History of Thought: Final Summary Lecture

• I. Three issues that the authors are interested in:
  • A. Price Theory: How do you explain relative prices, their changes over time, who gets what, tax effects, ....
  • B. Welfare economics: How do we evaluate changes?
  • C. Public Policy Issues: Combine your answers to A and B to determine what ought to happen.
    
• II. Price Theory:
  • A. Smith: Prices tend towards the sum of factor costs--wages, interest, rent. Supply driven price theory.
    • 1. Utility, hence demand, comes in only as a necessary condition for production, and in the special case of fixed supply (vinyards producing special wines).
    • 2. Wages are determined in the long run by subsistence, although the reason is not entirely clear, and are above that when demand for labor is rising
      • a. Wages vary across employments according to the principle of equal net advantage
      • b. Which allows for the fact that wages are not entirely the reward for labor, but also for human capital and scarce abilities, although
      • c. Smith does not integrate this into the theory, as Marshall later does, and distinguish between wages and the actual payment to labor (which does not include the parts of wages that are going for other factors, such as human capital).

      3. The interest rate is determined by the supply of capital. No discussion of supply curve for capital--savngs as a function of the interest rate.

    • 4. Rent is a "monopoly price," no real theory of it.
    • 5. All of this assumes constant cost of production, hence no distinction between marginal and average cost.
    • 5. And goods that cannot be reproduced are special cased--no analogy to rent.

    B. Ricardo: Price tends towards the sum of factor costs, but ...

    • 1. Rent is not included. When land is used in production, it is factor costs on marginal land, which pays no rent, that determine price.
      • a. Note that this means Ricardo is dropping the constant returns assumption for agriculture
      • b. While keeping it for everything else
      • c. And is thus providing the tools necessary to drop it in general.
      • d. Which he starts to do in his footnote on quasi-rents.

      2. Interest is determined by wages, which are driven by the price of corn.

      • a. The beginning of a supply curve for capital, since very low interest rates stop accumulation.
      • b. But most of the time, he seems to think of savings as depending on the income of people who save, not the return on capital. He is thus looking at what we would call the income elasticity, rather than the price (i.e. interest rate) elasticity, of savings.

      3. His definition of value gives him a tool for looking at relative prices and for implicitly finding the general equilibrium.

    • 4. His model gives him a picture of what happens over time, driven by rising population and fixed land.
    • 5. And Ricardian rent theory lets him do the distributional calculation correctly.
    • 6. Still a supply driven theory of price--save that the tastes of the workers end up determining the longrun supply curve for labor, and thus wages!

    C. Marshall: Most of a modern theory.

    • 1. Prices tend towards the sum of input costs, using marginal not average costs.
    • 2. There is a continuum from floating capital to land, depending on the durability of the investment and the time interval being considered.
      • a. For an infinitely durable sunk cost investment, with no further investment possible (meteoric stones, first case), we have the pure land calculation.
      • b. And the same calculation applies for other things, over a time period short enough so that quantity is fixed.
      • c. For a good that is being continually produced and consumed, on the other hand, the price is always equal to the cost of production.
      • d. And the same calculation applies for other things, over a time period long enough so that quantity can adjust to demand.
      • e. So Smith and Ricardo's natural price is about the right answer for the long term --but Ricardo's theory of rent can be generalized to replace the earlier observation that prices in the short term could deviate from the natural price by a much more precise analysis.

      3. The answer to the "supply or demand (usefulness or cost of production) determines price question" is: "Both, simultaneously."

      • a. The price is that price at which quantity demanded equals quantity supplied
      • b. And at that quantity, marginal value equals marginal cost of production equals price.
      • c. Ricardo's answer for most goods (Smith's for almost all) is correct--if the supply curve for the good is horizontal.
      • d. Ricardo's answer for land is corrrect--if the supply curve is vertical.
      • e. Which blade of the scissors cuts the paper?

      4. Marshall does not have the sort of fully worked out axiomatic theory of economics that you have encountered, or will in a graduate price theory course, but he has a lot of the ideas that go into it. And he has a richer and more realistic picture of the economy than the one used to generate such a theory--we, in that respect, are more like Ricardo than he is.

• III. Welfare Economics
  • A. Smith does not really have a thought-out theory, except ...
    • 1. His value theory gives us a measure of what people can buy with their income
    • 2. But not of how much better they are for being able to buy it.
    • 3. And he mostly uses a common-sense "if workers can buy more, the world is a better place" approach to the question.

    B. Ricardo:

    • 1. He discusses the distinction between "value" and "riches"--utility comes into the latter, but he has no clear theory of how, in practice, we evaluate it.
    • 2. And carries over Smith's common-sense view of matters.

    C. Marshall:

    • 1. Explicit utilitarianism--trying to maximize total happiness ("satisfaction").
    • 2. Consumer and producer surplus give him a fairly clear definition of the distinction that Ricardo puts in terms of "riches." How much better off are you through the opportunity to buy (or sell) at a price?
    • 3. There are still at least two major problems:
      • a. Comparing across people with different incomes--consumer surplus implicitly does it as if a dollar represented the same amount of happiness to everyone.
      • b. Consumer surplus works almost perfectly for a single good, but starts to break down if we change many things at once--as he notes briefly. The loss in surplus to me from having Macintosh computers unavailable to me, plus the loss from having Wintel computers unavailable to me (zero, as it happens) is substantially less than the loss from having neither available to me.
• IV. Policy
  • A. Smith is in favor of laissez-faire in general, and in particular in trade
    • 1. He sketches out a general argument based on equilibrium in the capital market etc., but ...
    • 2. With neither a fully worked out price theory not a worked out welfare economics, he doesn't have the tools to make anything approaching a rigorous argument
    • 3. And in fact there are internal inconsistencies in the argument he makes--his attempt ends up producing an argument for subsidizing fast and near uses of capital, which he then tries to dismiss.
    • 4. He is in favor of government intervention in a few areas
      • a. Roughly speaking, areas where we would say there are externalities--fire walls
      • b. National defense, highways and canals
      • c. And he is sensibly sceptical of how well internvention will work in practice--hence his education argument, which concludes that a government subsidy for the education of the masses would be a legitimate government activity, but it might be more prudent to leave education entirely private.
      • d. Where the externality is via the character of the population.

      5 And he has a detailed discussion of the advantages and disadvantages of various taxes, the economic part of which is undercut by the lack of a good price theory.

    B. Ricardo is in favor of laissez-faire in general, and in particular in trade

    • 1. Unlike Smith, he has a fully worked out theory of how foreign trade works, and can show that free trade makes us better off in the sense of giving us more of the goods we want.
    • 2. And a fully consistent, if unrealistic, theory to predict the effect of every imaginable tax
    • 3. But no measure of net advantage to people, and ...
    • 4. No great interest, at least in this book, in public policy issues.
    • 5. He is simply trying to get his price theory right.

    C. Marshall is a much more qualified supporter of laissez-faire

    • 1. As implied by his reservations about the maximum advantage from laissez-faire conclusion of previous economists.
    • 2. One reason is that he has a welfare economics, which tells him that transfers towards poor people are a good thing
      • a. Note that he has abandoned the natural wage theory, which
      • b. Made such transfers unattractive to Smith and Ricardo
      • c. Although Smith does have a preference for taxes that are at least mildly progressive.

      3. Another is that he has consumer surplus etc., which ...

      • a. On the one hand, make it possible to rigorously prove what Smith could only sketch out--the efficiency of competitive equilibrium (subject to the problem of measuring utility by dollar value rather than by happiness)
      • b. But also make it possible to evaluate deviations from that, and see how they could in principle be exploited--his declining cost curve argument

      4. On the other hand, Marshall anticipates at least some of the modern public choice critique of interventionism.

      • a. The wrong industries will have the political muscle to get tariffs, and ...
      • b. Resources will be diverted into trying to control government (rent seeking)

  V. Methodology: The authors provide an interesting ranges of approaches to doing economics.

  • A. Smith: Gather as many facts as possible, try to make sense of them, don't worry too much if the theory is rough at the edges.
  • B. Ricardo: Make whatever simplifying assumptions are necessary to get a fully self-consistent theory. Glance at facts at rare intervals.
    • 1. Do wages follow the natural wage?
      • a. Actually, wages measured in corn have been rising for the past two hundred years or so, judging by Smith's figures
      • b. But that could merely mean that they were being pulled farther and farther above the natural wage by the increased demand for labor, or ...
      • c. That workers' tastes were getting more luxurious.

      2. Is productivity on marginal land falling?

      • a. Almost certainly not, but then ...
      • b. Ricardo has conceded that technological improvement in agriculture could temporarily lower the cost of producing corn on marginal land
      • c. And he has no theoretical grounds for saying just how long "temporary" can be--(currently three centuries and counting ...)

      3. Or in other words, all contrary evidence can be explained away.

    C. Marshall: Methodologically self-conscious, because the 19th century contained lots of critics of economics.

    • 1. How rational are people assumed to be?
    • 2. What sorts of incentives count? The ones we can include in a scientific theory--i.e. observe and treat in some regular fashion.

  VI. What you should have learned:

  • A. Primarily--to understand the ideas of three smart and original thinkers who among them created a large part of economics as we know it.
  • B. Some perception of different ways of looking at the elephant
  • C. Quite a lot of economics:
    • 1. Even Smith is quite often right in his analysis--joint costs--or if not necessarily right, ingenious and plausible--end of feudalism, the reason why one city required taxpayers to report their wealth, and another did not.
    • 2. Ricardo correctly understands and explains the logic of rent and foreign trade, and provides a self-consistent, if somewhat bizarre, first version of price theory.
    • 3. Marshall has a discussion of welfare economics that I prefer to modern versions, correct analysis of supply/demand/sunk costs, thoughtful justification of the methodology, and lots more good stuff that we skipped.
    • 4. Reading the whole book would be a useful supplement to your education as an economist.