What determines the general level of prices – that is what determines whether prices in general are rather low, or
high? What determines the inflation or deflation?
What is the best measure of welfare, well-being of the members of the society? How to measure individual and
social welfare? This is also a question from value theory.
Smith did not provide an easy, simple, unambiguous, transparent answer to any of these different questions.
However, he tried quite hard and presented them in a quite confusing way, not always specifying which question
he is trying to answer.
Economists and historians of economic ideas have long argued how many theories of values did Smith formulated
and whether his theories are right or wrong.
We will present only the most standard view of Smith’s theory of value.
First, some words about the meaning of a word ‘value’ in Smith’s economic language.
Smith believed that the word value has two different meanings.
First meaning is the “value in exchange”. It is the power of a commodity to purchase other goods – that is the
price of a good.
Second meaning is the “value in use” – that is the power of a commodity to satisfy human wants, the total utility
received when a commodity is consumed.
Smith could not connect these two notions of value; he could not perceive the general relationship between those
two kinds of value.
The struggled with the so-called water-diamond paradox.
The paradox is like this: How is it possible that the value in exchange (that is the price) of a diamond is so high,
while its value in use is so low. Remember, Smith thought of a value in use as a power to satisfy basic human
needs, like hunger, shelter, thirst and the like.
On the other hand, paradox says, there are goods with high use value, like water, but which do not possess high
exchange value – the price of water is very low.
So there seems be no connection between use and exchange value – paradox concludes.
Adam Smith could not resolve this puzzle.
And the paradox was not explained until late in 19
th
century when economists discovered that the price of a good
is its marginal utility, only the introduction of the concept of marginal utility, and the statement that exchange
value of a good is its marginal utility allowed economists to explain the water-diamond paradox. We will discuss it
on one of the later lectures.
The question of what determines the relative prices in the economy.
Smith’s analysis of the formation of relative prices in the economy of his time distinguishes two periods, the short
run and the long run and two broad sectors of the economy, agriculture and manufacturing.
During the short run, market prices depend upon both demand and supply. Long run or natural price in agricultural
sector depends also on demand and supply, because the long run supply curve in agriculture is upward-sloping,
indicating increasing costs in this sector.
But in the manufacturing sector, the long run supply curve is at times assumed by Smith to be perfectly elastic
(horizontal), representing constant costs of production and even sometimes is assumed to be downward-sloping,
indicating decreasing costs.
In manufacturing, when the long run supply is perfectly elastic, price depend only on costs of production, while
when it is downward sloping, natural, long-run price depends upon both demand and supply.
Therefore, his analysis of long run prices, natural prices is somewhat inconsistent and he did not specify when we
could expect perfectly elastic, upward-sloping or downward-sloping supply curves in practice. He simply did not
have a good theory of the costs of production, especially in the long run.
Adam Smith developed two more theories, which concern factors determining relative prices:
1) labor cost theory of value;
2) a cost of production theory of value.
He postulated two distinct states of the economy: the early and rude state or primitive society and an advanced
economy.
The first, primitive society is defined as an economy in which capital has not been accumulated and land is not
appropriated – there is only one factor of production – labor.
The advanced economy is defined as having three factors of production, labor, capital and land.
First, lets consider labor cost theory of value. According to labor cost theory of value the exchange value or price
of a good is determined by the quantity of labor required to produce the unit of this good.
However, how are we to measure the quantity of labor needed to produce a commodity?
Since people differ in their productivity and abilities, different people need different quantity of labor to produce a
unit of any given good.
You could supposedly measure a quantity of labor needed to produce a good by clock hours, by time spent at
work producing a good, but Smith recognized that different kind of labor will involve also different hardship or
skills of laborers.
Various kinds of labor are characterized for example involve different degrees of stress, of difficulty or can be more
or less unpleasant. So these characteristics of the labor should also be included if we want to have a good
measure of labor cost.
Smith could not resolve this difficulty and subsequent writers have not successfully solved it until today.
In primitive society, the labor cost theory of value has therefore a big problem, which cannot be solved.
In advanced economy, it is even worse. Since there is capital and land also, as factors of production and final
prices in this economy must include not only wages but also profits and land rents, then labor cost theory is
inapplicable in this model.
Smith abandoned the idea that labor theory of value could be applicable to an advanced economy.
He tried to explain prices in an advanced economy using cost of production theory of value. In this theory, the
value of a commodity depends on the payments to all factors of production: labor, land and capital. The total cost
of production (TC) is equal to the sum of Wages, Profits and Rents.
The relative prices of the goods (p
a
/p
B
) are equal to the relative cost of their production TC
A
/TC
B
.
Notice that this theory of value, cost of production theory of value only applies when the supply curve is assumed
perfectly elastic, in other cases demand also plays a role in determining the long run price and the theory is
useless.
But Adam Smith strongly emphasized the role of costs of production in determining prices even if the supply curve
was not perfectly elastic, he thought that if there is competition in the market than the natural long-run price will
equal the cost of production.
So much on Smith’s value theory.
Smith’s distribution theory.
What determines the distribution of incomes in the society?
The quantity of labor, capital and land held by the households and the prices of labor, capital and land, that is
wages, profits and rents (rent is here a price of land).
So wages, profits and rents determine the distribution of income, and we shall review Smith’s theories of wages,
profits and rents.
He offered several, sometimes contradictory theories of these variables.
Smith suggested at least 4 theories of wages.
We will discuss only one of them - the so-called wages fund theory. This theory became an important tool of the
classical economists.
The theory supposes that there is a fixed fund of capital to pay wages.
This fund, wages fund, includes goods that laborers can use for food, clothing, housing and the like, between the
start of the process of production and the sale of final products.
Wage rate is determined here as the ratio of wages fund to the size of labor force (the number of laborers).
Smith did not developed all theoretical and policy implications of this doctrine, but we will see later that this theory
played a very important role in 19
th
century, in writings of other classical economists.
Profits in Smith’s thought
Smith accepted profits as payments to capitalist for performing socially useful function – providing labor with
necessities of life and with materials and machinery in the production process.
Profit is composed according to Smith of two parts: pure interest return and a return for risk. But he never
explained the nature of these two parts of the profit and his discussion of the notion of profit is rather brief and
disappointing.
What is important and interesting Smith predicted that the rate of profit would fall over time in capitalism. He
offered three reasons for that:
- competition in the labor market will increase wages, that would bring about a fall in profits.
- competition in the commodity markets will tend prices of goods to fall and profits will fall
- competition in investment markets – investment opportunities are limited in number and increased capital
accumulation would lead to falling profits.
He was not very optimistic about the prospects of capitalism in this respect; the rate of profit will fall over time
according to Smith.
We may say here that this was the view of all classical economists and thanks to economic history we can also say
that they all erred, were mistaken in this, the rate of profit in capitalism is rather constant over time.
Rents in Smith’s theory.
He offered at least four theories of rent, the price of land, which contradict each other. He suggested that rent
exists because of monopoly, because it is demanded by landlords, because that’s how the nature works and the
like.
A satisfactory theory of rent was developed only later by David Ricardo.
So much on the theoretical contributions of Adam Smith
Summary of Smith’s thought.
Smith’s contribution to and influence on economic thought was tremendous.
More than any writer of his time, he saw the central ideas and forces that govern a market economy.
He was primarily interested in questions of economic policy affecting economic growth and development,
specifically in policies that would best promote the wealth of the nation.
His major recommendation was that the government follows a policy of laissez faire – this he claimed would effect
in a maximum rate of growth of per capita wealth in the economy.
His belief that laissez faire was the most effective policy was based on two premises: 1) the policy helps in efficient
allocation of resources; 2) it has beneficial effects on economic growth.
His policy propositions were always contextual; he proposed contextual economic policy. The policy propositions
were based on theoretical arguments combined with his observation of households, firms, markets, history,
institutions and political life.
In theory, he was able to describe the functioning of competitive markets with greater precision than previous
writers. His other theoretical attempts to build a theory of international trade or theory of value inspired later
classical economists to build more complete and advanced theories.
Of course, his theoretical achievements are not very great, he failed to formulate correct theory of value, theories
of wages, capital and rent.
However, he was not a pure theorist. Rather he was a political economist who was able to formulate a grand
vision of the free market economy, guided by the invisible hand mechanism, and argue that this is the best
possible arrangement for the society.
Lecture 5
David Ricardo (1772-1823)
During the review of Ricardo’s economic ideas we will also present some economic views of Thomas Malthus
(1766-1834), who was not exactly a classical economist. But some of his views were shared by classical
economists particularly by David Ricardo.
Ricardo and Malthus were close friends constantly debating economic issue; they differed on many points.
Some of Malthus’ economic insights were debated heavily by Ricardo and other classical economics - particularly
his view that there is a serious possibility of lasting economic depressions in capitalist economy. This view is in a
clear opposition to the most fundamental propositions of classical economists, who stated that capitalism is a self-
adjusting system and that depressions are short-lived and not very frequent in capitalism.
We will talk about the debate between Malthus and Ricardo on this issue, because this was one of the liveliest,
hotly debated, controversies in the development of economic ideas, in history.
We turn to Ricardo.
David Ricardo was a son of a stockbroker and he came from a Jewish family. At the age of 21, he married a
Quaker and was subsequently disowned by his father, deprived of the family property.
He started his own business as a stockbroker and soon he became successful. At 26, he was wealthy and
independent, in his early 40s he owned a fortune on the order of magnitude of half a million pounds and was an
influential financier.
He is a rare example of a famous economist who was also successful in business; other example would be John
Maynard Keynes.
He was not a professional scholar, but autodidact; he taught himself business and economics.
Later he became a Member of Parliament, member of the House of Commons,
He was there an authority of finance and was engaged actively in debating many issues in economic policy.
He made significant contributions to a number of areas of economic theory, including methodology, theories of
value, international trade, public finance, the concepts of diminishing returns and economic rent.
His major work is
Principles of Political Economy and Taxation, published in 1817. This book soon replaced Adam
Smith’s Wealth of Nations as the accepted book on economic questions.
He was one of the most gifted economic theorist of all times, the quantity of material written about Ricardo and
his theories is equaled only by that on Smith, Marx and Keynes.
Before we will discuss Ricardo’s views, we have first to deal with some views of Thomas Malthus, mainly with his
population theory.
Malthus in 1798 published an essay, transformed in 1803 in a book,
called Essay on the Principle of Population,
where he presented a theory of population growth, which has significant implication for classical economics. This
theory is essential to an understanding of certain parts of Ricardo’s economic theory, so we have to consider it
first.
The basic thesis Malthus defended about population is that population (the number of the members of society)
tends to increase faster than the food supply. This is Malthus population principle, or population thesis.
This principle was formulated earlier by many, for example by Adam Smith, but Malthus discussed in detail and his
account of it influenced existing and subsequent economic thinking.
This population principle was founded on two assumptions:
- that food is necessary for the existence of humankind (not controversial);
- that passion between the sexes is necessary and will remain unchanged.
He concluded from the assumptions that the population tends to grow at a faster rate than the food supply.
Malthus stated that human beings in the absence of checks on population would tend to increase their numbers
geometrically (1, 2, 4, 8, 16 …) in geometric progression.
But that the supply of food can only increase arithmetically (1, 2, 3, 4, 5), like in arithmetic progression.
So, there is a potential shortage of food.
He concluded that check on population would develop in society to keep the rate of population growth in line with
the rate of growth of the food supply. He postulated two types of these checks, positive and preventive.
Positive checks are increases in the death rate because of wars, famines, disease and similar disasters.
Preventive checks lower the birth rate – like postponement of marriage, prostitution, contraception, moral restraint
even (he was a clergyman) and the like.
Therefore, in the presence of these checks, in fact population grows in line with the growth of food supply, not
faster.
What is the economic implication of the Malthus’s thesis? You cannot help the misery, hardship and poverty in the
society, especially in the working class. In the early 19
th
century, in early capitalism, poverty of lower-income class
was increasing rapidly, when people were moving to towns and started to work in urban factories. Therefore, the
working class was in real poverty in early 19
th
century (we will see this in detail when discussing Marx’s views).
And the implication of Malthus’s thesis is that the government cannot help the poor, because if their welfare is
increased above the subsistence level (above the level at which their basic needs, like hunger and thirst, are
fulfilled), they start to reproduce at a higher rate then the grow of their welfare. In the end the welfare of their
families returns to the subsistence level.
This is a very sad consequence of Malthus’s thesis.
This reasoning is connected to the so-called iron law of wages.
The iron law of wages declares that wages can never rise above the minimum level that will enable the laborer
to survive. Because it wages rise above the subsistence level, laborers start to reproduce, the number of the
working class members is increasing, there is an increased competition for labor and wages tend to decrease to
the subsistence level.
Ricardo and other classical economists generally accepted this view.
The prospects of laborers, the working class, for classical economists were bad, dismal, their welfare cannot be
improved even in the long run. Any effort to improve the welfare of lower-income class is futile, the governments
should abolish any pro-poor legislation because it can not help them.
Malthus’s population principle caused considerable controversy. It has some obvious flaws.
He did not take into account that sexual desires do change and that thanks to increasing levels of affluence and
education members of the working class started to realize that the decision to have children is costly, so they
finally limited the number of children.
In addition, Malthus failed to consider the possibility that developments in agricultural technology might permit
sufficient increases in the supply of food to feed an increased population.
Malthus’s thesis is not correct from the modern point of view, but nevertheless we have to remember that all
classical economists thought that it was true and used it in their theories – for example to formulate the iron law of
wages.
Now we turn to Ricardo.
First, his views on methodology to be used in economics, later about his views on economic policy and the proper
subject of economic science, and finally we will discuss his contributions to the economic theory
We start with the methodology Ricardo proposed for economics.
As I said while discussing A. Smith, Smith used the so-called contextual economic policy, while he formulated
prescriptions for policy
This means that his conclusions in economic policy were not only based on abstract, non-contextual, theoretical
arguments, but that they were contextual, that is, they are based also on Smith’s observations of the existing
historical, political and institutional circumstances.
Ricardo on the other hand, represents the pure theorist. He abstracted from the economy of his time and built an
analysis based on the deductive, logical, purely theoretical method.
His skill in this approach was so great that pure theorists admire him even today, though he did not used any
mathematics.
Although he was a pure theorist, his economics was not impractical, he was strongly oriented toward policy issues
– he just wanted to resolve practical issues in policy only by the means of economic theories, which are possible to
apply in any country at any given time.
The existing historical, political and institutional context in economy did not matter for Ricardo.
His policy recommendations were non-contextual; they were based only on purely theoretical considerations.
Ricardo’s method is thus highly abstract modeling, he postulated that economists abstract from nonessential
factors and build a highly theoretical model that will reveal the casual relationships between economic variables
(that is relationships identifying which economic causes produce certain economic effects).
Ricardo’s method (building highly abstract models) and his approach to economic policy (non-contextual)
ultimately became the path followed by mainstream economics, especially in late 19
th
century and in 20
th
century
with the rise of mathematical economics.
Most economists today argue that this is the important contribution of Ricardo, introducing abstract modeling and
non-contextual economic policy. But there are of course minority that this is a dubious heritage from Ricardo – as I
said in one of the previous classes, they regard today’s highly abstract economics as unrealistic and irrelevant for
policy matters and they name this feature of modern economics as ‘Ricardian vice’, evil, badness in modern
economics.
Whoever is right, it is Ricardo, who introduced abstract modeling and non-contextual policy in the history of our
discipline.
The problem of what is the proper subject of economics.
Ricardo represents a turning point in the conception of the basic task of economics. Adam Smith, mercantilists,
and others were striving for discovering the forced determining the wealth of nations, so they thought that the
investigations into the nature of economic growth are most important in economics.
Whereas Ricardo maintained that the principle purpose of economics is to determine the laws, the principles that
regulate the distribution of national income among social classes in the society, that is the distr. of income among
landlords, capitalists and laborers.
He was preoccupied with what is now called the functional distribution of national income, the relative shares of
output, of national income, going to labor, capital and land. What is the share of national income going to the
working class, capitalists and landowners?
He was particularly interested in changes in the functional distribution of national income over time, over the long
run.
He considered this problem in the context of society made up of three classes: capitalists receiving profits,
landlords receiving rents and laborers receiving wages.
In order to explain changes in the shares of National income receiving by these three classes he found it necessary
to develop theories explaining profits, rents and wages.
He was primarily concerned with the effects of the changes in relative income distribution on the rate of capital
accumulation and the rate of economic growth. His theoretical conclusion was that in the long run the rate of
economic growth would be zero, so this maybe explains why he was not interested in growth in the first place.
He was not very interested in microeconomics, but he developed a theory of value, theory of relative prices, but
this served almost only as a tool to discover the forces governing the changes in the distribution, functional
distribution of income among social classes.
Before discussing his theories, let’s consider one practical problem in English economic policy in early 19
th
century.
Many of his theoretical arguments are designed especially as arguments in the debate on this problem.
This is the problem of the so-called Corn Laws. Corn is grain, right, like wheat, rice or rye.
The Corn Laws were regulations placing tariffs on the importation of grain into England. In late 18
th
and early 19
th
century, during the period of Napoleonic wars, the prices of grain were very high, because the import was not
possible during the wars and because of the fact that Britain was not agriculturally self-sufficient after the year of
1790.
After the wars, English landlords and farmers were afraid of falling prices of grain, so they went to Parliament to
get increased protection.
The Corn Laws then in effect had been passed in 1791; they placed a floor on the price of grain at 50 shillings per
quarter, which was substantially increased later. The import of grain was only possible when the domestic price
was higher then this floor level.
In early 19
th
century there was a constant discussion in Britain whether to increase or decrease the price-floor in
corn laws, or even whether to abolish the corn laws or not.
Of course, landowners and farmers were the supporters of the Corn Laws. Ricardo was the most prominent critic
of these regulations. He introduced into discussion new economic ideas, based on his theories of land rent and
distribution of income. We will get back to the problem of Corn Laws while discussing these theories.
Now we turn to theoretical contributions of Ricardo.
First I will discuss his theory of land rent, that is how he explained the payment for the use of land as a factor of
production.
Later, we will review his value theory, theory of relative prices
Next we will turn to his most important theory explaining the distribution of income in time.
And later I will shortly present his comparative advantage theory in international trade. We will finish the
discussion of Ricardo’s views with the debate between Ricardo and Malthus on the problem of stability of capitalist
economies.
OK, so we start with his theory of land rent.
In this theory Ricardo formulated the principle of diminishing return, which has become an important economic
concept.
Actually, the principle of diminishing returns appears to have been discovered in 18
th
century, but Ricardo and
other British economists in the early 19
th
century formulated it very clearly and brought it back to economics.
The principle of diminishing returns, as you know, states that if one factor of production is steadily increased while
the others are held constant, the rate at which the total product increases will eventually diminish.
Ricardo in his model, for simplicity of analysis, assumed that only one combination of labor and capital inputs can
be used to produce a given output – that is he combined labor and capital – two factors of production into one –
doses of labor and capital. It is as if production process in his economy would be some kind of row digging, for
example, where the factor of production is a person with a spade.
To increase output, you need another unit of labor (worker) and another unit of capital (spade). Increasing only
labor or only capital will be useless. It is the assumption of Ricardo’s model. Capital and labor are used in doses,
one dose of labor and capital, two doses… and the like.
He also assumed that the principle of diminishing returns begins immediately, so that the marginal product of the
second dose of capital and labor used in the production process is less than that of the first dose.
Ricardo maintained that land rent, payment to land used as a factor of production, exist because of 1) the scarcity
of fertile land and 2) the law of diminishing returns.
Let’s discuss the model with the help of a diagram.
Let there be an economy, which produces only one good – wheat.
Let there also be 3 plots of land, plots or areas or parcels or locations of land, of different fertility. Plot A is the
most fertile, while plot type C is the worst, the least fertile.
Assuming that 3 doses of labor and capital are applied to type A land, 2 doses to type B land, and 1 dose to type C
land, suppose that marginal product of three separate plots of land are as in the diagram.
Plot A
Plot B
Plot C
100
90
80
90
80
80
Successive doses of capital and labor applied on any given type of land give us diminishing marginal product,
because there operates the law of diminishing returns. First dose of capital and labor on land type A gives MP of
100 bushels of wheat. Second one gives 90 bushels, third only 80. And the same principle applies to land of
different types.
Also because of the difference in natural fertility MP of the first dose of capital and labor on the land C is smaller
that MP of the first dose of capital and labor on the land of type B, and the latter is smaller then MP of the first
dose of capital and labor used on land type A.
There are two sources of the land rent: 1) the scarcity of fertile land (there is limited number of plots type A for
example) and 2) the law of diminishing returns (which works on every type of land).
As you can see the MP of the last dose of capital and land applied to each type of land will be equal; if they were
not it would be economically feasible and profitable to shift labor and capital to the land with a higher MP.
Therefore, the MP of last dose of capital and labor on each type of land has to be equal.
Land rent is defined here as a payment to the landlord that equalizes the rate of profits on land of differing
fertilities.
Or, and this is easier to explain, as the maximal amount which a farmer working on a less fertile land would be
willing to pay to the owner of a more fertile land.
Rent is maximal amount which a farmer working on a less fertile land would be willing to pay to the owner of a
more fertile land.
If a single dose of capital and labor is applied to three separate units of land type C, the total product will be 240
bushels of wheat, of grain. While three doses of labor and capital on one unit (on one plot) of type A land yield a
total product of 270 bushels of wheat. The rent on land type A is 30 bushels.
This is the maximal amount that a farmer working on land of type C would pay the owner of land type A for using
such a fertile land.
The same reasoning leads us to the conclusion that rent on land type B is 10 bushels, and that there is no rent on
land of type C.
Also from the model, we can deduce the price of a bushel of wheat.
Let us assume that the price of one dose of capital and labor is 100 dollars.
Then the marginal cost of production – the increase in total cost required to produce an incremental amount of
final production, from the first dose of capital and labor on land of type A is 1 dollar, while the marginal cost of
production when we use third dose of capital and labor on this land is 1 dollar 25 cents.
The MC of the last bushel of wheat produced on land of types B and C is 1.25.
This is the price of wheat in competitive markets, if all producers are to sell their products, and they are by the
assumption of the analysis.
The market price of a good equals the MC of the most inefficiently produced wheat. This is the first conclusion of
the model – price of grain is equal to the MC of the most inefficient producer.
Second conclusion – owners of more fertile land will receive land rent.
Third conclusion – the market price of wheat is settled on the least fertile land, where there is no land rent, so the
price does not depend on rent. Land rent does not determine price, we do not have to worry about land rent when
we want to calculate relative prices of goods in the economy.
It is rather that the price of good determines the amount of rents received by landlords.
This theory of land rent is used in Ricardo’s other theories and especially in his most important theory of the
distribution of income among social classes in time.
Ricardo limited his discussion of the concept of rent only to land because he thought that the amount of available
land was fixed, constant and that agriculture was the only sector in the economy to which the principle of
diminishing returns applied.
But these concepts of diminishing returns and rent actually have a much broader application: they are the
foundations of marginal productivity theory, which was developed late in 19
th
century and which explains the
supply side of the forces determining the prices of all factors of production – not only land but also capital and
labor.
Only late in 19
th
century economists were able to see that Ricardo’s concepts of rent and diminishing returns were
a special case of a general theoretical principle – that these concepts are used in supply side explanations of the
prices of capital and labor. This was done by Alfred Marshall and other the so-called marginalists in 1890s. We will
return to this issue later.
So much on Ricardo’s rent theory; now we turn to his value theory.
Ricardo’s value theory was developed in response to the Corn Law controversy (whether to rise or not tariffs on
the importation of grain, which is wheat, rice, or rye into England).
A number of writers, chiefly Malthus, argued that raising tariffs on the importation of grain would be beneficial to
England.
Ricardo however was in favor of free international trade and against tariffs, which he claimed would be harmful to
English economic development. According to Ricardo, high tariffs would reduce the rate of profits, which in turn
would mean a slower rate of capital accumulation. Because the rate of economic growth depended upon the rate
of capital accumulation, tariffs would lower the growth rate.
We’ll return to this reasoning when discussing his distribution theory.
Now let’s see how a theory of value is involved in the problem of Corn Laws.
Proponents of the rising tariffs used Adam Smith theory of value to argue that tariffs would not result in lower
profits and therefore in lower economic growth.
Why? Higher tariffs would result in higher money wages, because to increase the domestic production of wheat
you would have to cultivate less fertile land.
So then, the price of wheat would increase and so the money wages of workers, because grain was a major part
of the worker’s budget.
Protectionists, proponents of rising tariffs, using Adam Smith’s cost of production theory of value argued that
higher money wages would not necessarily reduce profits in the long run, because the price of goods also rises
and therefore profits should not fall. If they do not fall, than the rate of economic growth remains unchanged.
Ricardo therefore wanted to refute cost of production theory of value in order to show that removing the tariffs on
grain would be beneficial for England.
As we said while discussing Adam Smith’s theory of value, most theories of value aim to explain the forces
determining relative (relative) prices at any given point in time.
However according to Ricardo, the primary problem for a value theory is to explain the economic forces that cause
changes in relative prices over time.
Ricardo stated that primary economic problem is the problem of distribution of income over time, so he needed
also a value theory, which would explain changes in prices over time.
Therefore, he dealt with a rather different problem than Adam Smith – how to explain changes in relative values of
goods (changes in relative prices) rather than how to explain relative prices at any given moment.
First, Ricardo stated that there are two kinds of goods sold in markets – 1) scarce not freely reproducible
commodities – supply of these goods cannot be increased, they have perfectly inelastic supply curve – examples
would include rare pictures, books, coins, wines.
2) freely reproducible goods – you can increase the supply of these goods in perfectly competitive markets –
supply curve is elastic.
The first category of goods – rare, not freely reproducible goods, are excluded from his theory of value. Since they
have perfectly inelastic supply curve than the value of these goods is determined solely by the demand; the higher
the demand the higher the price of this goods.
His theory of value applies only to the second category of goods – freely reproducible goods.
Ricardo rejected Smith’s cost of production theory of value in favor of labor theory of value, that is the statement
that the value of a commodity depends only on the quantity of labor, which necessary for its production.
He claimed that this simple in its formulation theory of value, was appropriate to explaining the prices even in the
advanced economy, where there are three factors of production: labor, capital and land.
He tried to prove that labor theory of value is correct for the advanced capitalist economy. His reasoning is very
difficult to follow and to understand and we will present only a simplified version of it.
There are at least four fundamental problems with Ricardo’s theory of value and they apply to all other theories of
value. We will state the problems and try to investigate the solutions given by Ricardo.
First problem: How to measure the quantity of labor?
Labor theory of value claims that the value of a commodity depends solely on the quantity of labor, which
necessary for its production.
But how to measure quantity of labor, since labor is multi-dimensional variable, that is different kind of labor differ
by the time of work, by the necessary skills of the workers, by the degree of pleasure involved and the like.
To put it simply it seems that an hour of work at producing a financial report for example does not involve the
same quantity of labor as an hour of work at cleaning toilets for example. The second kind of labor is for sure less
pleasurable and this fact should be taken into account when comparing the quantity of labor involved in producing
different goods and services.
Ricardo saw the problem clearly but he simply stated that a correct measure of the quantity of labor is only the
amount of time involved in producing a good, that is, the number of clock hours, which are devoted to producing a
unit of a good. This is rather disappointing solution, but Ricardo did not give any other.
We will see later that Marx developing Ricardo’s theory gave a little more accurate theoretical concept of a
measure of the quantity of labor.
So much on the first problem. Ricardo solved it in his way, but it was not a very attractive solution.
Second problem. And the most important one.
The production of almost all commodities requires the utilization of both labor and capital. However, labor theory
of value states that the value of any given good is determined only by the quantity of labor needed to produce a
unit of a good.
So there is a question – does capital does not have any influence on the values of the goods produced by the use
of capital?
If not, how to measure the influence of capital on the prices of the final goods under a labor theory of value?
Ricardo solved this problem by identifying capital as merely stored-up labor - labor, which has been applied in a
production process in previous periods.
So according to this solution every capital good, a machine, a building, a tool is made up of labor needed to
produce this capital good in previous periods.
Therefore, the quantity of labor in a commodity produced today by both labor and capital is measured by the sum
of two kinds of labor. First, the quantity of labor immediately, directly applied in the production process today.
Second, the quantity of labor stored in the capital good that is to produce the final good – indirect labor.
For example, we use capital and labor today in producing spoons for example, and we use in this process some
machine – a capital good.
Let’s assume that the production of this machine requires 100 hours of labor. Moreover, let’s assume that this
machine depreciates at the rate of one percent of its cost for each spoon it produces.
Then the total labor needed to produce one spoon today is the sum of the numbers of hours of labor immediately,
directly applied (the number of hours a worker spends producing one spoon with the use of the machine) and 1
hour of labor used up from the capital good (because 1 hour is the labor value of the capital good used in the
production process, the value of capital good is 100 hours of labor and the machine depreciates at the rate of one
percent of its cost for each spoon it produces).
In modern terminology, we could name this second type of labor – time equivalent of the depreciation of capital
goods during the production process. Because it equals the depreciation of capital good with the labor time needed
to reproduce the original value of a capital good.
This is the Ricardo’s solution to the problem of explaining how capital influences values of goods under labor
theory of value – capital goods are identified with the labor stored-up, accumulated in them.
However, this solution is not satisfactory.
If labor has been applied in some past periods to produce capital goods, the price of a final good produced today
by the use of this capital goods, must include not only the sum of direct and indirect labor, but also the interest on
funds paid to the indirect labor from the beginning of the production process until the final good is sold.
Because capitalist has to advance funds to cover the expenses of laborers during the production of a capital good.
If capital is invested, the interest have to be paid.
Let’s consider the example:
There are two goods x1 and x2, and they are produced by the use of labor only. There is also circulating capital to
cover the live expenses of workers during the production process.
a
1
and a
2
are the coefficients of labor – that is the number of hours needed to produce a unit of, respectively, good
1 and good 2.
The time needed to produce a unit of a good 1 and a unit of good 2 differs, t1 and t2 denote the periods in which
these units are produced and t
1
>t
2
.
Production of a good 1 is more time consuming; w – is a monetary wage and i – is the interest rate.
Then according to labor theory of value, the prices of goods 1 and 2 are:
p
1
=wa
1
(1+i)
t
1
p
2
=wa
2
(1+i)
t
2
wa – is the term comprising the labor cost of value but it must by multiplied by the interest rate term (1+i)
tk
,
because you have to pay interest on the circulating capital – capital spent on the workers’ cost of living during the
production process.
Thus, the relative price is:
p
1
/p
2
= a
1
/a
2
(1+i)
t1-t2
If the production time differ in different industries than there is also the interest rate term in the equation and we
do not have the pure labor theory of value. If there is no interest rate term, then we have pure labor theory of
value, relative prices depend only on relative amount of labor needed to produce goods 1 and 2.
And notice that in the example we have only assumed that there is only circulating capital, if there is also fixed
capital (machines, buildings and the like) it is only getting worse for labor theory of value.
Labor theory of value ceases to be exact, it is not an exact theory of value if the time needed to produce goods in
different industries differs – and this is a well-known fact.
Therefore, Ricardo’s solution is not completely correct. You cannot explain prices in capitalist economy by labor
theory of value alone. Any other labor theorist of value did not solve this problem correctly. The theory is today
thought to be an incorrect theory of value.
Third problem related to the labor theory of value.
A theory of value must also deal with the problem of land rent. In the production process, you have also to pay for
the use of land, so this payment should also have some influence on the value of final goods, at least in theory.
Ricardo, in his land rent theory, argued that rent does not determine prices, but rather that prices determine rent.
Therefore, if rent do not influence prices, you do not have to worry about the influence of rents on relative prices.
And the last, 4
th
problem.
You should also take into account the role of profits in determining relative prices. The profit is included in the final
sales prices so, if there are different rates of profit in different industries than, profits should also have some
influence on relative prices.
Ricardo was very well aware of this problem, but he thought that empirically different rates of profits in different
industries accounted only for very small differences in relative values of goods.
In other words, he admitted that this is the problem for labor theory of value – different rates of profits in
production processes of various goods – but he thought that the influence of the rate of profits is not
quantitatively important.
He even made some calculations and stated that 93% of variations in relative prices can be explained by changes
in the quantity of labor required to produce commodities while only 7% of these variations are caused by different
rates of profits. So Ricardo maintained that labor was quantitatively the most important element explaining
variations in prices.
Of course, his calculations were not exact, as we know it today.
Because of this, some economists claim that Ricardo held not a labor theory of value, but 93% labor theory of
value.
To sum up, Ricardo knew that labor theory was not completely exact, but he thought that other factors influencing
variations in relative prices, beside the relative quantity of labor, are quantitatively unimportant. He thought that
this was theoretically quite sound, the best, theory of value and a theory empirically relevant. However, he knew
that there were also other factors influencing relative prices (rate of profits), but he thought that those factors
were of smaller theoretical and empirical importance. So he held labor theory of value, with this small qualification,
we have just discussed.
So much on Ricardo’s theory of value.
We will return to this theory shortly while discussing Karl Marx’s views.
Now, we can turn to the heart of Ricardo’s economic analysis – his theory of distribution.
Ricardo was preoccupied with what is now called the functional distribution of national income, the relative shares
of output, of national income, going to labor, capital and land. What is the share of national income going to the
working class, capitalists and landowners?
He was particularly interested in changes in the functional distribution of national income over time, over the long
run. What will happen to the distribution of income over time as economic development occurs?
He considered this problem in the context of society made up of three classes: capitalists receiving profits,
landlords receiving rents and laborers receiving wages.
Capitalists perform the essential roles in the economic world – they are producers and they accumulate capital.
They contribute to the efficient allocation of resources, because they move their capital to the areas of highest
return. Second, capitalists initiate economic growth by saving and investing.
According to Ricardo, they are the most important class in the society at least from the economic point of view.
As to workers, laboring class, Ricardo accepted Malthus’s theory of population and thought that the real wage will
remain constant in the long run on the subsistence level of living – some minimum level of living, which allows to
buy a minimum amount of food, clothes, shelter needed for normal work and living. The real wage remains
constant on the subsistence level over the long run in capitalism according to Ricardo (because he believed in
Malthus’s theory of population). If the real wage increases in the short run over the subsistence level, than the
population of workers increases, and hence the labor force increases and after some time real wages return to the
subsistence level).
Landlords are mere parasites, bloodsuckers let’s say, they are not serving any socially useful function. They receive
their incomes form land rent merely for holding a factor of production, they do not work, they to not save and
invest. They are only engaged in consumption spending. Ricardo and other classical economists were highly critical
of landowner class, they considered they activities to be harmful to the growth and development of the capitalist
society.
As in Ricardo’s land rent theory, we have the assumption that there are only two factors of production land and
doses of capital and labor – capital and labor are joined in one factor of production to simplify the analysis.
We can present Ricardo’s theory of distribution with the help of a simple graph.
In graph, doses of capital and labor are measured on horizontal axis and the marginal products of these doses are
measured in bushels (british measure of capacity) of wheat on the vertical axis.
The downward sloping curve represents these marginal products (Ricardo assumed diminishing returns in
agriculture).
The real wage is given by the Malthusian population theory and we assume that the subsistence level is w, and
this is constant in the long-run.
Let’s start the analysis by assuming that certain quantity of capital and labor (x) is applied to land.
The marginal product of the last unit of capital and labor applied is represented by MP
x
and the total output in this
model is equal to the area OABx – because the total product is the sum of all the marginal products.
Ricardo wanted to determine the division of this total product among wages, profits and rents.
Wages are given by the area OWEx – it is the wage rate multiplied by the quantity of labor applied.
Profits are given by the area WFBE. Why?
At the margin, when we use the last dose of the capital and labor – there is no rent and the MP of the last dose,
that is MPx is equal to the wage rate and the rate of profit.
Then BE is the rate of profit in the model, when we use x doses of capital and labor.
And the rate of profit BE multiplied by the amount of capital, that is x, gives the sum of profits in the economy –
WFBE.
So the rest of the total product (OABx) must be rent – this is the area AFB – the sum of land rents going to
landowners, when we have x doses of capital and labor.
Now we can turn to the question how this distribution of relative shares of national income is changing over time.
At point x we have a young capitalist economy – the rate of profit is quite high, and because capitalists accumulate
capital, there is a high rate of capital accumulation.
Capitalists use more capital for circulating capital, for wages of laborers, and in the short-run the real wage rise.
In accordance with Malthusian population theory, the size of the population and particular, the size of the labor
class increases.
This increased population requires larger quantities of food, so more land has to be brought into production and
you can only brought land with less and less fertility. Since land of better fertility is already used.
So, the price of wheat rise, because price is determined by the MC of the least efficient producer, and now we
MP
Doses of C and L
W
x
O
A
B
E
F
S
G
have in use less fertile land than before.
The prices are rising and because of that, rents are also rising, while profits are falling.
The economy moves to the right, more capital is invested and accumulated but at ever falling rate, the rate of
profit also decreases. This process continues gradually until the rate of profit is zero and capital accumulation
ceases, stops.
At this point, point S on graph, there is no capital accumulation, rate of profit is zero, wages are at subsistence
level and there is no economic growth. This is a stationary state.
At stationary state rents are very high and capitalists manage only to reconstruct the capital from the previous
year, there are no profits. And no economic growth, the number of population is also constant – hence the name –
stationary state, static state.
So this is rather pessimistic conclusion or prediction from Ricardo’s model – in the long run capitalism will achieve
a stationary state, where there is no economic growth. Sad pessimistic view, but it follows logically from Ricardo’s
abstract model of capitalist economy.
We can say also some important things about the distribution of income among social classes over time. In its way
to stationary state there is a redistribution of income among classes in capitalism. Rents are continually rising,
while the sum of profits is falling. In stationary rents are enormous (WFG on the graph) and profits are zero.
There is a redistribution of income over time in favor of landowners. The share of income going to capitalist is
decreasing to zero, while the share going to landowners is gradually rising.
Average income of workers, wage rate, remains constant.
This is Ricardo’s prediction concerning the functional distribution of income among social classes over time in
capitalism.
It is a quite simple model, but its implications are very powerful, capitalism heads for, drives at the stationary
state, where there is no economic growth.
What are the weaknesses of this analysis from the modern point of view?
Because as we all know, the rate of profit is positive today, and there are no historical trends suggesting that the
rate of profit is falling in capitalism.
The most important reason why his analysis fails is that Ricardo underestimated technological progress in
agriculture and industry. This progress occurred faster, continuously and at the bigger rate than Ricardo ever
imagined and on the graph, the technological progress moves the MP curve up, and the stationary state becomes
only a theoretical fantasy.
Finally we can say something about the implications of the model for the problem of Corn Laws. Ricardo’s analysis
implies that Corn Laws or other tariffs would accelerate the coming of stationary state. These regulations would
tend to move the marginal product curve down on the graph, making the arrival of the stationary state simply
faster.
So Corn Laws would contribute to slowing down the rate of economic growth and from this point of view, these
regulations were perceived by Ricardo as extremely harmful to capitalism.
So much on the distribution of income over time according to Ricardo.
A short summary of Ricardo’s views.
Ricardo is without a doubt one most important figures in the history of economic thought.
He introduced abstract reasoning in economics, analytical rigor, modeling approach based on highly simplified,
restrictive assumptions.
Using abstract models allowed Ricardo to reach striking, clear predictions (as for example the coming of the
stationary state in the long-run).
He made great contributions to both micro- and macroeconomics. In microeconomics he formulated advanced
theory of relative prices – labor theory of value. He widened the subject of macro theory by including the problems
of distribution of aggregate income over time.
With the help of Malhusian population theory, he demonstrated the impossibility of improving the lot of lower-
income classes of society.
He successfully defended Say’s law (see next handout) and therefore contributed greatly to the view that
capitalism operates efficiently with regard to the employment of economic resources. His analysis of stationary
state cast a long shadow of doubt over the future of capitalism.
He also developed, as you should know, very elegant and powerful theory of international trade – comparative
advantage theory of trade. We do not discuss it in the lecture due to lack of time needed for it.
The theory made even stronger the classical arguments for laissez-faire policy in international trade.
There are many substantial theoretical results proved by Ricardo, but most historians of economics agree that one
single most important contribution of Ricardo was inventing the technique of modern economics – using logical,
deductive analysis, modeling approach, to work out as precisely as possible the implications of various theoretical
assumptions. This is the methodological nature of economics of 20
th
and twenty first century economics and it has
its roots in the economics of David Ricardo.
So from this point of view the founding father of modern economics is rather David Ricardo than Adam Smith,
whose approach to economics was based much less on theoretical, abstract reasoning.
Lecture 6
Malthus and Ricardo on stability of capitalist economy
This argument between Malthus and Ricardo over the stability of a capitalist system to maintain full employment of
its resources significantly influenced the development of economic theory.
In the history of thought, this argument between Malthus and Ricardo is also known as the controversy over Say’s
Law.
Jean Baptiste (1767-1832) was a French economist. He formulated what is today known as Say’s law – a
statement that there could be no underutilization of the resources in market economy – supply creates its own
demand – in other words, incomes received while supplying the services of productive factors are just sufficient to
buy all final goods, which are produced in the economy.
In other words – a capitalist system will automatically provide full employment of its resources and high rates of
economic growth.
A crucial step in this statement is that all potential purchasing power, that is all incomes are returned to market as
demand for consumer goods (consumption) or producer goods (investment). With regard to the investment, it
means that every decision to save some money is also a decision to invest this money. This excludes the possibility
of hoarding the money (that is keeping money in the strongbox, in safe, under the bed or hide it somewhere). All
money is returned to the economy as consumption spending or investment through the banking system for
example.
However, savings do not always turn into investment easily and this is the main weakness of the Say’s Law from
the modern point of view.
Say’s law gives a very positive, bright view of capitalist system. Almost all classical economists accepted Say’s Law.
Only Malthus attacked it, opposed strongly to this view.
Ricardo’s arguments won the battle and Say’s law was accepted in mainstream economics until 1930s, when John
Maynard Keynes developed his macroeconomic theory and criticized Say’s Law. Since then this is a controversial
view, no longer accepted by the majority of economists.
But in the most of the 19
th
century Say’s Law was accepted generally and economists believed that market
economy has the power to always maintain full employment of its resources – there is no unemployment of labor
in capitalism with the exception of these people who do not want to work at the market wage or are in the process
of changing employment.
So let’s see what were the arguments of Malthus against the view that capitalist economy has immanent stability
and always fully employs capital and labor.
Unfortunately, Malthus never precisely stated his arguments, but he presented some both naïve and more
sophisticated points about problems of maintaining full employment of resources in capitalism.
His more naïve view was that labor does not receive the whole product produced in the economy (because there
are also savings made by capitalists in the economy) and so demand created by the labor class is not sufficient to
purchase all final goods at market prices. Labor class lack the purchasing power sufficient to buy all the goods
produced in the economy.
This is of course correct, but Malthus did not see that capitalists return their savings to the market in form of
demand for produces goods (as investment), there will be no deficiency of aggregate demand.
His more sophisticated view was that too much savings in capitalism can produce troubles in capitalism in the
long-run.
He claimed that there is appropriate rate of capital accumulation in the economy that the economy can absorb and
that too much saving and investment will cause difficulties.
According to Malthus, the process of savings leads to a reduction in the demand for consumer goods (we save
more and limit our expenditures for consumer goods) and the process of investment leads to the production of
more consumer goods in the future – but the demand for these goods is reduced today (we save more).
Therefore, according to Malthus there is a possibility that in the long run, consumer demand will not be sufficient
to purchase all final goods produced. Therefore, there is a possibility of depression and unemployment of factors
of production in the long run.
This is quite confused and not a very detailed explanation of a possible depression in capitalism in the long-run
and most economists at the time were not persuaded. The problem of stability of capitalism returned to economics
only after over 100 years during the Great Depression of 1930s. and the discussion of the reasons for
unemployment in capitalism was taken up then by J. M. Keynes. Classical economists during the whole 19
th
century
did not rather believe that there could be some excessive unemployment of resources in capitalism.
Lecture 7
The last great classical economist was John Stuart Mill (1806-1873)
His main economic work is
Principles of Political economy, published in 1848.
Mill was a most unusual and probably the most gifted writer who contributed significantly not only to economics
but also to political science and philosophy.
His intellectual powers were in much the effect of his education. His father, James Mill was also an economist but
of lesser importance. James Mill educated his son in a very disciplined and restrictive way.
At three years of age J. S. Mill was studying Greek and by age eight he began Latin. After mastering mathematics,
chemistry, physics and logic, he started to study political economy at age thirteen. He was not allowed to read any
religious writings or poetry, nothing that would make him irrational.
By his 15
th
year his formal education was finished, he had the knowledge of formally educated 30-years old
person.
He suffered mental breakdown at the age of 20 (due to the psychological costs of this intense education), but after
the period of depression he became one of the leading intellectuals of his and all time. He is an important figure in
the history of economics and in the field of logic, political science, philosophy of science and political or social
philosophy.
Mill contributed to economic theory, but his main interest was in broader social issues than economists typically
address. He was rather social philosopher, social reformer, who wanted to improve the lot of the individual in the
society.
So first, we have to say something about these broader social issues, which Mill was interested in, and only after,
we will discuss his theoretical achievements.
There are two social movements, which influenced Mill. The first is socialism, the other utilitarianism.
Let’s start with socialism.
Early socialist thinkers appeared in economic thought in the beginning of 19
th
century. This group of writers was
very diverse and one unifying that binds them together is their view that the functioning of capitalism in 19
th
century Western Europe was disharmonious. While classical economists were in general strong advocates of
capitalism, early socialists against Smith, Ricardo and others, founded many objections to capitalist system.
They proposed many various means of eliminating evils of capitalism, most of them were of non-violent character.
Most of them argued simply that capitalism is unjust, because there is too much inequality and poverty in
capitalism.
Karl Marx called them – utopian socialists, since he thought that their critique of capitalism was not based on
scientific science – we’ll get back to this issue, while discussing Marx’s views. Marx claimed that he scientifically
proved that capitalism in inherently unstable and self-destructing, while early socialists, pre-Marx socialists mainly
criticized capitalism on ethical basis, as unethical, unjust system. This is the difference between Marx and early,
utopian socialists.
Before we proceed, further we should define what we mean by socialism and capitalism, because these terms
have many different meanings.
We can use the following workable, but not generally agreed on, definitions.
There are two important features of ideal capitalism: 1) private ownership of economic resources; 2) market as a
allocation and distribution mechanism
Ideal socialism is defined respectively as system where 1) there is a state or public ownership of economic
resources; 2) market still serves to some extent as mechanism of allocation of resources and a mechanism of
distribution of incomes.
Communism here would be a system with 1) state or public ownership of resources; 2) state or some central
planning authority decides on the allocation of productive factors and on the distribution of incomes. There is no
market. Ideally, according to Marx, in communism each person should be given as much resources as to fulfill her
needs. In addition, everyone should give to the society as much as his or her ability is – to work as hard as
possible.
Hence, the communist phrase describing allocation and distribution in communism says – “from each according to
his ability, to each according to his needs”
In times of Mill early socialist ideas were becoming more and more popular and Mill is the first classical economists
who gave response to these ideas, and evaluated them objectively.
Second social movement, which is important while discussing Mill’s views in utilitarianism.
Utilitarians, proponents, advocates of utilitarianism, were social reformers, social philosophers, who held some
specific views about the economy and society.
The leader of the group was Jeremy Bentham (1748-1832), economist and philosophers.
What is utilitarianism?
Simply it is the ethical view that the only standard by which moral rules, civil laws, economic actions, government
economic acts, or decisions in economic policy should be evaluated is the principle of utility: the maximization of
the sum of the happiness (they named happiness also as utility) of all individuals that make up a society.
Early utilitarian economists thought that if society could measure happiness, than economic laws and regulations
could be created that would result the maximal possible sum of the utility (happiness) of all members of society.
They thought that the best way to measure happiness was by the use of money.
How to use money in practice to measure happiness resulting for any economic action or event?
According to them, you have to ask how much would you pay for this economic action or event, if it can be
brought about. Willingness to pay is the measure of happiness.
Thus, Bentham and early utilitarians thought that they could design an optimal society, that they can formulate the
best possible economic policy for example, by using the principle of utility and by the use of money as to measure
happiness.
This principle of utility became the most popular standard of evaluation economic policies, economic actions, and
economic arrangements later in 19
th
century and today is used as one of the most popular criterion of social
welfare in welfare economics – the sum of the utilities of all members of society.
According to this criterion, the social welfare increases, if the sum of utilities of all members of the society
increases.
We may say here as a digression that there are many theoretical limitations of money as an instrument to measure
utility and in general it is not easy, if not impossible to measure utility by the use of money.
In 20
th
century, in 1930s, 1940s, utilitarianism was largely rejected in economics because most economists agreed
that there are no exact, scientifically valid methods for measuring utility or happiness, and what is more that there
are no scientific methods for comparing utility of different persons.
Still, today utilitarianism is a quite strong movement in economics and social philosophy. Many of contemporary
economists are in principle advocates of some form of utilitarianism. In later part of 20
th
century economists
invented several more precise methods of measuring and comparing utility. We will discuss this issue, while
studying the development of 20
th
century economics.
John Stuart Mill was a pupil, a student of Bentham, and soon became a leader of utilitarian movement, developing
a sophisticated version of utilitarianism in economics and philosophy.
So much on Mill’s intellectual background, and especially the influence of socialism and utilitarianism on his
thought.
Mill’s views on the economic policy, his attitude to capitalism and socialism and his general social philosophy.
Socialist writers influenced Mill. This influence is best evident in his distinction between the laws of production and
the laws of distribution.
Mill maintained that this distinction between the laws of production and the laws of distribution was his single most
important contribution to economic thinking.
The laws of production (for example the principle of diminishing returns), according to Mill, are laws of nature (like
the law of gravity in physics) that cannot be changed by human will or institutional arrangements.
However, the laws of distribution are not fixed; they result chiefly from particular social and institutional
arrangements.
Therefore, the laws of production are fixed, independent of human will, but the laws of distribution can be
changed by human decision. This is the important difference between those two kinds of economic laws according
to Mill.
Why he made the distinction?
Because he was reacting strongly to the way, in which classical economics was being used in economic policy.
Conservative economists, politicians and general opinion used classical theory to show that the distribution of
income is determined by fixed, unchangeable laws (that cannot be changed anymore than the law of gravity can
be changed).
According to this argument the many efforts to improve the quality of life, the welfare of the mass of society,
particularly of the working class, through social legislation, the trade union movement and income redistribution
policy are futile, because the distribution of income is governed by immutable, fixed economic laws, which result in
the masses being poor (recall the so-called iron law of wages – the wages of laborers are on the subsistence level,
they are sufficient to fulfill only basic needs of workers).
According to Mill the distribution of income or wealth (the laws of distribution in his language) can be changed
through the social legislation (pro-poor legal acts, redistribution policy and the like).
Therefore, the government can redesign the institutions of capitalism, to some degree, to make the distribution of
income and wealth more equitable, more equal.
We have to discuss here Mill’s distinction in more detail. What does it actually mean that the laws of distribution
are not fixed, while the laws of production are fixed, independent of human will?
There are two meanings of distribution of income in economic theory. One is functional distribution of income –
the distribution of income among the factors of production or the social classes – how big is the part of national
income going to the owners of labor, how big is the share of NI going to the owners of capital and the like. The
factual, real functional distribution of income depends on the prices of factors of production (rate of wage, profit,
and land rate) and on the marginal productivity of factors of production.
As such, because it depends on the MP of factors of production, the functional distribution of income is in direct
relationship with the laws of production, because we determine the MP of factors of production on the basis of the
production function.
Therefore, the functional distribution of income cannot be changed any more, than the society can change the
laws of production (the production function).
However, there is a second meaning of distribution in economics and this is personal distribution of income, the
share on NI going to every household. The personal distribution of income depends on number of factors
(economic ones – such as the resources in the possession of the household, the effort of the members of the
household and the like). Moreover, a variety of non-economic factors do influence the personal distribution of
income (factors like the laws, customs, institutional, political arrangements and, for example, the fact how lucky is
the household in the market economy).
Most of these non-economic factors influencing personal distribution of income are outside the subject of analysis
of economic science, so modern mainstream economics has little to say on factors explaining the personal
distribution of income.
So the laws on production only loosely influence the personal distribution of income and the society have the
ability to effect this distribution of personal income in accordance, for example, with some ethical judgments.
Therefore, Mill’s laws of distribution concern personal distribution of income, not the functional one. In this sense
his distinction is correct.
But, against his views we could, from the modern point of view, argue that society, in a way, can influence also
the laws of production, for example, by investing smartly in the development of technology, the production
function of any country can be changed and governments can influence, the seemingly physical, unchangeable,
relation between economic resources and economic output. Well, but classical economists generally did
underestimate the importance of technology for economic development.
As you can see, Mill made the distinction between these two kinds of laws, because he was a social reformer and
he was concerned with the standard of living of the working class. He thought that society should act in a more
wise and humanistic way, so that a more equal distribution of income and wealth.
In practice, to achieve this aim, more equal distribution, he favored the following means in economic policy:
5. high rates of taxation on inheritances, but he opposed progressive taxation because he feared the
disincentive effects of progressive taxation (that is he thought that those who are progressively taxed
would put less than optimal amount of effort into work)
6. he advocated the formation of producer cooperatives, that is firms in which workers would receive not
only wages but also would participate in profits achieved) – this would contribute to more equal
distribution of wealth.
7. he argued that more equal distribution would be achieved if population growth could be reduced.
Therefore, he wanted to enlighten the working class through education (including education about birth
control. Reduced family size would contribute to higher living standards of the masses.
8. limitation of right of property in land. State may expropriate (take over the ownership of land) land if it
pays compensation. He also thought that there should be a tax on all increases in land rent.
So much on the Mill’s distinction between the laws of distribution and the laws of production.
Mill’s economics was often described as eclectic (that is deriving ideas from many various, possibly contradictory,
sources). His basic economic theory was Ricardian, but he used rather the methodology of Adam Smith than of
Ricardo (that is he used contextual economic analysis, he was not a pure, abstract theorist).
He also drew inspirations also from socialism and utilitarianism; he thought that economic activity must be
considered in a broader social context of all human activity; he was concerned not only with economics but with
social philosophy in general
All this contributed to his main economic work being called eclectic.
This Mill’s eclecticism is best visible in his approach to economic policy.
His writings on economic policy are a strange mixture of opinions and he cannot be easily classified as an advocate
of laissez faire or an advocate of government intervention or as a proponent of socialism. He was subtle writer, but
also ambiguous one. And complex one too.
Possibly the best way to characterize such a subtle, complex economist as Mill is to say that in terms of economic
policy he represents a midpoint between classical liberalism and socialism.
His views were not close to Marxian, revolutionary socialism, but rather to some kind of evolutionary, non-violent
version of socialism.
What were Mill’s specific views of the role of government in a good society?
His philosophical book “On liberty” (1859) is a classic statement of political liberalism. In the book, he claimed that
individual freedom is the most important social value. He maintained that the only rightful exercise of power by a
government over an individual will is “to prevent harm to others”. So individual freedom is restricted only by not
harming other people. You can do anything you want (in your private and public spheres of life), unless it is
harmful for other people.
Until today, it is a classical statement of liberalism in political and philosophical tradition of the western world.
However, in his discussion of practical social action Mill abandoned such a strong liberal position and found
exception upon exception to the general rule of liberty and freedom.
He found it necessary in one place to make a forceful statement, I quote it: “Laissez faire, in short, should be
general practice: every departure from it, unless required by some great good, is a certain evil”. Therefore, the
laissez-faire should be general practice in economic policy, according to this statement.
However, he was far from being an unqualified supporter of laissez-faire, going so far as to describe the
exceptions from laissez faire as ‘large’.
He listed five classes of actions that had to be performed by the state.
They included cases where individuals were not the best judges of their own interest (it would include education
for example), he advocated that state should complement private education by providing public education, but not
on the monopoly basis, state education should compete with privately provided education.
He thought also that individuals may not be able to judge future consequences of actions, so the of long term
obligations (long term job contracts for example) should be regulated by state.
He thought also that state could intervene in joint-stock companies, because if a task needs to be delegated to
joint-stock associations, it would be better done by
the state; in joint-stock companies there is a problem with shareholder control over the management; while state
can better control the management of the company.
In addition, he thought that the state intervention is required in situations where coordinated action is required, for
example if workers aim at reducing hours of work, they should coordinate this action, they should all require the
reduced hours of work at the same time. Because none of them (of workers) has the incentive to start to require
the reduced hours of work individually – he would be fired and replaced by others from the labor market.
So reduction of the hours of work can be only implemented by government legislation.
Further, state should strongly participate in such a activities as public charity (it should be regulated by state),
colonization, and in general in public services that cannot be performed by an individual.
Even more radically, Mill argued that there might be circumstances in which it became desirable for the state to
undertake almost every activity:
“In the particular circumstances of a given age or nation, there is scarcely
anything, really important to the general interest, which it may not be desirable,
or even necessary, that the government should take upon itself, not because
private individuals cannot effectually perform it, but because they will not. At
some times and places there will be no roads, docks, harbours, canals, works of
irrigation, hospitals, schools, colleges, printing presses, unless the gvovernment
establishes them; the public being either too poor to command the necessary
resources, or too little advanced in intelligence or appreciate the ends, or not
sufficiently practiced in joint action to be capable of the means.”
So in cases of underdevelopment or possible the economic transformation, Mill proposed that state should take
control over almost every economic activity in the economy.
The range of exceptions to laissez faire in Mill’s writings is quite extensive, much more extensive than exceptions
to laissez faire proposed by Adam Smith.
Having made the case for laissez-faire in the first place, Mill thus qualified it so heavily as to open the possibility
that this level of state activity could be regarded as socialist.
So should we call Mill a socialist thinker?
In principles of political economy, he compared capitalist and socialist economic systems.
He wrote that if we would compare existing capitalism (with its excessive inequality and poverty among laborers)
with ideal socialism (with definitely more equal distribution of income and wealth) than we should choose without
hesitation socialism. Even if socialism has the problems of its own, (the authority has to decide on the distribution
scheme, has to decide how much equality should be among the members of society). However, he thought that
theoretical, conceptual socialism is better in comparison with real, existing capitalism.
However, Mill wrote, the system of private property, capitalism, does not have to be as it is.
With universal education and limitation on the population growth poverty could be eliminated from a system of
private property.
Some basic institutions of capitalism can be changed in favor of redistribution toward the poor, and capitalism with
a more equitable, more equal distribution is a fully workable alternative to socialism.
We should compare this modified, ideal capitalism with ideal, theoretical socialism (socialism at its best).
In such a comparison, Mill argued, we should choose rather capitalism because capitalism would assure better
individual freedom and diversity of opinion among the members of society, which are, to Mill, the sources of
mental and moral progress in society. So finally, he preferred capitalism over socialism but rather on a political
non-economic basis.
He argued that people should experiment on a small scale with socialist economic arrangements in practice in
order to determine what are their practical economic advantages and disadvantages and in order to make a better-
informed decision whether socialism or capitalism is a better economic system.
As we can see he was not a socialist or communist, but was sympathetic to socialism, he flirted with socialism. In
fact, he was rather a proponent of a modified version of capitalism, he saw many advantages of markets and
market competition, but he wanted capitalism with more equal distribution of income and wealth, so we could call
him a precursor of modern “third way” between capitalism and socialism, some kind of modern social market
economy.
One final issue about Mill’s economic policy and social philosophy concerns his analysis of Ricardian stationary
state. Mill agreed with Ricardo that stationary state (a state where there is no economic growth, the economy is
not expanding) is the ultimate fate of capitalism.
For Mill this vision of coming stationary state was not a sad or dismal one. He thought that ever-growing economy
is not necessarily a desirable place in which to live. Mill found many aspects of a prosperous, growing economy to
be rather objectionable or reprehensible and the aspects of interpersonal relationships in market economy such as
trampling, crushing, elbowing, and treading on each other’s heels on the way to make more and more money.
Therefore, some egoistic, competitive aspects of human relationships in the market economy were for him rather
not very attractive for the overall human happiness and well-being.
In stationary state, the situation would be different, it could be a highly desirable place to live, as the pace of
economic activity would decrease and more attention would be focused on the individual and his or her non-
economic well-being. In Mill’s vision of stationary state a gentler, less materialistic culture exist. A redistribution of
income in stationary state has occurred and no one is poor, no one desires to be extremely rich (it is quite not
possible, since economy is not growing, and redistribution mechanisms are working), no one fears that he we will
be excluded from the society or become poor by the efforts of others to make themselves rich.
In a stationary state, according to Mill, you can spend more time improving the art of your living, you work less,
you can engage in developing your interests, your hobbies and the like.
So in Mill’s view stationary state would bring about a good society, it is therefore not pessimistic conclusion of
Ricardo’s model, a better society, more humanistic, less materialistic, would emerge in this state, in which the
fruits of capitalism would be shared by all its members.
This was a very unusual interpretation of the concept of stationary state.
From his analysis of stationary state, we can see that he was not an economist in a narrow meaning of this word;
he was considering economic problems from a broad, social perspective.
Now, let’s now turn to Mill’s contributions to the mainstream economic theory.
His main economic work,
Principles of Political Economy was first published in 1848 and remained, in its
subsequent seven editions, the standard, the ruling textbook on economics until the end of the century.
Mill claimed that in this book he was only updating Smith’s
Wealth of Nations and Ricardo’s Principles of Political
Economy to incorporate into them the new ideas that had appeared during the second quarter of the 19
th
century.
Mill summed up classical economics, showing how it had changed since Smith and Ricardo, his theories of value,
income distribution and growth are basically Ricardian, but he modified some of them in important ways.
First, Mill recognized that Ricardo analysis was too abstract and that it has to be tempered by an awareness of
historically prevailing institutions. Mill argued for example that market forces are only one type of factors
influencing the distribution. The other type is custom and tradition.
Mill criticized classical economists for emphasizing the role of competition and market forces while almost
neglecting the role of custom and tradition.
He then presented historical material describing a variety of institutional arrangements (customs, traditional rules)
that had existed in the past and governed the distribution of income in historical economies.
In the whole book, he was generally pondering the question of how much importance should be given in economic
reasoning to abstract theory and how much to institutional and historical context.
At the same time, he was convinced that economics if it wants to remain science has to rely to some extent on
competition model of markets, because it gives exact and certain conclusions and predictions. While the analysis
based on historical study of customs and traditions is not capable of giving any predictions. So it has to remain
only complementary to abstract, theoretical reasoning.
So his views on proper methodology of economics were rather closer to those of Adam Smith (who was a
proponent of contextual economic analysis) than to those of Ricardo – pure theoretician of economics. This was a
consequence of his deep conviction that economic activity in only a part of all activities and should be studied in a
broader social context. The mainstream economics in 20
th
century has followed rather the approach of Ricardo –
modeling of economic activity abstracted from social context. This was the result of growing specialization is social
sciences in the 20
th
century.
Returning to Mill’s economic theory.
He supported Say's Law when discussing long-run growth; in discussion of fluctuations argues that people may
have the means to purchase goods but desire to postpone their consumption (to hold money); glut (the excess of
supply for some goods) may exist as part of the business cycle, but not in the long run. Therefore, he accepted
the Say’s Law and thought that there is no possibility of long-lasting economic crises in capitalism.
In value theory, theory of relative prices, Mill rejected Ricardo’s labor theory of value.
He was a proponent of a cost of production theory of value (that is he claimed that relative prices in the market
economy equal the relative cost of production, where the cost of production is the sum of wages, profits and land
rents paid in the process of production).
In case of rare goods (wines, works of art, rare books, coins and the like), he argued that only demand determines
the prices of such goods. However, this is relatively unimportant category of goods, because only few commodities
are perfectly inelastic in supply.
A second category of goods, manufactured goods, has a perfectly elastic supply curve, according to Mill, and Mill
concluded that the cost of production of these goods determines their price. He assumed that all manufacturing
industries are constant-cost situations, that is supply curve is horizontal – the marginal cost of production do not
change as the output increases.
Third group of commodities, agricultural commodities, are produced in situation of increasing costs – MC do
increase as output increases, the price of these commodities depends, to use his language, upon the cost of
production in the most unfavorable circumstances (that is the MC of production of the least efficient producer, who
still is able to sell his product in the market).
Mill did not use mathematical equations, supply and demand schedules or curves to explain his theory, but he was
able to describe better the process of determination of prices in the long run in market economy than Smith and
Ricardo.
He only failed to cover those commodities, which are produced in decreasing costs industries, when long run
supply is decreasing, downward sloping.
We could say that the analysis of the working of supply and demand in the long run in competitive markets has
not fundamentally changed since Mill. Of course, many developments have occurred since Mill’s times,
mathematical advancement of the theory for example, but he was able to carry out a significant analysis of
markets in the long run with few analytical errors.
The great gap, omission in Mill’s microeconomic theory, not filled until 1930s, was his inability to analyze less than
perfectly competitive markets.
Mill contributed significantly also to international trade theory. His most important achievement here is his analysis
of the division of the gains from international trade among trading countries. It is probably his most important and
lasting contribution to the technical economic theory.
He used no mathematical techniques but surprisingly he gave a quite correct, although inexact, answer to this
problem of division of gains from international trade.
He stated that the division of gains from international trade depends on the relative strength of the demands for
import in trading countries, by which he clearly meant something like the elasticity of demand. The concept,
elasticity of demand, was not developed at the time yet, but Mill described the cases of elastic, inelastic and
unitary elastic demand in his analysis.
He also introduced the concept of transport costs into the comparative advantage theory of international trade and
showed how transportation costs may produce situations where trade will not occur at all even with differences in
comparative costs of production of different goods.
He also analyzed the influence of tariffs on terms of trade, and the problem of how price and income changes
influence the trade equilibrium between countries.
It is general judgment that major changes in the classical theory of international trade were made only nearly 100
years after Mill, when Bertil Ohlin made a first advancement in the so-called Heckscher-Ohlin model of
international trade.
His contribution to this part of economic theory was significant.
Another contribution of Mill to economic theory involves the wages fund doctrine.
This doctrine, theory of wages fund, claims that the wage rate (w) is determined by the ration of the size of wages
fund (capital advanced by capitalists to cover the life expenses of laborers) and the size of the labor force.
The wages fund doctrine was used by some economists and a number of popular writers against the formation of
labor unions in England. It was used as anti-union economic argument.
According to the theory any effort by labor class to raise wages, by whatever means, would be fruitless, because
the wage depends solely on the decisions of capitalists about how much to invest in wages fund. (if the size of
labor force would decrease, capitalists would invest less in wages fund, possibly, to keep the wage on the
subsistence level).
This is an example of how orthodox, classical economic theory was used to prove that attempts to improve the
welfare of the working class by providing more equal distribution of income could not be successful.
Mill supported the wages fund doctrine, but also he supported the formation of labor unions.
Unions and strikes seemed to Mill to be appropriate tools for labor to use in its attempt to counterbalance the
power of the employing firms. He followed a suggestion of Adam Smith that a single unorganized laborer is at a
competitive disadvantage in bargaining over wage rate with an employer (when employee asks for a raise of
wage, employer could always argument that there are thousands of workers in labor market who are willing to
work for a lesser wage.
Later in his life Mill rejected the wages fund doctrine arguing that in any given moment there is a possibility that
although the maximum amount on funds advanced for wages is fixed, a given wage rate and a given labor force
may not exhaust this fixed amount. Therefore, there is a possibility that labor unions can raise wages through
bargaining process with employers. The existence of labor unions is justified.
This is not a very convincing argument, but if you assume that the demand for labor is fixed (as classical
economists assumed) then there is a little room for explaining how labor unions could effectively fight for higher
wages.
The assumption of fixed demand for labor was rejected later toward the end of 19
th
century.
This support of Mill for labor unions is in general with his program of social reform in capitalism centering on a
more equal distribution of income. He was the first classical, mainstream economist who explicitly argued in favor
of labor unions.
Let’s sum up Mill’s thought.
John Stuart Mill attempted to combine the classical economic theory with the humanism of social reform to
promote the society and economy that were less concerned with the business side of the economy and more
concerned with the problem of individual improvement and welfare of underprivileged members of the society.
Mill’s concern with the social reform led him to stress the distinction between the unchangeable laws of production
and the changeable, institutionally determined laws governing the distribution of personal income.
He was concerned with let’s say “closer to real life” economic policy and his approach to this issue was more in
Adam Smith style, than in that of David Ricardo. He was not a pure theoretician.
His thought is hard to classify ideologically; his writings contain strong dose of classical liberalism with its
insistence on freedom and laissez-faire policy; yet he often advocated government intervention in the economy.
Still he rejected socialist condemn for private property and free competition, suggesting that capitalism can be
improved by social reform in order to retain the benefits of capitalistic institutions, while removing the glaring,
obvious for him, evils of capitalism. The evils included mostly restrictions of personal freedom and opportunities for
individual development which were connected to the high inequality and high poverty rates in capitalism.
He proposed several, quite moderate, means in economic policy to make the distribution of income and wealth in
capitalism more equal – those means were designed in such a way as to save intact the fundamental institutions of
capitalism (that is free markets and private property)
He can be classified as a proponent of some kind of improved capitalism, precursor of modern concept of “limited
welfare state” or social market economy, again a quite well specified limited version of this conception.
He made some lasting and important contributions to economic theory.
He finally rejected the Ricardian labor theory of value an in its place developed a long-run cost of production
theory of value that included both labor and capital costs of production.
He extended the Ricardian theory of international trade to explain the division of gains between trading countries
and came close to inventing the concept of price elasticity of demand.
He defended smartly the Say’s law, giving classical economics a powerful argument in favor of the view that
capitalism is stable in the long-run.
Toward the end of his career he withdrew his support for the wages fund doctrine, removing an important
economic argument from the arsenal of those who believed that the mass of society were unable to raise their
wages through collective bargaining or political process.
He originally contributed also to political science, philosophy of science and political philosophy, so it was quite a
good fortune for economics that John Stuart Mill spent a large part of his life doing economics.
Orthodox, mainstream economics was ruled by Millian economics, economics of J. S. Mill almost until the end of
19
th
century, that is for about 50 years from the publication of the first edition of his
Principles of Political
Economy.
This is the best evidence of his importance and significance for economics.
Lecture 8
The economics of Karl Marx.
Marx, was a German economists, philosopher, sociologist and revolutionist. His influence economic theory and on
economic practice was enormous – we could say, as you know, that in the name of his ideas entire societies were
transformed, especially in the second half of the 20
th
century.
He was born in 1818 and died in 1883. Therefore, he lived and wrote in the classical economics period.
Marx is the best proof of the importance of economic ideas. It is therefore very important for us to examine the
ideas of such an influential economist as Marx, especially since his ideas are nowadays forgotten – justly or
unjustly – or presented in a distorted way.
Let’s start with a short overview of Marx’s views.
Marx was primarily a philosopher, who formulated philosophical a theory about how the whole physical nature
evolves in time as well as a theory about how the civilization in all its aspects (economic, social, political and the
like) evolves in time.
Therefore, his theoretical system is overwhelming; Marx had the ambition that his system would explain every
aspect of the reality – both physical nature and social arrangements.
We will cover only his theories about social reality, especially his economic theory.
First, we should state that Marx was a harsh critic of capitalism; he was the strongest opponent to the classical
economics.
He was an advocate of socialism and communism, but he did not write much on these systems, he did not explain
in detail how they should be working. His writings are devoted mostly to the analysis and critique of capitalist
economic system.
His major economic work is called
Das Kapital (English – Capital), first volume of the Capital was published in
1867. Later two volumes heavily edited by his friend and collaborator Friedrich Engels, were published after Marx’s
death in 1885 and 1894.
Moreover, the fourth volume, called
Theories of Surplus-Value, was first edited and published by Karl Kautsky in
1905-1910. These forth volume was itself published in three volumes, so the Capital in overall is more than 2000
pages long. And this is only a part of Marx’s economic writings.
Marx’s economics is in a large part the application of his general theory of history to the capitalist economy. He
wanted to formulate general laws governing the dynamics of capitalism. Therefore, he was not interested in the
static analysis of equilibrium in capitalist system but in the long-run tendencies of capitalism.
Marx’s economics is the application of his general theory of history, history of civilization to the capitalism. Before
we will review his economics, we have to present his theory of history – which was called historical materialism.
Marx was a very ambiguous writer, he did not made precise definitions of the concepts used, was rather a bad
mathematician, made some logical errors in his theory, probably on purpose and the like, he wrote in a very
unclear way – and there are thousands of interpretations of what Marx really wanted to say.
Marx’s historical materialism.
The grand question of this theory is the following: can one develop a theory that explains the different ways in
which societies have been organized over time and can this theory be used to predict the possible future
organization of society?
Are the social structures like feudalism, slavery system, capitalism part of an evolutionary process, which is driven
by some factors you can rationally analyze, or are they only a result of random historical events?
According to Marx, there is an evolutionary process in the history of societies that can be rationally analyzed and
you can predict what will be the future organization of societies.
Marx believed that all societies could be divided analytically into three parts:
1) the forces of production (technology, labor skills, scientific knowledge, tools, capital goods)
2) relations of production – rules of the game in the society, relations between persons in any society; social
relations and relations between people and things – example include: work relations (selling labor for
wage in capitalism, slave work in slavery-based systems); property rights (private property in capitalism;
collective property in communism) and the like.
3) social superstructure – widely understood culture, the art, literature, music, philosophy, political system,
religion, the legal system and the like.
The forces of production are inherently dynamic and changing (people continuously improve technology); they are
the main source of changes in the societies.
According to Marx then, economic or materialistic (and not spiritual) factors are the primary determinants of
historical change. Mainly economic technology, technology, materialistic, economic factor is the ultimate, the most
fundamental cause of change in the social structure of societies in history.
In contrast, the relations of production, institutions of property rights and work relations are static, they do not
change very often, and they are always from the past. Therefore, they are never fully adjusted to the continuously
changing forces of production – technology.
The static nature of relation of production is reinforced by the nature of the social superstructure. Its purpose,
according to Marx, is to keep intact the relations of production – to maintain the status quo. To keep property
rights, work relations unchanged.
For example, prevailing idea in economic philosophy in capitalism, provided by classical economics, is the
acceptance of free labor markets and private property.
The process of historical change according to Marx, and his theory, can be described in a following way.
In the beginning of every historical period (slavery-based economies, feudalism, capitalism, socialism and the like),
there is a harmony between the forces of production and the relations of production.
Over time the changing forces of production, which are dynamic by its nature, bring about contradictions in the
system, as the existing and static relations of production (institutions of property and work relations) are no longer
appropriate to the forces of production (technology).
These contradictions manifest themselves, Marx said, in class struggle. In capitalism, there is a class struggle
between capitalists and workers.
Finally, these contradictions will become so intense that there is a period of social revolution, and a new set of
relations of production is brought into being.
At this point, just after revolution, there is again harmony, but the dynamic, changing forces of production ensure
that new contradictions will soon develop and that in the future, possibly distant future. However, they will develop
unless you have a society, which is classless, there are no social classes in such a society and the class struggle
cannot develop. Which society is classless in principle? Communist, of course (no markets and property is
collectively owned) - so communism according to Marx will be the end of social history.
This is short explanation of historical materialism – Marx’s theory of history. (Why it is materialism – because the
fundamental factor of change is economic technology – and this is a material, not spiritual factor. There are many
theories of history in which spiritual factors, human ideas or human reason, human mind drives the development
of history. However, Marx’s theory of history is not of that kind – it is materialistic theory).
Marx was especially interested in applying historical materialism to the analysis of capitalism, analysis of the
contradictions of capitalism and to explaining why capitalism has to collapse. In addition, he wanted to predict
what would emerge after the collapse of capitalism, what new relations of production will appear in societies on
the ruins of capitalism.
This system (historical materialism), these 3 concepts, according to Marx, is sufficient to explain the history of
social organization in Western societies. That is historical materialism can explain why we had first societies based
on slavery, how these societies had developed, why this slavery-based system had collapsed.
And further, why feudalism developed, how in the beginning the relations of productions were appropriate to the
existing forces of production, and that these relations of production were supported by the social superstructure.
Then he showed how the changing forces of production destroyed this harmony, as the institutional structure of
feudalism (property owned by the church and the nobles; and peasants bound to the land and working on leased
land) became incompatible with developing technology in agriculture, increased trade and the beginning of
manufacturing.
What do we mean by incompatibility here? That the improved technology could be much better exploited in a
system with a more widely shared property than in feudalism, and that’s why after centuries, feudalism finally
collapsed and was replaced by capitalism.
In early capitalism we had also a harmony between forces of production and relations of production, but
continuous and enormous improvement in technology in capitalism soon brought about conflicts and contradictions
– for example extreme inequality and poverty. We will discuss this and other contradictions of capitalism, using
Marx’s terminology, later.
However, according to Marx those contradictions will bring about the fall of capitalism finally and emergence of a
new set of relations of production – socialist one.
Socialism, then, will give way to communism, and this will be the end of history since in communism there are no
social classes.
By socialism, Marx meant a system where 1) there is a state or public ownership of economic resources; 2) market
still serves to some extent as mechanism of allocation of resources and a mechanism of distribution of incomes.
There are markets, there is a state, but inequality is limited and there is no poverty. Property is collectively owned.
While in communism there would be 1) state or public ownership of resources; and in communism each person
should be given as much resources as to fulfill her needs.
Everyone should give to the society as much as his or her ability is – to work as hard as possible.
So in communism, there are no markets, there is no state, there is no class struggle, there is also economic
equality.
So much on the historical materialism.
How can we assess, judge this theory of history? Is it a correct theory of history?
Well, if we take this theory as saying that technology is the only factor determining every aspect of relations of
production and every aspect of the superstructure (for example music, technology determines music) then the
theory is simply absurd and definitely not true, incorrect.
On the other hand, if we interpret historical materialism as saying only that technology is one among many factors
determining history (like biological, cultural, spiritual and the like) then the theory becomes obvious and even
trivial, not very important.
It is true that technology determines history to some extent, but this is only one factor and you cannot make any
predictions on the basis of such a loose theory.
So historical materialism, from the modern point of view is either false, (incorrect) or trivial (not important) theory.
Marx’s economic theory.
Marx’s main investigation in economic theory was his analysis of labor theory of value.
We have discussed this theory while reviewing views of Adam Smith and David Ricardo. We said that A. Smith
rejected this theory and that David Ricardo was a strong supporter of this theory. We also stated that in general
classical economists rejected labor theory of value in favor of cost of production theory of value.
Labor theory of value states that the relative value of commodities is equal to the relative amount of labor needed
to produce these commodities.
Marx developed Ricardo labor theory of value, because he thought he needed theory of value (theory of prices) to
formulate his predictions, his ‘laws of motion’ of capitalism, long-run tendencies of capitalism. He was rather a
macroeconomist, not a microeconomist. He also used labor theory of value to make ethical, normative, ideological
critique of capitalism, as we will see later.
We have discussed how Ricardo was trying to solve many difficulties connected to labor theory of value. Marx
essentially followed Ricardian solutions to these difficulties. For example, such as Ricardo, Marx treated capital, as
accumulated, stored-up labor.
He therefore stated that labor time required to produce a commodity is the number of hours applied immediately
in production process plus the number of hours of work needed to reproduce the capital destroyed in the
production process. It is just like in Ricardo’s thought.
Like Ricardo he also thought that land rent does not influence prices.
He dealt better than Ricardo did with the problem of quantifying the amount of work needed to produce a unit of a
good.
Since different workers possess different skills and abilities, the time needed to produce a unit of a good is
different for various workers. How then should we determine the amount of time needed to produce a unit of any
commodity?
Marx originally claimed that the amount of labor needed to produce a unit of a commodity is the so-called socially
necessary labor time – which is defined as the time taken by a worker with the average degree of skill possessed
by labor class at the time. This is original solution to this problem.
Moreover, there is a most important difficulty to this theory – the fact you should also take into account the role of
profits in determining relative prices.
If there are different labor-capital ratios in various industries, that is if industries in the economy differ in capital
intensity (some use more capital in relation to labor than others do) than profits influence prices in different way.
If industries differ in capital intensity, labor theory of value is incorrect, because profits also influence prices.
Ricardo was very well aware of this problem, but he thought that empirically different rates of profits in different
industries accounted only for very small differences in relative values of goods. In other words, he thought that the
influence of the rate of profits is not quantitatively important.
Marx also knew the problem but in the first volume of
Capital he assumed in his model that all firms and industries
have the same capital intensively.
He relaxed this assumption in volume III, and tried to prove that labor theory of value is even then correct, but he
failed – this is the general opinion.
However, this technical problem (influence of profits on prices in labor theory of value) was examined in thousands
of papers and books after Marx and still is examined by some Marxists. However, the general opinion is that Marx
and Marxist writers did not solve this technical difficulty and that labor theory value is not a correct economic
theory of prices. Modern economists generally abandoned labor theory of value.
We will not investigate this technical problem here.
Labor theory of value serves in Marx’s system also as a tool to developing the concepts of a surplus value and
exploitation.
According to Marx value of any given commodity can be divided into 3 parts
W=C+V+S
C – expenses on constant capital (machines, buildings, tools, intermediate goods) – capital used to buy…
V – expenses on variable capital (wages), capital used to buy labor
S – surplus value
According to Marx expenses on constant capital are not productive, if you invest C on constant capital, you will get
in return exactly C in return.
Expenses on labor, V, are productive; they give in return amount of V+S (where S is a surplus value, surplus over
the costs of production.
In fact only labor is a productive factor of production.
Surplus value arises because the capitalist buys labor at its market value, that is at the subsistence level of wages.
Because the value of commodities (C+V+S) is greater then the value of cost of production (C+V) capitalist is left
with a surplus.
Surplus value belongs to the capitalist, since he employs workers.
Marx used the concept of surplus value to show that workers are exploited under capitalism. Why they are
exploited?
Because, only their labor is productive, produces surplus, profits and they do not get the full value of their work
(they get only V, while producing value V+S). So surplus value is expropriated from workers, and in this sense,
they are exploited in capitalism.
Notice, that workers do not have an opportunity to work less and not to produce surplus value.
Let’s assume that it takes only 4 hours’ labor a day to produce V (equivalent of worker’s wage). If he worked only
4 hours a day, than there would be no surplus value and no exploitation.
However, capitalist is the owner of the means of production and he demands that worker has to work let’s say 12
hours a day. Then a surplus value (over V) is created and capitalist appropriates surplus, this is some kind of
unearned income for capitalists.
A worker in capitalism does not have a choice: he can work 12 hours, create surplus value and be exploited or he
can refuse to work and die from hunger.
Therefore, exploitation is a necessary feature of capitalism, according to Marx.
Of course, this understanding of surplus value and exploitation derives from the fact that Marx assumed that only
labor is productive, mainstream economists do not make such an assumption – capital and land and other factors
are productive in modern and classical economics. Therefore, this problem does not arise in modern economics.
For Marx, this was scientific proof that there is exploitation at work in capitalism and that this is unjust. Capitalism
is exploitative and this is ethically wrong, unjust. Therefore, this was an ethical critique of capitalism. He used
therefore labor theory of value to state that capitalism is ethically unattractive, that it exploits workers. He used
this theory for ethical or ideological, not economic reasons.
Of course, modern economist shy away from making such ethical evaluations of the economy, but Marx was not
only an economist but also was engaged in ethics and philosophy. Since he was mistaken claiming that only labor
creates surplus value (is productive) than he was also mistaken claiming that workers are exploited in capitalism.
Well, they may be, may have been exploited in the past, but not for the reasons Marx stated.
So much on labor theory of value and exploitation in Marx’s thought.
Marx’s ‘laws of motion’ of capitalism - his long-run predictions about tendencies in the development of capitalist
economy.
Those laws of motion are at the same time, abovementioned, contradictions between the forces and relations of
production inherent in capitalist system, which in the long run bring about the collapse of the system.
He formulated five such “laws of motion” or long-run predictions about the fate of capitalism, by Marxist
economists they are treated with much the same relevance as the laws of supply and demand by mainstream
economists.
So let’s see what Marx’s predictions were:
9. the law of a reserve army of the unemployed
10. the law a falling rate of profit
11. the law of increasing concentration and centralization of capital
12. the law of business cycles
13. the law of increasing misery (poverty) within the proletariat, working class
Of course these are ‘laws’ only metaphorically, Marx called them like that, in fact they are rather rough predictions
from Marx’s system, following from his assumptions and theories. Often they are not based on scientific basis or
even do not follow correctly from Marx’s theory – he made several analytical errors in his analysis.
As you can see, all of them are about negative, undesirable tendencies in capitalism. It was because Marx was
critical of capitalism and examined capitalism with a view to find bad tendencies or contradictions in the system.
As historical materialism claimed – in mature capitalism, like in every other social phase (beside communism of
course) economic contradictions, resulting from class struggle, will develop.
Those economic contradictions are described by five Marx’s laws of motion of capitalism.
In addition, of course, according to Marx, as these bad tendencies, contradictions become manifest over time,
Marx thought that capitalism as a phase of history will pass away, give way to socialism and communism.
So let’s examine those propositions, ‘laws of motion’ of capitalism in more detail.
•
reserve army of the unemployed.
According to Marx there is always an excess supply of labor in the market, which has the effect of keeping wages
low in competitive markets and keeping surplus value positive. This ‘army’ is being recruited from several sources.
For example:
3. Workers displaced by new machines (some kind of technological unemployment) do not find often a
job in other areas of the economy;
4. Children finishing schools, housewives who desire to enter the labor market are potential new
members of the labor force
Also during the depression the size of reserve army of the unemployed increases according to Marks. Therefore,
the Marx’s prediction is that this reserve army of unemployed will increase in number over time in capitalism.
This notion of reserve army of the unemployed was never accepted in mainstream, classical or neoclassical
economics. Because according to mainstream economics if there is an excess supply in labor market wages will fall
down until market clears and there is equilibrium at the market. So, according to mainstream economists Marx’s
concept of unemployment is not valid or correct.
Nevertheless is Marx’s prediction that the reserve army would increase in number over time, correct or not?
It is hard to estimate this since official measures of unemployment are not very helpful here.
People who dropped out of the labor force, because they had given up the hope they find the job, or people who
have part-time job, would also be included in the reserve army of unemployed.
Therefore, it is not easy to estimate whether reserve army is larger now than in the past.
In addition, Marx’s model assumed competitive markets, while there are labor unions in modern labor markets, so
it is not easy empirically to say whether there exist something like reserve army of the unemployed, which keeps
wages low in capitalism.
Therefore, this prediction, this law of motion is rather not subject to falsification by empirical evidence, and
therefore rather not scientific according to modern standards.
2. the law of falling rate of profit
This is one of the most important contradictions of capitalism according to Marx.
As you remember all classical economists predicted that the rate of profit would fall over time, so Marx’s prediction
is not so original.
Marx maintained that competition in labor markets would lead to a fall in profits in a following way.
Capitalists accumulate more and more capital and employ more labor to work with increased capital. Wages than
will increase (demand for labor increases) and therefore the rate of profit will fall.
Also competition in commodity market will result in decrease in the rate of profit because capitalists will try to
reduce the costs of production to sell output at lower prices.
This will lead capitalists to search for new, lower-costs methods of production, which usually involves employing
more capital (more efficient machinery). Increased use of capital will result in falling rate of profit.
Increased use of capital results in lower profits, according to Marx, because the added capital has reduced
productivity, according to the law of diminishing returns.
However, Marx did not see that increased use of capital does not necessarily results in lower profits. There is
opposing force to the law of diminishing returns.
New capital usually incorporates new technology, which reduces the total costs of production and thereby
increases rate of profit.
The total influence of increased use of capital is an open question – it depends on how fast is the rate of
technological development.
Therefore, Marx was not correct theoretically in this prediction.
He thought that this is very important mechanism in capitalism that will bring about the ultimate collapse of the
system – because in the end the rate of profit falls to zero and the very existence of capitalists as a class is not
justified.
Empirically it is very hard to measure changes in the rate of profit over time – but on the basis of some empirical
research we can state that the rate of profit is rather constant over time.
However, of course Marxist economists argue that the rate of profit in US, for example, is constantly falling.
The issue is hard to settle empirically in definitive way.
3. the law of increasing concentration and centralization of capital
According to this prediction, capitalists accumulate more and more capital, thereby increasing the absolute amount
of capital under their control. The size of firms is increasing correspondingly, and the degree of competition in the
market tends to be diminished. This is growing concentration of capital.
Competition is also reduced in capitalism over time due to a slightly different phenomenon -
centralization of
capital.
This occurs through a redistribution of already existing capital in a manner that places capital and control over
capital in fewer and fewer hands.
Concentration (that is the number of firms prospering on every market is decreasing over time in capitalism) and
centralization of capital (the number of owners of firms is decreasing over time) are little different, but closely
connected tendencies in capitalism, according to Marx.
Marx correctly thought that larger firms could produce at lower average costs than would smaller firms. This will
result in the elimination of the smaller firms and the growth of monopoly.
Competition will end by destroying itself, and the large corporations would assume monopoly power.
This prediction, law of concentration and centralization of capital, has been to some extend fulfilled. Some markets
today are quite highly concentrated – for example world market for cars.
However, Marx did not backed up this prediction by any scientific reasoning, a model, showing analytically factors
responsible for concentration and centralization of capital.
It was rather a brilliant guess about a specific tendency in capitalism that will lead to the ultimate destruction of
capitalism.
So this prediction is the most successful, it describes to some extent a tendency in modern capitalist economies.
However, at least up to today, the consequences of concentration of capital are not as disastrous as Marx thought
- this process has not been brought about the fall of market economies.
4. the law of business crises (business depressions)
Marx constantly repeated that business crises would develop in capitalism and that those crises would become
more and more lasting and severe. However, he did not formulate any clear theory of business cycle or business
depressions.
However, he suggested several reasons for economic fluctuations – he did not show precisely how those reasons
(economic factors) would cause economic depressions to happen.
First, Marx thought that economic crises can repeatedly occur in capitalism because in different industries
technological change is introduced unevenly, that is in some industries the pace of technological change is faster,
while in others it is slower. This may result in depression for the whole economy.
Second, Marx thought that depression could occur in any single industry in the economy and spread all over the
economy to cause a decrease in the general level of economic activity.
Third, the falling rate of profit will cause economic depressions in capitalism. Marx used his law, his prediction
about the falling rate of profit to argue that capitalists will periodically react to this fall in the rate of profit by
reducing investment spending, causing fluctuations in economic activity, and therefore generating economic
depressions.
So together, these three reasons, that is uneven pace of technological change, depressions in particular sectors
that are spreading throughout the economy and the falling rate of profit, according to Marx, make capitalism an
inherently unstable economic system, that will ultimately be destroyed by itself.
Marx vision of cyclical business depressions in capitalism was largely ignored in mainstream economic theory until
the 1930s, when the coming of the Great Depression has turned the attention of economists to the problem of
business cycles and since then mainstream economists produced many different theories of business cycles.
However, is Marx’s prediction – that capitalism is subject to more and more disastrous economic depressions – a
correct one?
Empirical research is not conclusive. It is a fact that after the 2
nd
world war, economic fluctuations in US, for
example, are rather less frequent and less severe (production and income drops to a lesser degree) than before
the 2
nd
world war.
However, this seems not to be the result of the free working of capitalist economy, but rather the effect of
organized state action, designed to stabilize the economy – the so-called stabilization policy, introduced in US and
other capitalist countries since 1940s.
Therefore, against Marx’s prediction we could say that capitalist societies produced forces that prevent some
negative tendencies in capitalism.
Still, it is to some degree an important contribution of Marx that he focused on the not very well appreciated and
noticed problem of the business cycles.
5. the law of increasing misery (poverty) of the working class, proletariat
There are at least three different interpretations of this prediction, Marx was not a careful, unambiguous writer
1. increasing absolute misery – real income of the mass of society decreases over time in capitalism
2. increasing relative misery – proletariat’s share of national income declines over time
3. quality of life of proletariat declines over time in capitalism (this includes economic – income, and non-economic
aspects of life, happiness, cultural educational development, working conditions and the like).
According to this interpretation it is possible that real absolute income and relative real income of the working class
would be increasing, but in overall their well-being, their quality of life would be still decreasing because of the
conditions of work getting harder and harder, because of the hardening pains connected to the specialized work
they do, because of the narrowing opportunities for education, for increasing conscience that they are exploited in
capitalism, that they are deprived of the opportunity of cultural and mental development and the like.
What can we say about this prediction from the modern point of view?
1
st
and 2
nd
interpretations are falsified by data – absolute and relative income of working class has increased over
time in capitalism even in 19
th
century.
3
rd
cannot be tested empirically because there is no widely accepted measure of quality of life. There are many
different measures, and accordingly different outcomes about the trends in the quality of life of the working class.
In overall against this Marx’s prediction, we can state that it is not the workers in capitalist societies in 20
th
century, which are the most underprivileged, the least fortunate members of society. The standard of living of the
working class has dramatically improved; they have often long-term job contracts, the salaries are continuously
raising and the like.
On the other hand, there are many groups in capitalism, which live in worse economic conditions.
Homeless, disadvantaged, single mothers with children – all are (as groups) probably poorer than workers, so in
modern capitalism – workers are not the least privileged members of the society – against Marx’s prediction.
Therefore, this prediction is not confirmed by the data – it failed.
So much on the Marx’s laws of motion of capitalism, as we could see most of them is either not possible to falsify
by evidence (and therefore not scientific according to modern standards) or simply was not confirmed by data. In
overall capitalism did not perform as bad as Marx thought it would.
A summary of Marx’s thought.
Marx was not only an economist; he combined philosophical, sociological and economic analysis in a unique way,
which makes it difficult to consider his economic contribution separately.
In general, Marx wanted to predict the general tendencies in development of capitalism; he wanted to show that
capitalism has to fail, because of the inherent contradictions of this economic system.
To this end, he applied his theory of history – historical materialism, which describes contradictions between the
dynamic forces of production and the static relations of production that would lead to the collapse of capitalism
and the emergence of a new economic orders, first socialism, and ultimately communism.
Those contradictions, he described in his five laws of motion of capitalism. Those laws, predictions, are not very
well founded theoretically and as we concluded, however, the evidence did generally not confirm these laws.
He borrowed many aspects of his economic theory form classical economists especially from D. Ricardo, especially
his labor theory of value. He made some advancement in this theory, but generally, he failed to prove that this
theory could explain prices in market economy.
He was a harsh critic of capitalism, and tried to show that the working class is under exploitation in capitalism – he
developed the concept of surplus value, to realize this aim.
So is there anything important left from Marx’s analysis for modern economics?
Many thinks that the answer is: no, Marx was very wrong, was a bad scientist and rather a philosopher than
economist.
However, others argue that what remains of Marx’s thought is the grand vision of capitalism as dynamic and
changing economic order.
Order, which is plagued with difficulties in maintaining the full employment of labor, which is sometimes prone to
long-lasting economic depressions and the decreasing competitiveness of markets.
These are all important problems for capitalism, and even if they are not so unsolvable as Marx thought, still
modern economics have not solved them adequately and it remains Marx’s merit that he focused on those
important problems.
In addition, he turned the attention of many economists to the problems of philosophical and ideological
underpinnings of capitalism, socialism and communism. These are important questions in normative economics or
in the philosophy of economics – is capitalism a just economic system, are workers exploited in capitalism or does
socialism or communism fares better than capitalism with respect to freedom, equality and justice.
Marx at least inspired later writers to notice that these important questions arise and that you have to deal with
them.
One final thing about Marx.
Marxism in general has not influenced much the mainstream economic theory, which followed rather classical
economics in praising capitalism as just and efficient economic system.
However, as you all know Marx theory inspired the introduction of socialism in many countries in 20
th
century.
Marxism has become a ruling ideology and economic doctrine in those countries.
Although many advocates of Marxism claim that in those socialist countries a rather distorted, vulgar versions of
Marx’s thought were applied, it is nevertheless, to some extent, Marx himself, who is responsible for many of the
bad or even disastrous consequences of the fact that some countries tried to adopt Marx’s thought in practice.
So many thinkers, probably rightly, put the blame on Marx, for poverty of the masses in socialist countries in the
second half of 20
th
century, for underdevelopment of these countries, for many faces of injustice in real socialism,
for lack of freedom and what is most important, millions of victims of 20
th
century attempts to put Marx’s vision
into work.
We have to acknowledge these facts also while evaluating Marx’s thought.
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