Having Fun with History of Economic Ideas [1 ed.]

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Having Fun with History of Economic Ideas

經濟思想史的趣味 （簡明版）

Http://historyofeconomics.wordpress.com/ Cheng-chung Lai 賴建誠 Emeritus Professor of Economics National Tsing Hua University, 300044 Taiwan [email protected]

Tai-kuang Ho 何泰寬 Professor of Economics National Taiwan University, 10617 Taiwan [email protected]

This version: October 2020

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To readers

This is an entry level text (popular science) in history of economic thought for readers aged 15-99. It is the authors’ responsibility if you do not follow each chapter smoothly. As such, some basic economics knowledge would be helpful, but not required. We have three aims in mind for this book:

to be interesting, entertaining, and thought-provoking. In some

cases, we are opinionated, but intentionally so in order to alert readers to form their own views. History of ideas does not make us smarter nor richer, but it can reduce our ignorance and the “banality of evil” - a term Hannah Arendt referred to people who lack self-reflection, “He did his duty...; he not only obeyed orders, he also obeyed the law.” What is our basic mentality behind writing this book? We invite Isaac Newton to speak on our behalf:

“I do not know what I may appear to the world, but to myself I seem to have

been only like a boy playing on the seashore, and diverting myself in now and then finding a smoother pebble or a prettier shell than ordinary, whilst the great ocean of truth lay all undiscovered before me.” Yes, the great (expanding) ocean of truth in history of economic ideas lays undiscovered before all of us:

the sea gets deeper as you go further into it,

according to a Venetian proverb. This book is free of charge, it is meant to share knowledge with wider audience. Bon appétit!

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About the authors

Cheng-chung Lai ([email protected]) is Emeritus Professor at National Tsing Hua University (Taiwan), with three decades of experience in teaching economic history and history of economics thought. His books in English include:

Adam Smith across Nations:

Translations and Receptions of The Wealth of Nations, Oxford University Press (2000); Braudel’s Historiography Reconsidered (2004). He was educated in Taiwan (BA) and Belgium (MA), received his doctorate from École des Hautes Etudes en Sciences Sociales, Paris. Tai-kuang Ho ([email protected]) is Professor of Economics at National Taiwan University, educated in Taiwan (BS and MA) and at the University of Bonn, Germany (Ph.D.). Specializing in International Money/Finance as well as its historical aspect, he has been published widely in many learned journals, including Oxford Economic Papers, Economica, and Explorations in Economic History.

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Acknowledgements

T.K. Ho was a student in my early career, and years later we became colleagues and frequent co-authors. He has been familiar with both economic history and history of economic thought ever since his undergraduate years. He is now an expert in International Money/Finance and their historical issues and is published widely in learned journals. I am particularly glad to have his insightful inputs in this book. This book is adapted from a Chinese edition (2016) that has 40 chapters in three parts, all of which are also in accessible Q&A style. Market reaction has been quite encouraging. Among the 25 chapters in Parts I and II, the first four chapters are condensed into two for sake of simplicity. So, the final result of this English version is 22 chapters plus an Epilogue and two Appendices. All are condensed and updated. Part III “Concepts and debates” (chapters 26-40) are on various selected topics, such as chapter 26 “Quantity theory of money is theoretically unfounded”, and chapter 27 “How Isaac Newton’s concepts influenced Adam Smith.” These 15 issues are a bit lengthy and less systematic for non-experts, and thus we opt to omit them. The original edition was published in Taiwan by Asian Culture (允晨文化, 2011) along with a China version by Zhejiang University Press (浙江大學出版社, 2011). The above publishers hold copyrights for the Chinese versions to be circulated in Taiwan and China only. The rights for other languages remain open.

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To readers

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About the authors

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Acknowledgements

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I Fun and useful 1

Welcome!

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2

Dead men’s wrong ideas?

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II Pioneers and contenders 3

Wealth and power:

mercantilism

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4

The physiocrats and law of nature

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III Classical school 5

Adam Smith and the invisible hand of the market mechanism

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Thomas Malthus and effectual demand

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David Ricardo and differential rent

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John Stuart Mill and the peak time of the classic school

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66 77

IV Socialism and the old historical school 9

Antagonists to the classic school and the rise of socialism

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Karl Marx and the collapse of capitalism

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The German historical school and protectionism

92 99

86

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V Marginal analysis and the neo-classical school 12

The marginal school in France

110

13

The marginal school in Germany, Austria, and the U.K.

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Application and extension of the marginal school

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Alfred Marshall and the foundation of the neo-classical school

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The Lausanne school:

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Theories of imperfect competition

128

Léon Walras and Vilfredo Pareto 154

VI Contemporary trends 18

Bourgeoning of mathematical economics

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The institutional school

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Keynes and Keynesian economics

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Early Austrian school

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The rise of the Chicago school

Epilogue:

162

170 179

189 198

Economic ideas in retrospect

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Appendices A

Further readings

210

B

Nobel Prize in economics, 1969-2020

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120

145

136

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Part I Fun and useful

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1 Welcome!

A new theory is guilty until proven innocent, and the pre-existing theory innocent until proven guilty ... Continental drift was guilty until proven innocent. ―David Malcolm Raup

Picture yourself in a classroom on history of economic thought under a teacher with some 30 students. This is a new semester day, and the teacher explains what this course is about and how to grade performance. Teacher:

Hello everyone! This is a class on history of economic ideas. Please be sure

that you are in the right classroom. The basic tone today is a kind of warmup chatting. No serious issues will be raised, and so please sit back and enjoy. We have been teaching this since the mid-1980s, when at that time this course was mandated, as a way of protecting a so-called endangered species. By the early 1990s, the protection was removed under the wave of education liberalization. It’s a great relief to see so many people today, but our long-term experience is that the number of students next time will be less and less, although not in a logarithmic way. We have long gotten used to this embarrassing situation. Q:

How is this class scheduled?

A:

Let’s begin with the rules. This is a 3-hour course every week, divided into two

parts, Tuesday and Friday, 10:10-11:30; you won’t need to get up early and you won’t be late

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for lunch. This arrangement has two rationales. If we do a 3-hour session on the same day, then the marginal effect of learning will decline rapidly. If we do it once per week, then some national holidays will interrupt the schedule; also, if you can’t come for any reason, then a week is lost. Twice-a-week is thus meant to minimize time cost. Q:

How do the exams proceed, and what are the criteria of grading?

A:

It is open-book (I can hear the sighs of relief), and so you need not memorize

anything. We hope that you are a learning machine with an ability to explain or to retell a good story. Our aim is to help you to grasp the spirit and inner logic of this field. Years later, when your boss, friends, or even father-in-law ask you the main message of The Wealth of Nations, we hope you can offer a brief and insightful answer to impress them. If you can grasp the basic differences among various economic schools, then this course can help you to develop useful skills to master other remote knowledge, which is quite important for lifelong benefits. In other words, our job is to show how to transform old materials into living knowledge. Q:

Would you suggest some background readings?

A:

Over the past decades we have used virtually every textbook available in the

market. Which ones do we like the most? For post-graduate students, Mark Blaug’s Economic Theory in Retrospect (5th edition, 1997) is a good one. For an undergraduate class, we like three and use them alternatively. 1) Stanley Brue and Randy Grant (2012):

The

Evolution of Economic Thought, 8th edition. 2) Robert Ekelund and Robert Hébert (2013): A History of Economic Theory and Method, 6th edition. 3) Harry Landreth and David Colander (2002):

History of Economic Thought, 4th edition. These four books are the main

sources of the text you are reading. Q:

Some have said that history of economic ideas is about the wrong ideas of dead

men. Why is this course useful? A:

Appendix B lists the Nobel Prize winners in economics since 1969. Take the 1995

winner Robert Lucas (1937-) as an example; his main contribution is rational expectations theory in macroeconomics. As an undergraduate student, he majored in history at Chicago,

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entered the Ph.D. program in economics at Berkeley, but decided to return to Chicago to complete it. If you read his Nobel Lecture, you will find that in this 20-page text, immediately from the second paragraph, he discussed the writings of David Hume Of Money and Of Interest (1752) to re-examine the idea of “money is a veil” (the neutrality of money) as prevalent in the classical school. Lucas then went into Wicksell’s Money, Interest and Prices (1895), Hayek’s Monetary Theory and the Trade Cycle (1933), as well as Keynes’s The General Theory of Employment, Interest, and Money (1936). As Newton said in 1675:

“If I have seen further it is by standing on the shoulders of

Giants.” If you could win a Nobel, would you show PowerPoint at the Nobel Lecture to explain some equations? No, it would be better to explain your significance in science and to compare it with past masters. Q: Lucas mentioned the historical factor, because his majored in history. This could be a rare exception. A:

Paul Samuelson (1915-2009) of MIT was the first American economist to win this

prize (1970). If you take a look at The Collected Scientific Papers of Paul A. Samuelson (7 volumes, with 596 published scientific papers, reprinted during 1966-2011), you can see he wrote nearly 100 on the history of economic theory, ranging from “Lord Keynes and the General Theory”, Econometrica, 1946, 14(3):187-200 to “Classical and Neoclassical harmonies and dissonances”, European Journal of the History of Economic Thought, 2007, 14(2):243-71. Some of these papers are very technical and an in-depth analysis on the economics of Marx, Piero Sraffa, and von Thünen. What truly is admirable is that when any topic runs into his hands, he always manages to add something new. His historical knowledge, writing skill, and logic power are all superior to his mathematical skill, which most economists have envied. When we read the scientific works of Einstein, one can easily sense the influence of his predecessors such as Newton, Mach, Maxwell, and Planck, with a profound

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understanding of their contributions and limitations. Most people look down upon history of economic ideas, mainly because there are no mathematics and they are not scientific enough. Economists such as Hayek (1974 Nobel), Buchanan (1986), Coase (1991), and North (1993, for economic history) used very little or no equations at all. We are confident that the Swedish Academy is capable of identifying true scientific contributions; equations are of course scientific, but not enough to blind them. Q:

So you really think history is useful?

A:

We cannot prove it and it is hard to convince you. Let’s offer an example. The

Neanderthal man is a close relative of Homo sapiens sapiens (that is, us), who once dominated Europe and West Asia for 200,000 years and disappeared some 28,000 years ago. It is now widely known that human beings also have some Neanderthal DNA. It is rumored that Homo sapiens made the Neanderthal extinct. Physically speaking, the Neanderthal is taller and stronger than Homo sapiens and also has a larger brain size. Why were they eliminated in the process of natural selection? Several sorts of arguments exist, and below are three simple rationales. 1) The Neanderthal preferred large-size mammals for substance, such as mammoths, and their sources of food were narrower. On the other hand, Homo sapiens are omnivores, eat mostly animals and vegetables, as well as many other stuffs. When environmental temperatures change (such as warming or cooling), food sources also change, and thus the survival probability of Homo sapiens is higher. With a larger size, the Neanderthal needed to consume 100-350 calories more than Homo sapiens, which means that we human beings are more “fuel efficient.” 2) Most Neanderthal males and females worked/hunted together (i.e. no division of labor), while Homo sapiens have another strategy: most males work outside (hunting) and females work at home (nursing). As Adam Smith made clear, a clear division of labor increases productivity and that the “division of labor was limited by the extent of market.” This means one simple thing:

if males/females do not practice division of labor, then their

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“market size” (food sources) would be smaller. The consequence is obvious:

our population

is now over seven billion people here on Earth. 3) Equally important, some 30,000 years ago, the average life span of Homo sapiens became long enough to cover three generations (the rise of grandparents). Why is this important? Because living knowledge can be transmitted directly to the third generation, such as where you can find water in dry seasons. As life spans got longer, we learned to establish wider and complex networks, acquiring more useful knowledge. On the other hand, the lifespan of the Neanderthal was shorter, and so some hard-earned knowledge became easily disconnected among generations. Q:

Are you trying to say that historical heritage helped us to be unique?

A:

If the success of a species is defined by its number of population and the duration

of existence, then our achievement seems superior. In terms of getting most resources within the shortest time, Homo sapiens is very successful. We believe that “history” must have played an important role in the survival of human beings. Almost everybody cares about our own past, but cats, dogs, elephants, lions, etc. do not. If the past is unimportant, are you willing to burn all the photos, diaries, and family souvenirs? Conversely, if past records are possibly destroyed, are you willing to pay half a year to preserve them? The price you want to pay is the value of history in your mind. Why do all human societies worship ancestors? Cats and dogs become unrelated to their own family as soon as they can survive alone. The function of history in human evolution is probably more important than we realize. If we cannot remember our own past, we would panic, wouldn’t you? Q:

But why most people do not care about history and consider it useless?

A:

We learn useful knowledge from the past. History is particularly useful when we

face something unprepared. It also reminds us of some keys points that we might have ignored. Stated otherwise:

if history is so useless, then why does every college around the

world teach its own and world histories?

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Looking down upon history is simply another form of ignorance. We now realize that history is not repeating itself, but instead it is people who are repeating history. In a famous quote Marx said, “Hegel remarks somewhere that all great world-historic facts and personages appear, so to speak, twice. He forgot to add: the first time as tragedy, the second time as farce.” Yes, we are repeating tragic farce. Expanding our visions and horizons from historical databases in order to extract useful experience is both convenient and cheap. If someone is so smart, should they not try to care a little about history? Others have said, “the only thing we learned from history is that we learned nothing from history.” Think about this again after reading this book. Q: Why do most parents not encourage their children to read history at college? A:

Taking Chinese society as example, it has experienced a long-term economic

decline since the Song Dynasty, spanning over one thousand years. Its population density was too high to escape from the Malthusian trap. The experience of maintaining survival is that short-term benefits in daily life are the most important. Even though GNP has been growing very fast recently, this deep-rooted value remains. Most people still consider that art, philosophy, literature, and history are useless, but by this judgment, one can see which level you are at. Social value, by contrast, is quite different in France. The social status of philosophers, historians, and artists is unusually high. For instance, the father of the well-known philosopher Michel Foucault (1926-84) was a surgeon and hoped young Michel would follow in his steps. When Michel was in high school, he was very interested in philosophy, and his mother hired a private tutor that helped him to enter the prestigious École normale supérieure (Paris), and the rest is history. Q:

I heard that those economists who majored in history of economic ideas are mainly

because they are not good in mathematics. A:

You have good reasons to say so. Actually, the mathematics used in economics is

not so difficult for physicists. For mathematicians, the mathematics used in economics is rather amateurish. If mathematics is really so important, then why do physicists and

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mathematicians not join “easy economics” to win the Nobel? People from developing economies are more fascinated by advanced technology, deeming that complicated equations means a higher level of science, whereas historical issues are worth nothing. Mathematics and statistics are tools for analysis - they are means, but not the ends. If you want to do something good, you have to sharpen your tools first. When you have your knife sharpened, another bigger problem is you cannot find a good target to show your talent. On the other hand, if your have good (historical) senses, you are able to envision key issues and deal big targets with bare hands. Which one is more brilliant? The ability to see the significant problems is more valuable:

as long as the issue is attractive, you always can

find technical supports. Q:

Several Nobel winners have also made considerable achievements in history of

thought, such as Samuelson and George Stigler (1911-91). Has a scholar in this field ever impressed you personally? A:

Quite a few and increasingly so. Mark Blaug (1927-2011) is a widely known

example. People are always impressed by the breadth of his knowledge, as well as his sharpness. In early 1950s, Blaug wrote a Ph.D. dissertation at Columbia University on the methodology of David Ricardo (1772-1823), and Stigler was his advisor. Blaug said that even when he was 50 years old and already an established scholar, he still would feel scared every time he saw Stigler. Q:

Why do we need to know history of economic ideas? No one takes note of it when I

apply for a graduate program, and general workers do not care either. The latest economic theories are so abundant to absorb, how can I have time and energy to read such old stuff? A:

Correct. That is why this course is often “not available” in an economics

department. We sometimes have to attract students with looser grades, so to speak, which insults in price and dignity. Some colleagues have told students that this course can neither be expressed in mathematics nor verified by statistical tools. Its scientific value is limited, if any; it is basically “Garbage In, Garbage Out.” This experience might be similar for many colleagues around the world.

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We do want to say something good about this field. Take Adam Smith as an example. His complete works and biographies have been printed by Oxford University Press over and over again for decades. One of Smith’s most famous arguments in economic theory concerns “the invisible hand.” Its basic meaning is that individuals need not consider the interests of others when pursuing their own interests. Without external intervention, there is an invisible hand (market price mechanism) that will reconcile the interests of everyone and make the whole society better off. As the archetype of classical liberal economics, this notion has prevailed for more than two centuries:

as long as it is laissez-faire, it will lead to the best collective interests of the

whole society. William Grampp wrote an article, “What Did Smith Mean by the Invisible Hand?”, in the June 2000 issue of Journal of Political Economy. His arguments are quite rigorous and not suitable for an quick summary here, but he identified nine different meanings in Smith’s writing, which are things never heard of before. This paper used no mathematics and no statistics. It is an old-fashioned account of a historical idea, but published in a top journal as a lead article. Mathematic models and statistical tests are neither necessary nor sufficient to warrant good economics. Q:

Some exceptional figures (such as Ronald Coase, 1991 Nobel) have written good

works (without equations) that change our widely held views. However, they are outliers, exceptions, rather than rules. When I read Wealth of Nations, why is it not more passionate to me? How can I read it with fun and insights? A:

The time and background of classic works are very different from our current era,

and the authors had particular perspectives and arguments in mind. We need contemporary experts to reinterpret them in modern languages. It is not so easy for untrained readers to digest the original text with insights. That is why our profession exists. From a purely intellectual point of view, we would like to now suggest to you to take a look at Marx’s Capital (the original title in German is Das Kapital) and Keynes’ General Theory. Marx is often viewed as anti-social, advocating class struggle and dictatorship of the proletariat. Perhaps you are not aware that Marx once wrote to Lafargue, “Ce qu’il y a de

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certain c’est que moi, je ne suis pas Marxiste” (All I know is that I am not a Marxist, Letter to Bernstein, 1882). You may want to reconsider if your impression about Marx is fair. If you think Capital is “revolutionary”, then you will be disappointed, because it is very academic (hard to read) and covers three very thick volumes - it presents a long and deep reexamination of European economic history and intellectual development. The copious footnotes in Capital are also done in academic style. The popular image of Marx was conveyed through the distorted visions of his book’s readers from around the world spanning 150 years. What we should do now is remove Marx’s unreal masks and read Capital in its own right. Marx is an example of someone being negatively twisted, while Keynes is a case of positive distortion (being beautified). You are probably familiar with Keynesian theory, and a major part of the economics community has been deeply under its influence. You have certainly heard “new Keynesian”, “post-Keynesian”, etc. Read General Theory, the 1936 original version, and you will be amazed to find that the knowledge taught at the college level is very different from Keynes’s own work. Why? There is a difference between the “economics of Keynes” and “Keynesian economics”. Many scholars have projected their own ideas into the framework of Keynes and claim themselves as Keynesian. A disciple of Keynes from Cambridge University, the famous Joan Robinson (1903-83), once said that the Keynesian school in the U.S. is a “bastard” and not the pedigree. Gossip is not our purpose here, but we do intend to remind everyone of one thing: when you hear someone claim that he belongs to an “economic school” and is promoting certain ideas, please take a neutral stance and return to the original works of that school, in order to make a better judgment if what you heard is indeed credible. Q:

OK. We are totally unfamiliar with this field; so, could you recommend one or two

introductory texts? A:

The Worldly Philosopher by Robert Heilbroner (1st edition 1953, 7th edition 1999).

A more recent one is Todd Buchholz’s New Ideas from Dead Economists: An Introduction to

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Modern Economic Thought (updated 2007); and Mark Skousen’s The Making of Modern Economics: The Lives and Ideas of The Great Thinkers (2009, 2nd Edition). See Appendix A for further readings. Our concern here is not the biography of past masters. Their lives are briefly mentioned only to show how their social experiences are related to economic thinking. Q:

Is the Internet rich in related resources?

A:

Quite so, see Appendix A. Time is almost up, one final point. Western economics

has accumulated a rich and abundant amount of wisdom for nearly three centuries. We hope you agree with the famous view by Keynes, “The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. ... Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” Are you also a slave of a certain economics school, but naively unaware of this danger?

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2 Dead men’s wrong ideas?

For every complex problem there is an answer that is clear, simple, and wrong. ―H.L. Mencken You never in economics kill a theory by a fact; you kill a theory by a better theory. ―Joseph Schumpeter requoted from Roger Backhouse (2017): Founder of Modern Economics Paul Samuelson, Volume 1, p. 310.

Someone once asked:

Why study the wrong ideas of dead men? In other words, why

bother to reassess these remote insights? Let us begin with the nature of science. There are two simple indicators to measure scientific progress: How quickly can researchers in this field overturn past misconceptions? (and) How far can the knowledge frontier be pushed outwards? Below is one example. Einstein initially asserted that the universe should be static, but in the course of this conjecture (1917), he doubted that the universe could be either expanding or shrinking. To support his “stable theory”, he added a “cosmological constant.” By the early 1930s, Edwin Hubble (1889-1953) proved that the distance among stars is expanding, i.e. confirming the “red shift” (“blue shift” if shrinking). Einstein was convinced and admitted that the idea of cosmological constant was his biggest mistake. Science has certainly progressed.

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Q:

Once something is proved wrong, why waste time to explore it backward? Science

should march forward, right? A:

Of course, but why was Einstein willing to read Newton's works? Simple:

the

more you are at the frontier, the more you care about the past. You want to know how past masters were “groping” unknown territory, which is a similar feeling like when you are at the top of Mount Everest and look back to how previous heroes have struggled. Another natural way is to revisit the Pantheon (read the work of past masters) to see how they made breakthroughs, and how they were rejected by future generations. Like all heroes, great scientists also care about their own historical significance. Q:

Noted, but social sciences are different from exact sciences. A natural

phenomenon is the same anywhere; while in social sciences there is no unique answer. In this sense, is economics a science? A:

On the one hand you are right in that social sciences are different from natural

sciences, so if economics is a science, it is not the same sense as exact sciences. Basic economic problems have not changed for thousands of years:

the law of supply-demand is

always operating; the issues of land, labor, capital, currency, interest rates, and prices are always the same. Yet, the environment of the socio-economy is never the same. We are playing an endless game, like pouring new wine into old bottles. The objective of medical science is also similarly unchanged (to heal diseases). Its progress has been spectacular, as we are now treating diseases at molecular level. No matter how advanced medicine can become, people will still eventually die:

who really wants to

live to be 500 years old? This is also an endless game. If Mozart were alive today, he would be astonished to see that his oeuvres are much better performed than his epoch, because musical instruments have greatly improved (such as modern piano vs. clavier in Mozart’s time). We are still willing to listen to classical music, because it still conveys meaningful messages. If you agree with this logic, why not take a look at Wealth of Nations or Das Kapital?

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Q:

I see what you mean. The problems are old, but the world and the answers are new.

Reading past masters takes many long years, and it is hard to distill a minor message. How can we enter this field effectively? A:

That is why you need a tour guide to show you where are the good places and what

makes them so great. When properly explained and interpreted, nothing is boring and useless. Studying past masters is not meant to satisfy any philological curiosity, but to use new tools to reassess old concepts, in order to derive (interpret) new meanings, just like playing classical music with modern instruments. Each generation has its own problems to solve. If the experts cannot answer, why not ask the opinions of past masters? When the world economy became greatly depressed in 1929, most economists at that time were obsessed by Say’s law (supply itself creates demand). That kind of economic thinking was unable to solve many new confusing and emergent problems. Based on his unusual instinct and classical knowledge, Keynes quickly took an idea from Thomas Malthus (1766-1834). Malthus asserted that supply does not generate its own demand and that oversupply (market glut) led to a recession in the mid-18th century. So his prescription was to create effective demand, i.e. active consumption. No one listened to Malthus, but Keynes did so in the early 1930s, advocating that the government should use deficit spending to create jobs and demand by way of public construction. President Roosevelt rendered this idea into a famous policy (the New Deal), which effectively help solve the ongoing economic crises. The central message we would like to convey is this:

the more important you are, the

more important historical knowledge is, and vice versa. Q:

You mean Wealth of Nations and Das Kapital may also be useful in the future?

A:

Probably so. When writing his Ph.D. thesis at Chicago, James Buchanan (1919-

2013, Nobel 1986) was inspired by the works of Swedish economist Knut Wicksell (18511926) he happened to have read on the library shelf.

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Q:

The ideas of dead men are not necessarily wrong, and the ideas of living people are

not always correct. It is the useful message that we are looking for, no matter from a person who is dead or alive. Still, why do most people find it dull and boring? A:

A good horse needs a good rider. Good historical materials need good interpreters.

Most good food are spoiled by mediocre cooks. The result is lamentable:

talented students

are not willing to delve deeper into the topic, and the vicious circle continues. Q:

Samuelson and Stigler were famous for their historical research. Could you provide

one more example to show that they are not exceptions? A:

William Baumol (1922-2017) of Princeton University was another one famous both

in economics and history of economic thought. His Ph.D. thesis Economic Dynamics (1951) was a milestone. In November 1952, he and his undergraduate student Gary Becker (19302014) published “The Classical Monetary Theory” in Economica (vol. 19). Baumol did not write much in history of economic thought, but he taught this course for decades at Princeton. In 1981 he served as the President of the American Economic Association. He published some 17 papers in American Economic Review, which is probably the highest recorded amount so far. Q:

Japanese scholars have paid a lot of attention to history of economics. Why?

A: During the period 1776-1990, Wealth of Nations was translated in Japan 14 times. The Adam Smith Library at the Economics Faculty, University of Tokyo has 315 books previously owned by Adam Smith (with his bookplates). 1 Professor Shionoya Yuichi (1932-2015), was a President of Hitotsubashi University (Tokyo) and an expert on Schumpeter. He was proud of the Schumpeter Library at Hitotsubashi:

it comprises 1,353 books, 2,835 copies of periodical publications, and 1,513

pamphlets, mainly offprints. Schumpeter donated them before moving to Harvard for good in 1932. 2

1

Visit http://www.lib.e.u-tokyo.ac.jp/english/?page_id=485. Professor Mizuta (Nagoya University) has a book Adam Smith’s Library, Oxford University Press (2000), that systematically explains this topic. 2 For details, see: 1) “The Schumpeter Library” (one page description, https://www.lib.hitu.ac.jp/service/tenji/amjas/pamph-e-p4.pdf). 2) The Catalogue of Prof. Schumpeter Library, published by The Hitotsubashi University Library (1962).

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Hitotsubashi also has a famous collection of Carl Menger (1840-1921, a cofounder of the Austrian school). The story goes that after Menger death when the Austrian economy was experiencing high inflation, his widow was persuaded to sell his books. When these 19,100 volumes were packed for shipping, the citizens of Vienna gathered in front of the door to protest. 3 This shows one thing:

Japanese scholars grasped this great knowledge opportunity

even during the Great Depression. Q:

If history of thought is interesting, why are there so few people in this field? If you

recommend a restaurant highly, why are there still so few customers? A:

We should not shy away from its dark side. Three points are of note. 1) The

problem of mentality:

Most people believe that economics requires mathematics to be

scientific; history of thought only uses words or simple charts, and so nothing seems important there. 2) Job vacancies are limited, and it is difficult to compete for research funds to attract talented students. 3) If you are skilled in statistics and mathematics, you can get a doctoral degree rather quickly and become employed. However, history of thought requires a lot of supportive cultural and knowledge assets, the need to read two or more languages, and difficulty in finding a meaningful theme. It also takes more years to get a degree. Given all this, you may want to think differently:

Why not give yourself an

opportunity to satisfy your intellectual curiosities? Read it as a side line like Keynes, Samuelson, Stigler, and Baumol. It could be more useful than you imagined. Q:

Ok, would you tell us practically how to study history of economics?

A:

Two major approaches are taken in this field:

historical reconstruction and

rational construction. When dealing with an economic theory, we need to be aware of its social background, i.e. to put the ideas into its era and to avoid misjudgment. This approach is called historical reconstruction (or relativitism). The rational construction approach (or absolutism), by contrast, does not care about the socio-economic background of the theory. It focuses on the development of a theory (such as

3 For details, see “Learning from Hitotsubashi's Carl Menger Library” by Gilles Campagnolo (16 pages, http://chssl.lib.hit-u.ac.jp/education/publication/images/20_00.pdf)

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the value of labor), how Adam Smith conceived it, and how Marx added new ideas. Absolutism is interested in such a series of processes that gradually move toward the truth. In the eyes of the relativists, the purpose is not to judge good/bad or right/wrong, but to arrive at a deeper understanding of the why and how. Everyone is a mixture of two approaches; some are 20% absolutism and 80% relativism, but 0% and 100% poles are rare. 4 Q:

Samuelson wrote some 100 papers on history of economics, mostly with scaring

equations. Apparently he was 100% belonged to the rational construction camp, right? A:

We think he was 80% absolutism and 20% relativitism, because in our opinion his

historical knowledge and prose-writing skill were even better than his mathematical talents. Thanks for asking this issue, for this opens up a debate concerning the “Whig interpretation of history.” Samuelson is an example par excellence to illustrate this controversy, and the documents are rich enough for telling a story. Please sit back, as we have something long and delicate to explain. During 1946-2007 Samuelson published nearly 100 papers on the history of economics. In terms of quantity, that is more than most researchers in this field have published in their career. In terms of quality, most of them appeared in major journals, which is also unachievable for most scholars. Medema and Waterman (2015) eds.: Paul Samuelson on the History of Economic Analysis: Selected Essays (478 pages) is an anthology of Samuelson’s studies on the history of economics. It contains 17 selected papers with a 21-page Introduction. It also provides a full list of his papers in this field, but by the time of their preparation, volumes 6 and 7 of Samuelson’s Collected Scientific Papers (2011) had not yet been published, and thus some minor papers were not listed in this anthology. Q:

Do you have one or two examples to show Samuelson was 20% relativitism?

A:

He has some articles that are not expressed in mathematics, such as his Presidential

address delivered at the 74th annual meeting of the American Economic Association in

4

See Mark Blaug (1997): “Introduction: has economic theory progressed?”, Economic Theory in Retrospect (5th edition) for an elegant discussion of historical construction (relativitism) and rational reconstruction (absolutism).

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December 1961 when he was 46 years old:

“Economists and the history of ideas”

(American Economic Review, 1962, 52(1):1-18). Another example is the keynote address at the History of Economics Society Boston Meeting, June 1987:

“Out of the closet: a

program for the Whig history of economic science” (History of Economics Society Bulletin, 1987, 9(1):51-60). Both articles are attractive and influential, and later on they will be our main subject. Samuelson’s history papers have two basic characteristics:

first, the scope and scale of

his topics are considerable; second, his analytical tools are fairly consistent, as he chose topics that fit his mathematical tools. He was not interested at exploring the deep meaning behind an issue, but rather took pleasure in demonstrating his skillful mathematical analysis. This does not deny his broad and deep historical knowledge, but this approach explains why he was able to intensively produce a large number of analytical papers in the history of economics. Q:

The history of economics is not only concerned with logical rigor, but we also want

to know more about the ideas and controversies behind it. My question is: When doing historical analysis, how can we distill useful insights from equations? Is mathematical analysis really more useful than the conventional history method to generate useful knowledge? A:

Good question. To answer it we need to see how Samuelson progressed in this

field. In 1946 he wrote “Lord Keynes and the General Theory”, Econometrica, 14(3):187200, and in 1951 “Schumpeter as a teacher and economic theorist”, Review of Economics and Statistics, 33(2):98-103. Both have no equations. In 1957, he then began to apply mathematical models to analyze wages and interest rates in Marx’s economic theory (American Economic Review, Vol. 47, No. 6). In 1959, two articles appeared in Quarterly Journal of Economics (vol. 73, nos. 1-2) on Ricardo’s economic system. In 1960, in American Economic Review (vol. 50, no. 4), he replied to a 1957 comment on his previous view on wages and interest rates in Marx’s system. In short, during 1946-1961 his four studies on Keynes, Schumpeter, Marx, and Ricardo were published in top journals, attracting

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extensive attention and comments. This greatly enhanced his interest in this line of research. He believed that mathematical analysis is an effective weapon to clarify and correct the wrong insights of the past masters. He cited Galileo Galilei “And yet it moves” 5 to claim that “But mathematics does indeed help” (Collected Scientific Papers 1966, vol. 2, p. 1500). When Samuelson was a graduate student at Harvard in 1935, Schumpeter said something that shocked him:

three of the world’s four economists are French - Walras for

general equilibrium, Cournot for Recherches sur les principes mathématiques de la théorie des richesses, and Quesnay for Tableau économique, which influenced Marx’s reproduction model and Leontief’s input-output analysis. Samuelson thought that the fourth was Adam Smith; in fact, it was Alfred Marshall. This indicates that Schumpeter favored analytical contribution and not social influence of economic ideas. Q:

What was the message in his 1987 History of Economics Society keynote speech?

A:

This 10-page “Out of the closet: a program for the Whig history of economic

science” was delivered when he was 72 years, 25 years after his 1962 American Economic Association Presidential address. By that time most of his mathematical contributions in history of economics were done. This 10-page Whig view of history can be regarded as an old general declaring his victory, as Carl Schmitt said, “The victor feels no intellectual sympathy.” After the opening page, he said since the 1930s, there were four revolutions in economics:

monopolistic competition, Keynesian macroeconomics, mathematical

analysis, and econometrics. Science must keep pace with the times, including the study of history of ideas. I propose that history of economics more purposefully reorient itself toward studying the past from the standpoint of the present state of economic science. To use a pejorative word unpejoratively, I am suggesting Whig Economic History of Economic Analysis. ... success being measurable by latest-day scientific juries who want to utilize hindsight and ex post knowledge. [Because Thomas Babington Macaulay judged the past completely in terms of how it led toward, or resisted 5

“And yet it moves” or “Albeit it does move” (Italian: E pur si muove or Eppur si muove) is a phrase attributed to the Italian mathematician, physicist, and philosopher Galileo Galilei (1564-1642) in 1633 after being forced to recant his claims that the Earth moves around the immovable Sun. The phrase implies that “it doesn't matter what you believe; these are the facts.”

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movement to, the present of his own day the name Whig History was coined.] Macaulay (1800-59) was a British historian and philosopher of the Whig party. Why was Samuelson in favor of this claim? Because “economics is in between belles-lettres and cold science.” He used The Works and Correspondence of David Ricardo (11 volumes) edited by Piero Sraffa (1898-1983) as a perfect example of historical reconstruction. Samuelson’s respect for Sraffa is unusual. In “Sraffian Economics” (New Palgrave Dictionary of Economics, 2nd and 3rd editions), Samuelson said in the opening page that “His 1926 article, ‘The Laws of Returns Under Competitive Conditions’ [Economic Journal, 36(144):535-50], was a seminal progenitor of the monopolistic competition revolution. It alone could have justified a lifetime appointment.” Volume 6 of his Collected Scientific Papers shows that from 1987 to 2006 he wrote 16 papers (pp. 285-558, papers 410-426) full of equations to explain the Sraffian system. Sraffa’s most famous book was Production of Commodities by Means of Commodities: Prelude to a Critique of Economic Theory (99 pages). Its central notion is Ricardo’s “standard commodity.” We now come back to his 10-page speech on Whig history. Samuelson devoted two full pages (55-57) with two examples, to assert firmly that Whig history is the right tract. What is the “Whig History approach”? Simply put, it means rational construction (absolutism). Historians of the idea strongly disagreed with this approach:

new, amazing, striking but

unnatural and uncomfortable. The first example in Samuelson’s 10-page speech is Schumpeter (1954) History of Economic Analysis. “It is even greater than its reputation, but, alas, it is sadly unfinished work. God permitted Moses to come near to the Promised Land, but refused him final entrance.” The second example is “Go to any economics library, as I have done at MIT and Harvard, and you will find the pages are dirtier in Mark Blaug’s Economic Theory in Retrospect than in the well known texts of Gide and Rist, Alexander Gray, Eric Roll, or even Blaug’s own Ricardian Economics.” Samuelson was particularly glad about his four papers using the Whig approach. 1) “von Thünen at two hundred” (1983). I draw from this genius’ writings the complete model that is there.

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2) “Canonical Classical Model” (1978). In one diagram there is captured what is held in common by Ricardo, J.S. Mill, Malthus, Marx and Smith. The fact that contemporaries quarrel must be understood against the background of an age in which writers imperfectly understood their own theories. 3) “Quesnay’s ‘Tableau économique' as a theorist would formulate it today” (1982). The Tableau was a comic case of puffery and mystification but it did foreshadow general equilibrium. 4) “Ricardo on machinery” (1987). I had to say that the machinery chapter is the best chapter in Ricardo’s Principles. It addresses a problem important in economic theory, and it gets the analysis right. … Literary economics at its worst and most boring: that is my report card on Ricardo’s first-chapter effort. … As the physicist Pauli once said of a new theory: ‘It isn’t even wrong’. Q:

Was there any fightback against his 1987 “Out of the closet”?

A:

Yes, Kurdas soon wrote an article that appeared in 1988:

on Adam Smith:

“The ‘Whig Historian’

Paul Samuelson’s Canonical Classical Model”, History of Economics

Society Bulletin, 10:13-23. Most historians of economic ideas would agree with this paper. Samuelson replied to this comment in the next issue “Keeping Whig history honest”, 1988, 10:161-7. Interested readers may want to have a go at it. Q:

Then what? Silence or the battle continued?

A:

Silence, but fermenting discord. Some 25 years later, Cambridge Journal

of Economics published a special issue edited by A. Freeman, V. Chick and S. Kayatekin: “Whig History and the reinterpretation of economic theory”, 2014, 38(3):519-699. These ten papers (180 pages) represent a deeper reflection and also deserve a read. Q:

I guess a basic source of disagreement is that Samuelson’s Whig approach reflects

his physics and mathematics envy, while historians consider this kind of envy to be illusive: a kind of wrong tool for wrong target. Is this conjecture correct? A: We quote Niels Bohr (1885-1962, 1922 Physics Nobel) to show Samuelson’s perception is doubtful:

“It is wrong to think that the task of physics is to find out how

Nature is. Physics concerns what we say about Nature.” To paraphrase:

“It is wrong to

think that the task of mathematics is to find out how Economics is. Economics concerns what

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we say about social Nature (instead of pursuing logical truth).” In this sense, Samuelson’s Whig approach was “More heat than light”, to borrow the title of Mirowski (1991). 6 Have you heard of the law, “Maslow’s hammer”? It is a cognitive bias that involves an over-reliance on a familiar tool. As Abraham Maslow said in 1966:

“I suppose it is

tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.” Is the Whig approach Samuelson’s “pride and prejudice”? He was a firm believer of this approach without “mauvaise fois” (bad faith), as he confessed:

“When meeting St. Peter my most

crime will be the spousal of a Whig-History approach to the history of science.” 7 This Whig approach controversy continued today, implicitly and explicitly.

6

Philip Mirowski (1991): More Heat than Light: Economics as Social Physics, Physics as Nature’s Economics. Samuelson (1991): “Conversations with my history-of-economics critics”, in Economics, Culture, and Education: Essays in Honour of Mark Blaug, edited by Graham Keith Shaw, U.K.: Elgar, p. 3. Wade Hands also said something quotable in his “Review of Paul Samuelson on the History of Economic Analysis”, Journal of the History of Economic Thought, 2016, 38(3):391-4. 7

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Part II Pioneers and contenders

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3 Wealth and power: mercantilism

Buying and selling is good and necessary; it is very necessary, and may, possibly, be very good; but it cannot be the noblest work of man; and let us hope that it may not in our time be esteemed the noblest work of an Englishman. ―Anthony Trollope, Dr. Thorne

Mercantilism is a common phenomenon in history as it is today. Tudor England and postwar Japan were successful examples. Under this common umbrella, practical strategies and policies are highly diversified, but two features are common:

the search for power and

wealth; and actively accumulating foreign exchange reserves through industry and commerce. Europe in the 16th-18th centuries was a good example of mercantilism. Ever since Columbus discovered the New World in the 1490s, Europe set off a wave of foreign trade and colonial development. Some 250 years later, a strong anti-commercialism wave emerged. The Wealth of Nations (1776) is often regarded as a benchmark of this tide. It has a long historical background. Henry Tudor (Henry VII) created a new dynasty and ruled England diligently, while his famous son Henry VIII ambitiously engaged the country in continental Europe affairs. That exhausted the financial resources of England, and the unavoidable Great Debasement dramatically devalued the Pound Sterling. His daughter Elizabeth I (the Virgin Queen) strived to restored the currency and the economy and even defeated the Spanish Armada in 1588. All these led to quick development of foreign trade

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and colonies. The period from 1500 to 1776 saw an up rise of economic activities, and these actions and policies set the model for mercantilism. Q:

I do not quite understand the whole process:

How did Western Europe shift from

a feudal system into world mercantilism? A:

You certainly know the story of Robin Hood. The historicity of this folk hero is not

proven, but he is often used as a reference to bandits - a living symbol of the feudal system. In a feudal society such as Nottingham (where Hood lived), the lord owned a castle with wide arable land and deep forests on all sides. Farmers of cultivated land were required to pay taxes and services. Feudal lords paid similar obligations to the king:

taxation and war.

As mercantilism came to center stage, goods and precious metals from overseas increased, and the merchant class gradually became dominant in industry and finance, while the traditional lords still owned the land, manpower, and food. In short, industry and foreign trade become important, European countries began to compete for colonial resources and markets, and feudal lords were gradually replaced by merchants and colonists. Q:

At the peak of English mercantilism, what were its main concerns?

A:

An obvious feature is the accumulation of gold and silver, which is exactly the

same as today’s typical mercantilism. A common current mentality is that foreign reserves are the result of trade surplus, which is a representation of national productivity and market dominance. The more precious metals accumulated, the more powerful the country is. A second feature is the rise of nationalism, fighting for resources around the world. It is a kind of zero-sum mentality: my gains are your losses (a situation in which one’s gain or loss is exactly balanced by the losses or gains of the others). A third feature is to encourage importing raw materials and discourage exporting them. A common practice is subsidies for exports and high tariffs for imports. Take the vital English wool industry as example:

the exporting sheep will be confiscated, the owner’s left

hand would be cut off, or he would face the death penalty. In short, it was a kind of warfare in commerce and industry.

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A fourth feature is colonialism, which predates resources, minerals, etc. An accompanying policy was to license a monopoly at home and abroad to increase tax income. To exclude foreign competition, in 1651 and 1660 England’s Navigation Law stipulated that foreign vessels were not allowed to enter its colonies, and foreign goods were not allowed to enter them either. These are external strategies. For domestic industrial and commercial policies, we see three examples. The first is to gradually abolish checkpoints and tolls so as not to impede the competitiveness of exports. Second, government’s power becomes increasingly concentrated, such as issuing licenses (from glass to cards), subsidizing exports, controlling production. The state is actively involved in maximizing income and overseas competitiveness. A third feature is a macroeconomic policy. During the era when technology was mainly labor-intensive, cheap labor was a key source of wealth, as human resources provided more powerful seafarers, soldiers, and workers and also reduced labor cost. Many Asian countries today are doing the same thing, but England in the 16th-18th centuries was even more straightforward:

punishing

lazy workers, cutting off ears, and slave them. Child labor was allowed at age 4; working at least 12 hours a day, or even 18 hours for adults. In short, this helped make the whole nation like a money printing machine that never stops. Q:

Who benefited most from mercantilism and how?

A:

“Rent-seeking” is an appropriate notion as an answer. Concretely speaking, a king

or a Pope could grant authority and/or monopoly to favor someone, then expect economic returns from them. Another example is to impose disadvantages on competitors. There are many possible forms of rent-seeking behavior. Abstractly speaking, it involves seeking to increase one’s share of existing wealth without creating new wealth. It results in reduced economic efficiency through a misallocation of resources, reduced wealth creation, lost government revenue, sharpen income inequality, and potential national decline. Q:

Those who are in good terms with the king or authority have a better chance to

obtain monopoly, colony, and industry; so they are the rent-seekers?

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A:

What they did were rent-seeking behaviors such as loyalty, flattery, and

collusion. This was self-interested and harmful to the society; some examples include: English wool traders were against cotton imports; French candle makers asked the state to ban folks from opening curtains during the daytime. As long as there are regulations, someone will benefit and someone will suffer. A mercantilism strategy also has advantages, otherwise England would not have prospered so quickly. The obvious consequences were wealth (precious metals) and power (Royal Navy), the rise of East India Company, and a well-developed transportation network. Q:

This basic mentality remains the same today. So we have good reasons to expect

mercantilism would be still alive in the next millennium? A:

Quite probably so because its features are common all the time:

protect domestic

industry, devalue exchange rate to pursue export surplus, accumulate foreign reserves, etc. Q:

Academically speaking, could you comment on some major mercantilism scholars?

A:

You know the name Thomas Mun (1571-1641) and his A Discourse of Trade from

England unto the East-Indies and England’s Treasure by Forraign Trade or the Balance of Forraign Trade is the Rule of Our Treasure. Yes, Mun was the Director of the East India Company. His main insights are similar to the mercantilist doctrines previously reviewed. There are many publications on economic issues in that period, mostly in the form of pamphlets. The authors were quite diverse:

merchants expressed their experience of

doing business abroad and the unheard-of local customs. Trade officials promoted policies; Parliament members defended their interests. Q:

I guess the mercantilist theory is a kind of rational reconstruction by later scholars.

A:

Right, one of the most famous works is Mercantilism by Swedish economic

historian Eli Hecksher (1879-1952). It was written in German in 1931 and translated into English in 1935 in two volumes. France, Germany, the Low Countries, Portugal, Spain, and Italy also had their own doctrines during that period. If you take a look at an online entry “mercantilism”, the ideas and references are much richer than imagined. If you read other languages, there are many more recent contributions to explore. Although mercantilism in

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each country seemed somewhat varied and their experiences divergent, the basic common principles should be similar to the English case. Q:

How can thinkers in the mercantilism era enlighten us today?

A:

The ideas of David Hume (1711-76) and Richard Cantillon (1680?-1734) would be

instructive. Hume was a senior (12 years older) friend of Adam Smith and was prolific in philosophical and social analyses. For economic issues, he was famous for “price-specie flow mechanism.” “Price” refers to the British general price level, and specie flow refers to the bullion flowing in and out due to trade. Hume’s message is valid even today:

mercantilism aims to

accumulate bullion (profits), which the U.K. had accumulated considerably (actually too much) by the 1750s. An inevitable result was higher and higher prices, including food and wages. Thus, the costs of everything in the U.K. became too high vis-à-vis trade counterparts (Prussia, France, and the Netherlands). The consequences are obvious. 1) The competitiveness of British products declined. 2) Britain need to use the bullion accumulated by trade surplus to buy cheaper food and commodities abroad. 3) Gold and silver then flowed out. This is a self-defeating process, sadly. Hume thus warned that bullion itself is not real wealth; money is only a medium of trade; it is a veil, not wealth. What really needs to be done is to increase Britain’s productivity and market share and not the quantity of bullion. Q:

Yes, but what Hume worried about did not happen. Because after the 1800s the

U.K. entered the Industrial Revolution era as a leading economy in the world. Is Hume’s theory still valid? A:

The U.K.’s real income soared from the 1800s until the first World War (1914).

This is an impressive epoch in human history:

the growth rate of real income was

significantly higher than the population growth rate; thus, the country successfully escaped the Malthusian trap (in which population growth rate is higher than real income growth rate).

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Hume’s theory is simple and reasonable, but why did it not happen? The following answer is a rational reconstruction of modern scholars. If domestic prices rise, then Hume expected the balance of payments to deteriorate, but whether this prediction will happen or not depends on two conditions (caution: a little hard to follow, but comprehensible). 1) Take domestic demand elasticity for imported goods (Ed, such as American demand for iPads made in Asia); and 2) foreign demand elasticity of domestic products (Ef, such as the world’s demand for American aircrafts). If the sum of 1) and 2) is less than 1 (i.e. Ed+Ef 1) could be unavoidable (selfdefeating). Q:

I did not expect such a sophisticated argument behind Hume’s warning. How can

you measure Ed and Ef specifically? If every country has 1,000 commodities trading with 100 other countries, how could you determine if Ed+Ef 1 for each product, and for each trade partner? A:

If you have a long-term price series of a certain commodity (such as computers) in

each country, and the quantity of imports/exports of each country, then it is possible to do a specific calculation. This is still only a conceptual solution, and the purpose here is to explain when and how Hume’s dilemma of mercantilism would or not happen. It is an

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economist’s theoretical construction; the business world makes the decision by “rule of thumb”:

by market experience and inside information.

Q: Was Richard Cantillon’s message similarly instructive? A:

He was an Irish businessman and banker, born around 1680-90, spending most of

his time in Paris. His main work was Essai sur la nature du commerce en général (Essay on the Nature of Trade in General). It was written in the 1720s, and in 1734 he was killed by a servant who set fire to the house and destroyed a lot of unpublished manuscripts. This work was published in 1755 and could be the most systematic economic analysis written before Smith’s Wealth of Nations (1776). Let us focus on a famous argument:

the Cantillon effect. Most scholars before him

thought that after foreign bullion flowed in continuously, prices in the U.K. would rise up proportionally. Suppose the money supply increased by three times due to a trade surplus and other sources; one can expect domestic prices in general will also up move up in kind. This principle was better expressed by Irving Fisher (1867-1947) as MV = PT (where M = total stock of money, P = price level, T = amount of transactions carried out using money, V = velocity of circulation of money). Cantillon thought it to be wrong, however. His argument makes sense:

when foreign

bullion is converted into Pound sterling, it will not be evenly distributed to every industry; so, MV = PT would not be valid:

if money supply increased by three times, one cannot expect

the price level to also rise by three times. The real world does not work so elegantly; equations are beautiful, but unreal. Most money earned from trade surpluses flew into the royal family, nobles, and traders. Farmers and artisans did not share much of this fortune. How could agricultural prices thus also increase by three times? Cantillon had a metaphor for it in Essai sur la nature du commerce en général (Higgs’s 1931 translation, p. 177):

“A river which runs and winds

about in its bed will not flow with double speed when the amount of its water is doubled.” Here is a modern example. In 1990-2010 China accumulated more than US$2 trillion from foreign trade; the price level in the coastal provinces (especially the trading ports like

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Shanghai) increased sharply, while the price effects in the hinterland provinces were not synchronized. By the same token, the price effects in industries and agricultural sector also diverged. The Cantillon effect is simply true:

the price level effect of trade surplus depends on

who got the money and depends on where it is used:

whether in real estate, luxury goods, or

for infrastructure. This will change the wealth structure of the whole society. Keynes said something similar: “monetary changes do not affect all prices in the same way, in the same degree, or at the same time” (see his The Treatise on Money, 1930, chapter 7 “the diffusion of price levels”). Q:

Intelligent people were clairvoyant in the mercantilist era. Most of us today are not

necessarily smarter than past masters. That shows the benefit from reading classics, right? A: Yes, compared with the future classical school, economic discourse in the mercantilist period lacked analytical concepts and tools. Good arguments existed, but not yet in the form of concepts and generalized arguments. That is why we need historians of economic thought to do rational reconstriuction. Q:

It sounds like Cantillon was more insightful in the 1730s than Fisher in the early

20th century. If this is not an isolated case, did mercantilists have useful insights on the main issue of our era such as unemployment? A:

In “Notes on Mercantilism” (chapter 23 of General Theory,1936), Keynes made a

mistake in thinking that the basic nature of unemployment in the mercantilist period was essentially similar to the situation in the 1930s (Great Depression). This view was criticized by historians, because the cause of unemployment in the 1930s was underinvestment, which never existed before the industrial revolution. While the main body of the U.K. economy in the 17th-18th centuries was still agriculture, unemployment was mainly caused by seasonality or poor harvests. At that time, the scale and scope of the industrial sector were still limited. Unemployment could be caused by bad weather such as the rivers were frozen in winter or flooded in the spring, or something caused the wind mills to stop running.

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Q:

Your message is clear:

under the same name (such as unemployment), the causes

and policies could be 180o opposite. My question is then how to distinguish two species under the same name “unemployment”? A:

What mercantilists really worry about was a kind of “voluntary unemployment”:

After people from rural areas move to the urban sector, sometime they choose to quit jobs (casual unemployment) due to too long working hours. In contrast, in the 1930s the problem was, as Keynes said, “involuntary unemployment”:

people wanted to work, but were unable

to find jobs. The cause and the nature of unemployment were essentially different. There is another more illustrative example:

the notion of unemployment between

Keynes and Marx. As said earlier, Keynesian unemployment is due to insufficient investment and/or lack of effective demand, such that the economy is unable to provide full employment. Marxian unemployment is different; it is a combination of three factors: 1) overpopulation (unlimited supply of labor); 2) low level income and the inability to accumulate sufficient savings to invest; and 3) technical level was still primitive. This kind of unemployment is structural and not cyclical. The Keynesian prescription for 1930s unemployment is well-known:

increase public

investment, monetary expansion, government deficit spending, etc. This kind of policy would be, however, ineffective for Marxian unemployment in mid-19th century and also useless for the 16th-18th century unemployment in the mercantilist period. This example has a clear message:

both history of economic ideas and economic

history can play an important role. There is no such a thing as a one-size-fits-all policy. We need different vaccines for various types of influenza. Businessmen and intellectuals in the mercantilism era were amazingly insightful, there are more instructive examples to be found: the sea gets deeper as you go further into it.

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4 The physiocrats and law of nature

To secure the greatest amount of pleasure with the least possible outlay should be the aim of all economic effort... when everyone does this the natural order, instead of being endangered, will be all the better assured. ―François Quesnay Toute notre dignité consiste donc en la pensée. (All our dignity consists in thought.) ―Blaise Pascal

We shift the scene now from the U.K. to France, from mercantilism to the physiocrats. The French term physiocratie was from the Greek for “government of nature.” In the 18th century his school was developed by a group of Enlightenment economists who believed that the wealth of nations was derived mainly from the value of land (hence, physiocratie). This school was both short-lived and long-lived. Short-lived for its timespan:

starting

from 1756 when François Quesnay (1694-1774) published an economic treatise in Grande Encyclopédie. It had two ending points, both in 1776. First, when Turgot (1727-81), an important member of this school, left his position as Finance Minister and lost political influence. Second, when Smith published Wealth of Nations, which absorbed two key ideas from the physiocrats:

anti-mercantilism ideology and economic liberalism. After that, the

glory of this French physiocrats was overshadowed by the British Wealth of Nations.

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From the perspective of “doctrinal longevity”, Quesnay’s Tableau économique (economic table) still remains influential today. There are two examples:

1) in the early

1930s Frank Knight (1885-1972) of Chicago simplified this table into the circular flow diagram (below) that we are still using today. 2) In 1936, using data of the 1919 U.S. economy, Harvard’s Wassily Leontief (1905-99) transformed this table to computable inputoutput analysis, describing the inter-dependence relationship among 46 industries. This is a key step for macroeconomic policies. The short-lived French Physiocrates (1756-76) did not expect to have their influence remain around the world for over two centuries.

This graph shows the circular flow of income in a five-sector economy. Flow of money is shown in purple, and flow of goods and services is orange. Money flows in opposite direction to that of goods and services. Source:

Q:

“Circular flow of income”, Wikipedia.

France was traditionally state-centered. Why did the physiocrats, who favored

liberalism, arise in France? A:

At the end of 17th century, the French economy was trapped in a long-term

recession. In addition to natural disasters, two were man-made: Louis XIV was involved in a series of wars and a series of failed mercantilist policies. A natural reaction was to overthrow both Louis XIV and mercantilism. You may know Jean-Baptiste Colbert (1619-83) who was an influential Finance Minister and policy maker. He was eager to pursue the nation’s wealth and power, believing

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that only four things are useful:

agriculture, trade, war for more territory, and colonies. He

was a typical thinker of the zero-sum game and advocated strategies to compete with other countries through commercial warfare. His domestic policies were interventionist (active state regulation), such as controlling the quality and quantity of the manufacturers, subsidizing new industries, increasing taxes through granting monopolies, encouraging hard work, and recommending early marriage to increase the labor force. He allowed children to work at the age of 6 and cancelled 17 religious holidays. And of course, he also standardized weights and measures, as all strong governments did. These policies were effective quickly, but not without side effects, like these five examples. 1) Too many and detailed regulations that hindered innovation and progress. 2) The industrialists and businessmen turned defensive. 3) Strict and excessive taxation caused complaints. 4) Seeking political support, the religious community, the rich, and the nobility were exempted from paying any tax, resulting in social injustice. 5) Prohibition of grain exports depressed the agriculture sector. All these obstacles, coupled with income inequality and notorious corruption, called for overall radical reforms. Q:

These physiocrats wanted to shift the orientation of policy?

A:

One can see it from several aspects. From a philosophical perspective, they asked

policy makers to follow the laws of nature. A ruler should not violate natural laws, but let everything co-exist at their own paces. Intervention might reach the target quickly, but in the long run it would be self-defeating by violating the laws of nature. When this philosophy was translated into policy, the state should adopt the laissez-faire principle; people know best their own interests, and they perform better and more satisfied when deregulated. A famous slogan is “Govern less to govern better” (Pour gouverner mieux, il faudrait gouverner moins). France was basically agricultural, and industry and commerce were not too essential. Colbert’s active mercantilism policies were inappropriate. In search of power and wealth, the

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mercantilists imposed heavy taxes extensively. In contrast, the physiocrats advocated a “single tax”:

tax the land (agricultural sector) only; all other taxes should be abolished.

Moreover, the interdependence and balance among various sectors should always be emphasized. An economic system functions like our human body; it has an organic structure composed of muscles, blood, nerves, and bones. This means the state should not be biased toward industry, as other sectors also need to be encouraged. Q:

The physiocrats were surely against the interests of the ruling class. Who looked to

benefit from the physiocrats’ policy? A:

Farmers. The physiocrats had two main claims: Remove complex regulations and

allow agriculture to develop freely; also, to actively assist agricultural exports to earn bullion. The physiocrats promoted a large-scale farming system, in the hopes that as agriculture developed, the single tax system could be adopted. Unsurprisingly, this idea failed, but it influenced American social reformer Henry George (1839-97) and others, including the Founding father of the Republica of China, Dr. Sun Yat-sen (1866-1925). Q:

How did François Quesnay develop his unusual ideas?

A: Born into a wealthy landlord family, he became Louis XV’s court doctor. The King showed great esteem towards him, called Quesnay his thinker, and ennobled him for arms with three flowers of the pansy (derived from pensée, in French meaning thought), with the Latin motto Propter cogitationem mentis. Quesnay was interested in economic analysis around 1750, wanting to turn France into an enlightened monarchy. By that time the farming sector was small-scale and inefficient. Quesnay tried to convince the King to encourage large-scale farms run by entrepreneurs. Louis XV once complained to Quesnay: To be a king is not an easy job. Quesnay replied:

“I do not see any difficulties.” The king:

“If you were the king what would you

do?” “Do nothing.” “But how would you govern the country?” “I rely on the laws of nature.” What Quesnay had in mind is that the basic principles of social mechanism are nothing different from the way the celestial body works.

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The task of the monarch is to simply let society and the economy follow the laws of nature. Let it run, do not intervene (laissez-fair, laissez-passer). Using Adam Smith’s expression, let the “invisible hand” (price and market mechanism) to coordinate everything, and the whole society would be automatically better off. Intended interventions can only do more harm. Q: What it the main idea behind Tableau économique? What did Quesnay try to convey? A:

Quesnay presented it to the King in 1758 and amended it in 1766. Tableau

provided the foundations for physiocrats’ doctrines - a first analytical work to describe how the economic system circulates. Its object was to exhibit how the products of agriculture, which are the only source of wealth, would fly to other classes of society (manufacturers and merchants).

Tableau économique, 1758. Source:

“François Quesnay”, Wikipedia.

Tableau illustrates how these three classes provide food, capital, and commodities, and how they exchange and accumulate. It is the first macroscopic view in economic science. In modern language, Tableau was: 1) an original analytical diagram of the national income; 2) How N sectors (N) exchange M goods (M). This is a simplified N×M exchange model - a basic general equilibrium (inter-dependence) system.

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Q: As a court doctor, how was Quesnay able to implement his ideals? A:

He could not. That is why we need to introduce Anne Robert Jacques

Turgot (1727-81). Turgot was a cleric from a Normandy noble family. In 1774 he became the financial minister, with two radical policies: promote free trade and eliminate tariff protection; and not to over-tax, “Taxation is the art of plucking the goose without making it squeal” (in a 1766 letter to David Hume: “…On cherche, comme on dit, à plumer la poule sans la faire crier”). Turgot’s orientation caused fierce opposition from feudal aristocrats, the religious circles did not trust him, and tax collectors resisted for a simple reason: this went against their vested interests. Turgot’s main orientation (pro-agriculture, anti-merger, anti-feudal) was not what Colbert’s mercantilism wanted. Facing fierce opposition, the King relieved him of his duties. The top members of the Physiocrates included Marquis de Mirabeau, Mercier de la Rivière, Dupont de Nemours, Le Trosne, and Nicholas Baudeau. Their influence outside France was mainly through Wealth of Nations, because Smith was travelling in France for two years and was quite familiar with this group. Smith was a key channel for diffusing their liberal doctrines to a greater audience, which is still widely influential today. Q:

Instead of asking a question, I have a comment to make. “Natural law” sounds like

a mantra for the physiocrats. It is a kind of attitude or mentality (do not violate the heaven’s laws), but not a scientific notion. I doubt it can be used for any economic analysis. Let me elaborate. Some 70 years before Quesnay’s Tableau, Newton (1642-1727) already had a deeper understanding of the Nature in his Philosophiae Naturalis Principia Mathematica (1687). This kind of scientific analysis with logical inference was more solid than the “natural law” that the physiocrats claimed for economic analysis. As a court doctor and a wise man (Propter cogitationem mentis), Quesnay should have been familiar with Newton’s ideas. Why was his Natural law still so philosophical compared to Newton’s analytical style? A:

You are right in terms of scientific progress, but not so fair to compare Nature

Laws in physics and economics. The physiocrats used natural laws as a metaphor to promote

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policies, and they should not be considered as an analytical tool. Newton understood that within the planetary system everything is interdependent and mutually connected. Political economists understood this view and applied it to social analysis. Q:

Let me explain why I asked that question. I am thinking how scientific revolution

have helped the progress of economic analysis. It seems the answer is negative in the age of the physiocrats. Following this line of thought but shifted to another related issue:

there is

another revolution that did help the progress of economic analysis - the Industrial Revolution that began around the late 18th century. A: Yes, the Industrial Revolution had a sweeping impact; demand for raw materials, labor, and resources increased rapidly; domestic and foreign trade also soared. A new working class and bourgeoisie emerged, while the old aristocracy faded away. The sociopolitico-economic relationship was gradually replaced by market competition. On the other hand, agricultural production began to be specialized and large-, medium-, and small-scale factories also emerged, while traditional craftsmen declined. Policies began to be less regulatory, and property and personal rights turned more liberal. Economic ideas also changed, with some new features. 1) The State intervened less, which reduced administrative costs:

to govern better, one should govern less. 2) Religious

power weakened, and usury laws were abolished. The mentality of self-interest also rose. 3) International exchanges of resources, goods, and personnel increased. 4) Economic analysis began be to influenced by physics, pursuing “the law of invariance”, such as the law of diminishing returns and the law of comparative advantage. Concepts and vocabulary also changed significantly; “competition” now became a rationalized term and a core concept of market efficiency. All these changes laid the foundation for the Industrial revolution. However, economic liberalism had its own shortcomings, such as the vulnerable workers and farmers. Economic liberalism encouraged capitalism that tends to exhibit overproduction and excessive competition and also likely leads to disorder and recession. Our next topic is the founder of classical liberalism: Adam Smith.

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Part III Classical school

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5 Adam Smith and the invisible hand of the market mechanism

… 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. ―Adam Smith

Today’s guest is the founder of classical school, Adam Smith (1723-90). His theory of economic freedom and growth are still fresh in our minds. Two bibliographies (one old and one new) are interesting: John Rae (1845-1915)’s The Life of Adam Smith (1895), and Ian Ross’s The Life of Adam Smith, revised in 2010. You may also want to have a look at The Glasgow Edition of the Works and Correspondence of Adam Smith (6 volumes plus index volume). 8 Q:

Why is it so unusual that many scholars today are still interested in Smith?

A:

Yes, taking the Chinese case as an example. Two facts are interesting: How

Smith’s Wealth of Nations (1776) was translated into Chinese in 1902; and how it was

8

The following surveys (since 2000) are also informative. 1) Cheng-chung Lai (2000) ed.: Adam Smith across Nations: Translations and Receptions of The Wealth of Nations, Oxford University Press (two overviews plus 29 texts). 2) Knud Haakonssen (2006) ed.: Cambridge Companion to Adam Smith (14 papers). 3) Jeffrey Young (2009) ed.: The Elgard Companion to Adam Smith, U.K.: Edward Elgar (20 papers). 4) Christopher Berry, Maria Pia Paganelli and Craig Smith (2013) eds.: The Oxford Handbook of Adam Smith (28 papers). 5) Ryan Patrick Hanley (2016) ed.: Adam Smith: His Life, Thought, and Legacy, Princeton University Press (32 papers).

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received by mandarins and intellectuals. The translator was Yan Fu (1854-1921), who spent two years at the Royal Naval College, Greenwich (March 1877-June 1879). 9

Yan Fu (1854-1921), translator of Wealth of Nations

Yan Fu’s translation of Wealth of Nations, cover and first page (1902)

Both issues are intriguing, because, first, translation was not an easy effort around 1900, as Chinese vocabulary and concepts (state of mind) were not ready to follow Western economics. Second, the first priority for Imperial China’s weak economy was to pursue wealth and power, which required a strong government and regulations. However, the central messages of Adam Smith are laissez-faire, anti-mercantilism, and minimum government. Smith and China were simply incompatible. Why even bother to translate it? Q:

Why has Wealth of Nations been so appealing over the past two centuries?

A:

England’s interventions in economic affairs were necessary and effective in

the 16th-18th centuries. The State actively allowed interest groups to be politically powerful and influential; the government extensively regulated economic activities; it pursued foreign

9

See Adam Smith and Yan Fu: Western Economics in Chinese Perspective, Palgrave Macmillan, 2021.

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trade surpluses, which caused hostility from trading partners; and it protected colonial interests, resulting in excessive military spending. These active policies were not all beneficial to Britain’s long-term interests. Smith was a promoter of laissez-faire, anti-mercantilism, free competition, and minimal government under the “invisible hand” of a free market price mechanism. It is a kind of economic liberalism à la physiocrats, with an ultimate goal of U.K.’s long-run wealth and power. Smith is known as the founder of the subject, political economy, for he was a systematic presenter of economic phenomena and principles. Wealth of Nations also serves as a theoretical basis for production and distribution and also uses abstract reasoning to review past policies. Smith’s arguments were not completely innovative, but the whole book offers a comprehensive framework and deep concepts for theoretical and practical discussions. His rhetoric writing style is also inspiring. Smith’s doctrines can be simplified into three basic points: the basic motivation of a person is self-interest; while pursuing self-interest, there exists an invisible hand that will coordinate everything to achieve a higher common interests; the easiest and most effective way to achieve this is laissez-faire and non-interventionism; the roles of the State are limited to justice, defense, public construction, and the maintenance of institutions (such as justice and education). Q:

Was Smith attached to an intellectual group, like Quesnay to the physiocrats?

A:

Smith was part of the Scottish Enlightenment, which had two characteristics:

use

rational reasoning to explain various social phenomena and apply Newtonian views and respect the law of nature. Sounds like the physiocrats, right? Yes, Smith was sympathetic with Quesnay and his milieu, they were all anti-mercantilism and against interventions. If Quesnay (1694-1774) had been alive when Wealth of Nations was published (1776), Smith would have dedicated him the book. Smith also had a close relationship with other members of the Scottish Enlightenment, such as David Hume and Francis Hutcheson (1694-1746), who was a teacher when Smith was studying at Glasgow.

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Q:

Before Wealth of Nations (1776), Smith had The Theory of Moral Sentiments

(1759) that made him famous at home and abroad. Both books seem irrelevant. Is there any internal connection? A:

Moral Sentiments came out 17 years before Wealth of Nations; its 6th edition was

the year of his death (1790). How are both interrelated? On the one hand, Sentiments laid the foundation for Wealth of Nations, and conversely Wealth of Nations spurred him to revise Sentiments. Both books are regarded as Smith’s “two faces”; Sentiments on social action, Wealth on economic mechanism. Both are insightful. By the way, in Smith’s time “moral” did not mean “good morality”, but rather “social philosophy.” The first chapter of Sentiments is “Of Sympathy” (meaning empathy):

why and how

everyone feels the same, reciprocally. Why do we feel the joys and sorrows of others? Modern neuroscience knows that we have a “mirror neuron” that fires both when an animal acts and when the animal observes the actions performed by another animal. The neuron “mirrors” allow us to feel how others feel. Such neurons have been directly observed in primate species. Most people have a common reaction to the same thing; e.g. when we see a car accident. Empathy is a kind of “social glue” that knits our society together:

mutual

assistance and cooperation. Members of society, on the other hand, fight each other, because resources are limited and everyone is self-interested. At the same time we have a bright side (sympathy) and a dark side (competition). German scholars named this as “Das Adam Smith Problem”:

in

Sentiments Smith emphasized empathy, but in Wealth Smith praised self-interest and competition. This seems an obvious contradiction. In fact, for Smith, Sentiments is treating the social aspect (mutual assistance); while Wealth is analyzing the economic aspect (competition and self-interest). We act differently when we are at home, in the workplace, or in a casino. We show different faces and play different roles. The two books by Smith are treating two opposing aspects: Q:

social vs. economic behaviors.

The first chapter of Wealth is on the division of labor. Why is that so important?

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A:

Its full title is An Inquiry into the Nature and Causes of the Wealth of Nations.

Smith believed that division of labor is the foundation of wealth. He gave a famous example on the division of labor in a needle factory. To make a needle required some 18 steps: a liter of fire, drawn steel wire, sharpening, drilling, etc. With every worker responsible for a single step, the results are amazing:

the average daily production per worker was 4,800 needles,

and the average output can be increased by 240 times.

Division of labor in a needle factory

This means 1+1+1+1+1 is not 5, but 1,200. The secret lies in a well planned division of labor that increases labor productivity enormously without adding extra capital or using newer technology. This example shows that productivity can increase exponentially without increasing employees or raising salaries, as long as the division of labor is efficiently scheduled. By the 1980s, British workers were able to produce an average of 80,000 needles per day. Excessive division of labor has it shortcomings, however: work becomes monotone; a worker’s ability is overly specialized and narrowed; and workers feel alienated from their products. Q:

Division of labor alone is unlikely to increase GDP infinitely. It is not a panacea,

we need other factors to match with, could you elaborate a bit on this? A:

Of course, it is not a panacea. It is the result of logical reasoning and also requires

several intermediate processes:

when the division of labor is efficient, investments will

follow to hire more workers and buy more equipment to expand production capacity. It sounds better than music, but the reality is not always so smooth and actually quite harsh. Q: Wealth of Nations is nearly 900 pages. There are many more key things in it, right?

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A:

That is why we suggest you to take a look at it. This 1776 book does not attract

your interest in every page or every chapter. A lazy way to read it is search keywords from the Index, such a self-interest and free trade. Some said that Smith’s texts are musical and should be read aloud. Here is a passage to show his writing style:

“It is not from the

benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” Behind these transactions there is an invisible hand that guides buyers and sellers to pursue their own best interests. This means, while pursuing self-interest, that each person, through this invisible hand, does not have to consider other people, but will maximize the interests of the entire society. Market competition and transaction will automatically lead the economy toward efficiency. Pursuing self-interest is not necessarily selfish. If the State can be hands-off, then everyone can pursue their own goals guided by an invisible hand. If the State was overly directive, it would deter people from pursuing self-interest, and that might hinder social progress and national prosperity. The same principle is applicable to foreign trade:

a laissez-faire policy would allow countries to circulate products freely,

which will benefit all the countries mutually. In short, the key idea is to let people enlarge the pie for themselves and to enjoy that pie. To make it happen, one has to tear down the monopoly walls of mercantilism. Division of labor, liberalization, and specialization are the roots of national wealth. The State only needs to do the following:

defend citizens against invaders; maintain administrative justice

and efficiency; build public infrastructure such as bridges, roads, canals, and ports; issue currency and manage interest rates; safeguard patents; protect infant industries; and promote business and education. Q:

Wealth of Nations is not only policy oriented, it also has theoretical contributions.

Could you explain one or two of them?. A:

We can present an example of the “diamond-water paradox”. Diamonds are

expensive, but useless for survival (metabolism). Water is a daily cheap item, but it can save lives. The paradox is:

Why are you willing to spend a fortune for a diamond while life-

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saving water is so worthless? Diamonds are beautiful and attractive, but are you willing to buy a third or fourth diamond at half price? The philosophers in Smith’s era were unable to provide a sound answer; they did not know how value is determined:

the simple law of

supply and demand can only partly explain this paradox. The concept of marginal utility developed in the mid-19th century provides a concise answer:

Diamonds are expensive, because of their “high marginal utility”. If you have a 20-

karat diamond in hand, it will attract high social envy, but you do not want to pay the same price (or even half price) to buy a third one, because its marginal utility declines sharply. Why is life-saving water so cheap? Because it is easy to get a lot of it, and so its marginal utility is low. We can live quite well without a diamond, but will die without water in a week. Thus, the “total utility” and “average utility” of water are very high every day. Try to answer another related question. Are pearls so expensive, because one has to dive deep into the sea to get them, or because one is willing to venture into the sea? In our view, both are reasonable and correct. You see, economics is not an exact science. If you think the answer is the first part, then it is the labor value theory that we are going to discuss. Its meaning is simple:

Why does a table sell for $100? Because in addition to the

material cost of $20, workers have to invest 7 hours (worth $70), and plus the seller wants a profit of $10. The main factor that determines the value of a table is the amount of labor input. If you work sloppy and complete it in 3 hours, then you can sell it only for $60; if you work carefully, you might need 10 hours to work on it, and so you sell it for $130. For most products in the 18th century, the amount of labor determined their price (value). Q:

Some of Picasso’s pictures only took 50 minutes, but the price (value) could be 500

times higher than the picture someone worked on over 50 hours. Value and labor input can be totally irrelevant, how can we explain this? A:

Yes, but that is a special case. For Smith (and many of us), in daily life, labor costs

are (the most) important component of our products. This concept was later used by Marx to develop the notion of exploitation:

workers spent 7 hours to produce a table that sold for

$70, but the boss only paid them $30. Laborers are therefore exploited.

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This theory is discussible, because not everyone is equally skilled. If you spend 20 hours to hunt a deer and your neighbor spend 5 hours to hunt a fox, the labor value theory implies that the value of deer is four times higher. Another hunter might catch a fox in 3 hours. Thus, the amount of labor input is not an ideal measure of value. Today we think value is determined by supply and demand:

the higher the demand is,

the higher the price will be; the greater the supply is, the cheaper it will be. Behind supply and demand is the price; behind the price is the utility of money:

a $10 Big Mac is cheap

for rich people, but expensive for poor people. Picasso’s paintings might have taken only 10 minutes, but the super rich (whose marginal utility of money is very low) believe that they deserve a value of $1 million. Q:

Smith has a famous dictum: “the division of labor is limited by the extent of the

market.” What does that mean in daily life? A:

There are still many discussions on it today. Simply put, why should we divide the

work? Recall the needle factory example:

after the division of labor, each worker can

produce 4,800 needles a day. The division of labor is required, because the needle market is very large. If the market demand is 20 needles per month at your home town, then why bother with division of labor? Market size determines the degree of division of labor (in scale and in scope, or in breadth and in depth). The computer market is global, selling hundreds of billion dollars a year. In such a large market, the division of labor must be global:

the mouse is made in China, DRAM (Dynamic

Random Access Memory) in South Korea, and assembly in Malaysia. This is quite obvious today, but its insight was offered by Smith in 1776. Smith was able to unite theoretical insights with policy implications and also knit various economic doctrines into a unified masterpiece in Wealth of Nations. This work built a systematic framework for political economy (what we call Economics today). Q:

The importance of capital is obvious, why this issue was discuss later in the book?

A:

Without capital, how can we buy equipment and hire workers to make the division

of labor effective? In 1776 the financial market was not yet sound, and capital was a rare

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asset. It was an important source of production, a source of capitalism, and an engine of growth. Of course, its importance is above the division of labor. Smith’s argument is clear: division of labor is important to promote production efficiency without increasing costs (capital and land). It is not enough to have capital; in Smith’s view, the division of labor is more important (which implies market size is big) than capital. Q:

I feel an important quality in the works of Smith. He was insightful on human

nature (Theory of Moral Sentiments), proposed relevant policies (Wealth of Nations), came equipped with a philosophical foundation (Scottish Enlightenment), and took into account the importance of a historical path. Is this kind of rare combination made him great? A:

Few people can do these four aspects at the same time. He insisted on burning

many manuscripts shortly before his death; otherwise, there would be many more of his works for us to study. Smith’s academic career was not always smooth. When Wealth of Nations was published, there were some negative comments at home and abroad. The following example is taken from James Boswell, The Life of Samuel Johnson, “Dr. Johnson on Adam Smith.” I mentioned Dr. Adam Smith’s book on the “Wealth of Nations” which was just published, and that Sir John Pringle had observed to me, that Dr. Smith, who had never been in trade, could not be expected to write well on that subject any more than a lawyer upon physick. JOHNSON. “He is mistaken, Sir; a man who has never been engaged in trade himself may undoubtedly write well upon trade, and there is nothing which requires more to be illustrated by philosophy than trade does. … A merchant seldom thinks but of his own particular trade. To write a good book upon it, a man must have extensive views. It is not necessary to have practised, to write well upon a subject. Q:

One has an impression that Smith opposed all kinds of intervention and favored

free market competition, but he supported the “Navigation Acts”, 10 which were not in favor of free trade. How can one explain his laissez-faire liberalism and these protective Acts? 10

The Navigation Acts, or more broadly The Acts of Trade and Navigation, were a long series of English laws that developed, promoted, and regulated English ships, shipping, trade, and commerce between other countries and with England’s own colonies. The laws also regulated England’s fisheries and restricted foreigners’ participation in its colonial trade. They were first enacted in 1651 and further developed and tightened by the Navigation Acts of 1663, 1673, and 1696. The Acts generally prohibited the use of foreign ships and required the employment of English and colonial mariners for three quarters of the crews, including East India Company ships. The acts prohibited the colonies from exporting specific, enumerated, products to countries and colonies other than those British and mandated that imports be sourced only through Britain. With the

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A:

Yes, these Acts violated the spirit of free trade. We now see better the basic

purpose of Smith - in search of Britain’s wealth and power, at the cost of ideal free competition. He opposed mercantilist interventions, because in the 18th century this policy was harmful. If he was born in the 16th century, he might have favored mercantilism, for that was an important way to help Tudor England to rise up and to defeat the Spanish Amanda (1588). Here is the key point:

economic liberalism is not a universal truth across time and

space. Its usefulness depends upon the conditions of the times. When the U.K. and U.S. were dominant, Smith’s liberalism was a favored doctrine. When Prussia was less developed, economic liberalism was not useful. As we shall see, Marxists (chapter 10) and Friedrich List (chapter 11) both have cursed Smith as a running dog of the capitalists.

development and gradual acceptance of free trade, the acts were eventually repealed in 1849 (based on a Wikipedia entry).

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6 Thomas Malthus and effectual demand

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment. ―Keynes, The General Theory, Chapter 3.

Two economists are introduced in this and the next chapters. They were personally good friends, but rivals in opinion and policy. Both had profound impacts, and we are still living under their shadow. Thomas Malthus (1766-1834) is known for An Essay on the Principle of Population (1798, Population). David Ricardo (1772-1823) is known for On the Principles of Political Economy and Taxation (1817). He is briefly mentioned here to contrast Malthus’ view. Everyone knows Malthus’ famous metaphor:

the growth of food is an arithmetic

progression (1, 2, 3, 4, 5, 6), but population growth is geometric (1, 2, 4, 8, 16, 32). Thus, population growth (numerator) will be much faster than food (denominator). An unavoidable result is that human beings cannot escape from poverty and starvation. We call this the Malthusian trap. Many parts of the world today are still the victims of this trap, living under the poverty line. That is what most economists know about Malthus, but it is a biased impression. Keynes was obliged to Malthus’s ideas on economic recession and policy, to whom Keynes wrote a

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readable biography reprinted in his Collected Writings, volume 10, pp. 71-108. In the opening paragraph, Keynes told us: Bacchus—when an Englishman is called Bacchus—derives from Bakehouse. Similarly the original form of the rare and curious name of Malthus was Malthouse. … On this test (Malthus, Mawtus, Malthous, Malthouse, Mauthus, Maltus, Maultous) there can be little doubt that Maultus, with the first vowel as in brewer’s malt and the h doubtfully sounded, is what we ought to say. His family had been in clerical work for generations before Thomas was born. His father Daniel was a famous gentry and had close contacts with intellectuals such as Rousseau (1712-78) in France and David Hume in Scotland. Having graduated from Jesus College, Cambridge in 1788, Malthus served in the church. He published the famous Population in 1798 when aged 32 (updated 1803). His Principles of Political Economy appeared in 1820, and a second edition posthumously came out in 1836. Q:

Population appeared 22 years after Wealth of Nations (1776). Why was Smith quite

optimistic, but Malthus pessimistic? Didn’t Malthus’s Population appear on the eve of the Industrial Revolution around 1800? Why was political economy a “dismal science”? A:

Dismal science is a derogatory term for political economy coined by the Victorian

historian Thomas Carlyle in 1849. It was in contrast to the then-familiar use of the phrase “gay science” that referred to song and verse writing. We shall answer your questions in a rough way.

Source: Gregory Clark (2007): A Farewell to Alms: A Brief Economic History of the World, p. 2 Figure 1.1.

British economic history scholars are now equipped with long-term real wage statistics (1200-2000) that confirm the U.K., since about 1800, has completely escaped from the

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Malthusian trap. As the above figure shows, the growth rate since 1800 rose spectacularly (nearly 80° upward), it could be the fastest-growing period in human history. If we look at the 1800-2000 period closely, every 5 years there have been several recessions with the worst one in 1795-1800. When Population appeared in 1798, it was a time when the British economy had fallen into poverty and unemployment. The government implemented the Poor Laws to help, but Malthus was against this policy, because he said that poor people will become more dependent. Recall that his family was religious. As humanity is certainly their main concern, Malthus was not against the Poor Laws, but rather their consequences. He was also against the repeal of the Corn Laws (high tariff to prevent foreign corn into U.K., thus making British food expensive). There were two rival camps:

one preferred to

repeal, the other was against. For those who said Yes, such as the manufacturers, the argument is simple:

If cheap foreign corn can be freely imported, there will be fewer poor

and famine problems, and the real purchasing power of workers will rise. For those who said No, such as landlords and nobles:

if we let cheap corn be freely imported, then the British

agriculture sector will be destroyed. If agriculture collapses, where the food will come from during wartimes? Malthus was not a landlord nor a nobleman. He defended the Corn Law for another reason:

the industrial and trade sectors were not important (in terms of GNP before 1800),

and the agriculture sector was the only source to accumulate capital. The repeal of Corn Laws would destroy the whole economy. However, David Ricardo was a eager defender of free trade and strongly tended to repeal the Corn Laws. Now it is easier to answer your question:

Why is political economy a “dismal

science”? Do you think political economy could solve these hard issues:

famine, poverty,

and the controversies over Poor Laws and Corn Laws? Q:

Malthus and Ricardo were good friends. What made their views so divergent?

A:

The above issues were disputed in the Parliament as well as throughout the whole

society. Stated differently, the key issue is another form of the protectionism vs. free trade

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debate. In 1813 the House of Commons recommended to ban foreign corn, unless the domestic price of wheat reached £4 per quarter (= 8 bushels = 291 liters). As an imprecise comparison, the purchasing power of £4 in 1813 was about £202 in 2010. Malthus considered this policy to be reasonable and necessary, but Ricardo believed that this protective policy has serious consequences. 1) The agriculture sector would become more and more inefficient, because farmers will cultivate more barren land due to tariff protection. In the extreme case, people will grow wheat in vases. 2) High corn prices mean higher wages and higher production costs. U.K. products are bound to lose their foreign markets. After fierce debates over many years, in January 1846 the Parliament decided that the Corn Laws would be repealed three years later (February 1, 1849). The tax rate for corn was to be gradually reduced over 1846-49. Only one shilling per quarter of wheat will be charged as tariff after February 1849. Malthus supported the Corn Laws not for self-interest. Ricardo was a stockbroker and earned a great fortune from that business. He was rich enough as a 27-year-old and developed a keen interest in the political economy. Ricardo possessed quite a lot of land and became a member of Parliament. He was against the Corn Laws, which were in fact against his own interests:

his farmland income would suffer great losses. If these two friends/rivals

disagreed with each other, then it was not from personal interests, but with a hope that the U.K. could have long-term prosperity. Their correspondence on various issues are now available, allowing us to understand more details about their different opinions. Shortly before Ricardo died in 1823, he wrote a final letter to Malthus:

“And now, my

dear Malthus, we have done. Like other disputants, after much discussion we each retain our own opinions. These discussions, however, never influence our friendship; I could not like you more than I do if you agreed in opinion with me. Pray give Mrs. Ricardo’s and my kind regards to Mrs. Malthus. Yours truly ...” Q:

Malthus said that population is “geometric” while food is “arithmetic”. How

could the U.K. escape from the Malthusian trap?

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A:

“Geometric and arithmetic” are just metaphors. The U.K. escaped from the

Malthusian trap after many struggles. From a food/population perspective, it simply happened, because agricultural production increased faster than population growth. Food increases are a technology issue to which not everyone can contribute. However, everyone can slow down population growth, such as marrying later or have fewer children; plus other factors like war, plague, famine, and natural disasters. How did the U.K. escape from the Malthusian trap after 1800? Frankly, it is not easy to reduce the population. It is better to focus on the growth side:

encourage free trade,

investment, and production. Ricardo held this view and was optimistic about the future. Historical evidence proves that he was right. Although the U.K. encountered some short-term depressions, the growth of capital and wages was not bad in the long run. This means the pessimistic Malthus was wrong. Ricardo said in his later years:

now that I am a grandfather, I understand that Malthus’s geometric

and arithmetic metaphors are wrong. Malthus was married at 38 and had three children, but no grandchildren. Ricardo was married at 21 and had eight children, with 25 grandchildren. If the reproduction rate of Ricardo’s family continued for two centuries, their offspring might have dominated England by now. Q:

In Malthus’s view what were the main causes of the 1795-1800 recession?

A:

The 1795-1800 recession that Malthus encountered was quite serious by 18th

century standards. He observed that workers and their wages, after basic living expenses, were unable to buy the products they produced. Unsold stock was a big problem. He thought that a cause of an economic crisis could be a lack of effective demand (desire to buy, but no money to buy over-produced goods), to which we now term as a market glut or underconsumption. This notion violates the basic understanding of the political economy at the time namely, Say’s Law:

“supply creates its own demand” - an important concept named after

the French economist Jean-Baptiste Say (1767-1832). For classical economists, each producer is well aware of who will buy their products and the total quantity of annual

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demand. Normally, there will be no excess supply (unsold stock). In other words, although there could be a short-term imbalance between supply and demand, in the long run, supply will equal demand. Say’s Law has one main feature:

the economy is basically in equilibrium, just like

Einstein once thought that the universe is static (not expanding). We now know the economy is in disequilibrium on most occasions, due to Keynes (to which Keynes was grateful to Malthus). We now know the universe is expanding, due to the discovery of the “red shift” by Edwin Hubble (1899-1953) in 1924, but the science community strongly resisted this new idea. Hubble struggled to publish the finding five years later. The basic idea of Say’s Law is not really new, as it was already discussed in Wealth of Nations, although without this name. It became well-known in the 20th century mainly due to Keynes’ General Theory (chapter 2 section VI):

“From the time of Say and Ricardo the

classical economists have taught that supply creates its own demand....” No matter who said it first, the classical economists basically agreed that, overall, the economic system can automatically restore to equilibrium. How could classical economists be so naïve? Didn’t they understand that imbalance is the norm and equilibrium is abnormal? Centuries later people also consider this elementary. Don’t blame an epoch. Keynes was grateful to Malthus, to whom he wrote a readable biography reprinted in his Collected Writings, volume 10, pp. 71-108. It has two parts:

1) “The first of the Cambridge

economist” (pp. 71-103). The first two sentences of a long Editor’s Note read:

“The earliest

version of this essay survives among Keynes’ papers dated from 1922. He read it on various occasions to the Political Economy Club at Cambridge (the undergraduate paper-reading club which for many years met in his room on Monday nights in term time).” 2) “Robert Malthus: centenary allocution” (pp. 104-8), written for the Economic Journal, June 1935. To our knowledge, Malthus is the only economist that Keynes wrote twice, once before the 1929 Great Depression and once after. We quote one sentence:

“So Malthus’ name has

been immortalized by his Principle of Population, and the brilliant intuitions of his more farreaching Principle of Effective Demand have been forgotten.” (p. 107)

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Q:

Does Malthus’ effectual demand mean something unusual?

A:

This idea appeared in the second part of Principles of Political Economy (1820). He

used another term “general gluts” (over-stock), which is a synonym for “ineffectual demand”: workers’ income is not enough to buy the goods produced. Malthus believed that an effective way is to encourage non-productive consumption (buy luxury goods or hire extra servants by noble landlords). The basic idea is that the rich class spends more to stimulate consumption, thus encouraging production, which eventually may help the economy. How can one encourage the leisure class to spend more? That is why we need to protect their income by the Corn Laws, because landlord/noble is the only class that can accumulate capital, invest in industry, and hire workers. Another way to eliminate excess supply is to engage in foreign wars, which can stimulate industries and reduce unemployment. A second way is the government expands spending and does public construction (bridges, roads, schools). This idea inspired Keynes’s General Theory and helped the U.S. economy to recover from the 1929 crisis. A third way is the State spends money on the unemployed and/or increases salary levels to stimulate consumption. Keynes once suggested jokingly that the government hire a group of unemployed, each one with a shovel and £50. They are free to choose a place to hide the money. Next, hire another group of unemployed, also with a shovel, to find the buried money for themselves. This will solve the problems of unemployment and income. Malthus’s notion of “general gluts” (underconsumption) gained popularity one century later. It is a good counter-example of the “wrong idea of dead men”. Malthus never dreamed that his “dismal science” (1820) would be revived one day, incarnated in General Theory (1936). Q:

I am curious about the Malthusian trap. How terrible was it, and how to escape

from it? A:

Nowadays about 10% of humanity is living under the international poverty line. As

the cost of living varies, the global poverty line has to be updated periodically. In October

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2015, it was US$1.90 per day, using 2011 prices. Over 700 million in 2015 were living in extreme poverty. The Malthusian trap was a big issue in history and is still so today. To have a deeper understanding about the Trap, take a good look at Gregory Clark (2007): A Farewell to Alms: A Brief Economic History of the World. It explains this Trap in theory with historical evidence (world scale):

Chapters 1, 2, 3, 10, 12, and 13 are

recommended for reading. Robert Allen, then-Professor of economic history at Oxford University, strongly disagreed with Clark (2007). Allen wrote a long review with six penetrating counterarguments (Journal of Economic Literature, 2008, 46:946-73). Both Clark and Allen are worthy reads and could answer your question better than we can offer. Q:

Using today’s standard, Malthus’s geometric and arithmetic metaphors seem

wrong. Almost inversely, food production is now geometric, as millions of tons of food are wasted in many areas, while population growth has decreased due to modern technology and medical science. Despite the fact that 10% of humanity are living under the poverty line, intellectually speaking, is this Trap still a valid notion? A:

Philosophically speaking, this notion is a kind of “apocalyptic fallacy”. During the

economic crisis of 1795-1800, Malthus was pessimistic with the geometric and arithmetic analogies. He used limited data of a very short time-span to predict a remote result (human misery). His pessimistic view was in stark contrast to his best friend/rival Ricardo. Decades later, the British Industrial Revolution also proved that Ricardo was right. Based on another crisis of the 1840s (The Hungry ’40s), Marx and Engels wrote The Communist Manifesto (1848). They also made a similar apocalyptic fallacy, predicting that human society will evolve eventually into communism. The Victorian boom of the 1850-60s soon denied their prophecy. Communism came to the stage only after the 1917 Russian Revolution. See George Boyer (1998):

“The historical background of the Communist

Manifesto”, Journal of Economic Perspectives, 12(4):151-74 for an insightful analysis. This kind of prophecy does not have a sound theoretical basis. They jumped to a very far conclusion based on insufficient facts; hence, one is usually wrong. Malthus could not imagine that our modern world experience such a fast technological progress. Malthus’s

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contribution is inspirational, but lacks an analytical foundation. As a stark contrast, Ricardo’s analysis and policy are much more solid and still influential today, which will be detailed in the next chapter. Steven Kates is an expert on Say’s Law, writing a Letter to the editors:

“Say’s Law: its

origins and meaning”, Journal of the History of Economic Thought, 2019, 41(1):123-8. As he told us:

“The parent stem for Keynes’ views on Say’s Law is Malthus and not Say. … But

while that is Say’s loi des débouchés, it is not what Keynes (or F. M. Taylor) had meant by what they referred to as ‘Say’s Law.’” (p. 125). Below is a letter from Keynes (August 1933) that Kates reproduced (2019 p. 128). We focus our attention on the second paragraph. 11 In the matter of Malthus, you will perhaps have seen from my account of him in my lately published “Essays in Biography”, which appeared before your book was out, but after I think you had written it, that I wholly agree with you in regarding him as a much under-estimated pioneer in the line of thought which to-day seems to me by far the most likely to lead to progress in the analysis of the business cycle. Your contrast between Ricardo and Malthus contains, I am convinced, the essence of the matter.

Source:

Box 1, Folder 33 of the Harlan Linneus McCracken Papers. Harlan Linneus McCracken Papers, Mss.

2569, Louisiana and Lower Mississippi Valley Collections, LSU Libraries, Baton Rouge, LA. Reproduced from Steven Kates:

“Say’s Law: its origins and meaning”, Journal of the History of Economic Thought, 2019, 41(1):128. (???Courtesy of Steven Kates???: [email protected].)

11

For a detailed analysis, see Kates “A Letter from Keynes to Harlan McCracken Dated 31st August 1933: Why the Standard Story on the Origins of the General Theory Needs to Be Rewritten”, History of Economics Review, 2008, 47:20-38.

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7 David Ricardo and differential rent

Rent is that portion of the produce of the earth which is paid to the landlord for the use of the original and indestructible powers of the soil. ―David Ricardo The Principles of Political Economy and Taxation Chapter II “On Rent”

David Ricardo (1772-1823) was born in London, the third of 17 children of a Sephardic Jewish family of Portuguese origin who had recently relocated from the Dutch Republic. His father, Abraham, was a successful stockbroker. David began working with his father at the age of 14. At age 21, he eloped with a Quaker, Priscilla Wilkinson, and converted to the Unitarian faith. His father disowned him, and his mother never spoke to him again. With the help of friends, he operated independently as a stockbroker. At the age of 51 he passed away with a fortune that exceeded US$100 million in current value, of which two-thirds were in real estate. Historically speaking, Ricardo was the first important economist who also made a great fortune, the second one being Keynes. Ricardo became interested in the political economy after he was rich and not the other around:

economics did not help him to be rich.

Q:

What did he do after getting rich, or how did he manage his fortune?

A:

At age 27 he read Wealth of Nations and developed a great interest in the political

economy and policies. He became a member of Parliament and actively engaged in policy

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debates. The Royal Economic Society commissioned Piero Sraffa to edit The Works and Correspondence of David Ricardo (10 volumes plus an Index volume, 1951-73), which include, among many other texts, his major work On the Principles of Political Economy and Taxation (1817) and his long-term correspondence with Thomas Malthus.

The Works and Correspondence of David Ricardo, 11 vols. (Sraffa ed., 1951-73)

Mark Blaug wrote his Ph.D. thesis on Ricardo (1955) under the supervision of George Stigler, parts of which appeared as “The Empirical Content of Ricardian Economics, Journal of Political Economy, 1956, 64:41-58. In the conclusion (p. 58) Blaug said that Ricardian analysis as “a macro-economic theory had all the advantages of what Keynes called ‘a complex of suitabilities in the doctrine to the environment into which it was projected.’ On this level of analysis, Ricardo had no competitors.” Ricardo had a kind of abstract talent in analysis, which was impressive in the past and today. From the perspective of modern analysis, Ricardo is the originator of theoretical construction. Under space constraint, we can only discuss one of his unusual theories: differential rent. Why is this strange theory? It can be used to do deductive analysis in two key aspects:

income distribution among classes and the dynamics of economic growth.

In terms of national policies, Ricardo championed the abolition of the Corn Laws and was in favor of free trade (zero tariff). Both directions are in accordance with Smith’s antimercantilism and economic liberalism. The first similarity between Smith and Ricardo is both thought deregulation and minimum government were necessary and useful for the U.K. A

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second similarity is their style of analysis:

both used plain English to analyze with some

basic statistical data and used no diagrams and no equations, but one still can feel their logic power. They have one main difference in methodology:

Smith was more inductive oriented -

that is, based on historical experience and contemporary observations to distill his economic principles and policies. Ricardo did the same, but he was more deductive oriented - he went deeper into the basic principles, such as the differential rent theory, and then used the basic theory to deduct a series of policies, such as free trade and Corn Laws. In other words, Ricardo’s polices are based on his own theoretical foundations, and so quite often he had to invent key ideas. Smith was knowledgeable, and his arguments are easier to understand for most readers. Ricardo was much more analytical, which is a style that attract scientific minds. Despite the difference, both are profoundly influential today. In terms of personality, Ricardo was a principled man, often recommending policies that were against his own interests. He only lived 51 years, was not a professional researcher, and had writing difficulties (for unknown reasons), but he managed to write 10 volumes of Works and Correspondence. Q:

“Differential rent”, what does that mean? Not the same as the rent paid by farmers?

A:

This is Ricardo’s original concept, and the basic idea is simple:

Why are the rents

of all lands not the same? Because their productivity is different. Grade A land produces 9 tons of wheat per year, and Grade B land does 7 tons; so, the rent of A land is 2 tons, and the rent of B land is zero. This is a strange statement. We are used to thinking rent is determined by mutual agreement or by supply and demand and not by differences in productivity. Now, consider which case is more reasonable. Case A:

As stated above, the productivity difference between Grade A land and Grade

B land is 2 tons, and so the 2 tons is the rent, which is not decided by demand and supply, nor by negotiation, but by their productivity.

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Case B:

Conventionally, rent is decided by the condition of supply and demand.

Suppose that we agree to pay 2 tons as rent, but unexpectedly there is a natural disaster that destroyed the whole crop. I still need to pay 2 tons even though the output is zero. Stated differently, Case A favors the farmer; Case B favors the landlord. We opt for Case A, but Case B is our social normal. Since most contracts are signed beforehand, Case B is easier to work with (i.e. with lower transaction cost), which is why this form prevails. Q:

OK, but how does one use Case A to do economic analysis?

A:

Ricardo puts forward an important argument based on this principle:

since food

prices become high under tariff protection of the Corn Laws, farmers want to cultivate Grade A land, because that will generate higher income (productivity). The next question is:

How

is the rent of Grade A land determined? It is determined by the “difference in productivity” between Grade A and Grade B lands. Under tariff protection, the price of British wheat could be twice higher that of Prussia, which creates several possibilities as follows. 1) Grade D, E , and F lands will be cultivated, because this is also cost-effective, but it means that the Corn Laws also caused inefficient use of resources (land and labor). If the price of wheat continues to go up and the population continues to increase, but grain imports are not freely open, then what will happen? One day, even Grade X, Y, and Z lands will be sorted, irrigated, and fertilized to grow wheat; in the extreme case, even vases will be used to grow wheat. 2) As a result, the rent of Grade A land will be unreasonably high, because the level of rent is determined by wheat prices. We take the academic jargon, “rent is corn pricedetermined”, which means high-priced grain causes higher rent. We would guess you agree with this logic. 3) The ideas discussed above are not the same as when you pay rent for a street shop: you pay $1,000 more rent every month, because its location and equipment are much better. People compete to rent this shop, because every cup of coffee here can sell for $1 dollar more, which could generate $3,000 more monthly income. In this case, higher rent causes higher coffee prices, and the shop rent is “price-determining.”

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Q:

Isn’t this the same thing? The shop owner and I both know its value, and so we

agree to pay $1,000 more. It works as a simple supply/demand. Why bother to be so complicated? A:

You are right. The rent in daily life is determined by supply/demand, but also by

the difference in productivity. Since productivity is hard to measure, the law of supply and demand wins. However, supply/demand cannot solve every problem; it helps at the microlevel (buy/sell), but not at the macro-level (such as income distribution). That is why we need Ricardo and his differential rent. Actually, he had various purposes in mind. First, to warn those who are in favor of the Corn Laws:

tariff protection will make

U.K. wheat prices abnormal; land rent is also unusually high, and the consequence is resource distortion and inefficiency (to cultivate Grade X, Y, and Z lands). Second, the ideas of “price-determined” and “price-determining” are now clear. This is to show that “high grain prices will lead to high rents”; not “high rents will make grain prices high.” The original sin is not the landlord; it is the tariff. Third, another more important purpose is to use the notion of differential rent to explain how national income is distributed among landlords, capitalists, and workers. We begin with the “income share of workers” (wage share). In the 17th-18th centuries, when workers’ income increased, it usually led to more children, and then the average living standard worsened. In the long term, real wages on average can only maintain the basic life of a family, and so the classical economist called it the “iron law of wages.” Assuming that the iron law of wages was £20 per year in 1810, and there were 1 million workers in U.K., the “wage share” was thus £20 million (grosso modo). The real trouble is the next question:

While wage share is known and deducted from

GNP, how is the rest distributed between landlords (rent share) and capitalists (profit share)? Do you want to do a national survey for the statistics of total rent income? No, because few respondents will be honest. Ricardo invented a wonderful way, not precise, but to quickly get an approximate answer - the secret lies in the notion “differential rent.”

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Suppose the “difference in productivity” of each acre between Grade A and B lands is 2 tons. You also know there are some 30,000 acres of Grade A land in the U.K.; so, you can estimate the total rental income to Grade A land is about 60,000 tons. By the same token, suppose that the productivity difference between Grade B and C lands is also 2 tons, and the total acreage is 40,000; then the total rental income for Grade B would be 80,000 tons. The same procedure continues until Grade Y and Z lands are calculated. By definition, rent income for Grade Z is zero, because there is no worse land to compare their differential productivity. Adding up total rent income from A to Z, one can quickly estimate the total rent share of the U.K. You might ask:

How accurate is Ricardo’s method? Well, even if you do the field

survey of every landowner, the answer could be worse. If so, whatever result Ricardo estimated at his desk for an evening could be better than you spending a year doing field work across the whole country. Ricardo’s purpose was not to be precise in statistics, but to know how income is shared among classes. If this method can generate pictures for 30 years, then policy makers know better what to do:

if a higher and higher proportion of national income went to land owners

(rent share), that would worsen the tension among classes. Suppose there are three classes in the U.K., and that wage share cannot be compressed (otherwise, there will be revolts). When the landlord enjoys more rent share, the less money there is to be used for industry and commerce. How can the national economy grow then? How could the Industrial Revolution be so successful? The long-term destiny of the U.K. could be ruined by the Corn Laws. You see, Ricardo’s differential rent theory is useful in theory and in policy. Q:

Your messages need time to digest. Could you sort out the basic points?

A:

In the era of Ricardo, the signs of the Industrial Revolution were not yet obvious.

The economy before the mid-19th century had several characteristics. 1) Workers only struggled at the edge of survival. 2) Tariff protection caused the marginal productivity of agriculture to decline. 3) The business community had limited capital funds to invest, and so

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industrial productivity was not easy to make a breakthrough. With these three constraints, the U.K. economy would soon reach a stationary state or even see negative growth. A simple way to break the dilemma of 1), 2), and 3) once for all is to repeal the Corn Laws:

workers can buy cheap food and have more children; thus, more labor supply. The

industries can reduce wage and production costs due to cheaper food prices; thus, hire more workers. Land owners are no longer too rich, and so the structure of income inequality improves, thus reducing social conflicts. Q:

How can such a small notion be the basis of so many policies?

A: Milton Friedman had a well-known argument for economic analysis:

It is not

essential that the “assumption” of a theory is true or not; what matters is to infer meaningful predictions based on these (virtual) assumptions. We provide an example of astronomical history. In the Middle Ages people believed that “the Earth is the center of the universe”. This view was gradually replaced by “the Sun is the center of the solar system”, and so astronomers needed to explain the complicated orbits of the solar system. They learned from observation that these orbits are not perfect circles, but since most people are used to visualizing relationship with circles, it became convenient to use circles to explain their relative position. Here is a representative model.

Heliocentric model from Copernicus’ De revolutionibus orbium coelestium (1543) Source:

“Copernican heliocentrism”, Wikipedia.

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We now know these circles are inaccurate, but still use them for popular science. This type of explanation is called a “heuristic model”:

inaccurate, but easy to use and explain.

Ricardo’s differential rent belongs to this kind of heuristic model:

abstract and unreal, but it

is a convenient apparatus to reach non-trivial conclusions, both in theory and in policy. Another example can explain the same idea. Most children have once asked their mothers:

Where did I come from? The answer is almost the same over the centuries: “my

belly”. Of course, the answer is incorrect, but how would you answer this to your 3-year-old kid? So people continued to use the same wrong answer: a mother’s belly. In a sense, the “heuristic model” and “belly model” have three common features: 1) the answer is incorrect; 2) everyone understands; 3) continue to use this wrong but easy answer. Q:

In the 1810s Ricardo was so clever to invent the notion of differential rent. Based

on this micro-idea one can infer compelling conclusions on macro-issues such as income distribution, class conflicts, and economic growth. That is surprisingly beyond my imagination, but was he right in the final analysis? A:

Ricardo was an amazing amateur scholar, if you read his Complete Works, the

untrained eyes may not be able to see so much ingenuity. The theory analyzed above is the result of rational reconstruction by modern scholars. Of course, Ricardo also has his limitations. For example, he believed that when capitalists began to use machinery, that it would crowd out employment. He failed to foresee the “increasing returns” by machinery: lower costs and newer markets, which in turn would create new jobs. For modern eyes, another shortcoming is that technological progress played no role in his model. That is because the era of great invention had not yet arrived. By the same token, he also implicitly assumed that unemployed workers can only be unemployed, with little opportunity to change jobs or start a business. Q:

Ricardo also made a major contribution to international trade theory, but why so

important? A:

Here, we would like to focus on a term often misunderstood:

the comparative

advantage. Let us say the cost of producing a TV set in country A is $100, and the cost of

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growing bananas is $10; while in country B the cost of producing a TV set is $150, and the cost of growing bananas is $5. Country A will then produce only TVs, and country B will only grow bananas. This is common sense. Is it a “comparative advantage”? No, this is “absolute advantage”. Ricardo’s comparative advantage means another thing. Country A has some other advantages than country B:

in addition to television, it has cars, machinery, and other

industrial products. Country B also has other advantages:

bananas, rice, vegetables, etc. are

all good and cheap. If each country wants to maximize trade gains, then each needs to choose “one product” to specialize, which has the most cost and resource advantages. Theoretically, it would be best if both countries exchange only with each other’s most advantaged product: country A produces only TV sets, and country B only bananas. Of course, in the real world no country only produces a single product. Comparative advantage is conceptual:

when a country has several products that enjoy

absolute advantages (all cheaper than other countries), then in order to realize the best trade gains, this country must specialize in one single product that is more advantageous than others. This idea was proposed by Ricardo and is still useful today as a basic of trade theory. Q:

I read a concept in public finance called the “Ricardian equivalence theorem”. How

original is this theorem? A: Its basic meaning is simple:

during the Napoleonic Wars (1803-15), the U.K. had

to raise money for warfare. Which method is better? 1) Increasing taxes has an advantage that the government does not need to repay anything in the future, but taxpayers will complain. 2) Issue government bonds to borrow money and pay interest on them. The advantage is not to burden taxpayers, but the government has to pay back a specific amount in the future. The Ricardian theorem states from a purely economic point of view that there is no real difference between both methods. This question is a bit like this. If you plan to give a monkey seven bananas per day, you need to consider if it wants “three bananas in the morning and four in the evening” or “four

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bananas in the morning and three in the evening?” Ricardo says that since the sum is seven per day, both are mathematically identical. Is that truly so? If you were a British citizen, do you prefer to pay more taxes or let the government issue national bonds? We are not good on this issue, but it seems to be highly debatable. Ricardian equivalence is not necessarily true in every country. Our intuition is that people’s preferences toward tax and bonds are different. The equivalence theorem is an empirical problem. 12 As an aside, the “equivalence theorem” was proposed by Harvard economist Robert Barro in the 1970s, but did not take Ricardo’s own term. Q:

Let me come back to the Corn Laws. From the perspective of daily life, what

trouble did the Corn Laws cause? A:

A few statistics may explain the trouble and why they should be removed. The

price of wheat in 1770-9 was about 45 shillings per quarter (= 8 bushels = 291 liters); it was about 55 shillings in 1790-9, 82 shillings in 1800-9, and 106 shillings in 1810-3; the peak was 177 shillings in 1801. There were three reasons why wheat prices were so high. 1) In the 16th-18th centuries England had accumulated a large amount of foreign reserves that led to a general high price level. 2) Tariffs on corn were too high, resulting in excessive food prices. 3) The embargo during the Napoleonic Wars and the fear of a lack of food during the war also pushed up food prices. Q:

In General Theory Keynes praised Malthus’s ineffectual demand (or market gluts).

I am curious about Keynes’ view on Ricardian analysis, could you elaborate a bit? A: Let us offer our own view and compare it with Keynes’s perspective, so that you can make your own judgment. We think Malthus’s contribution was inspirational and conceptual; his ideas were intuitive, but not analytical. His analytical ability is far behind Ricardo. This is a consensus of many academics. When Keynes wrote General Theory in the 1930s, he had a

12

See Alfred Haug (2020): “Testing Ricardian equivalence with the narrative record on tax changes”, Oxford

Bulletin of Economics and Statistics, (https://doi.org/10.1111/obes.12339): “For the [US] post‐1982:IV period, fiscal anticipation plays an important role as many of the tax increases are implemented with substantial delays. Anticipated tax hikes increase economic activity in the delay period. Ricardian equivalence is rejected.” (Abstract)

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specific purpose in mind:

to save the world from the Great Depression. In this sense,

Ricardo’s abstract, deductive style was meaningless. Keynes also understood that before the mid-19th century, Ricardo’s analysis dominated the academic world, and that Malthus’s population theory and effectual demand doctrine were totally ignored. In the 1930s, the pendulum swung back again, Keynes said that “the complete domination of Ricardo’s approach for a period of 100 years has been a disaster to the progress of economics. … If Malthus, instead of Ricardo, had been the parent stem from which 19th-century economics proceeded, what a much wiser and richer place the world would be to-day!” Most economists today would have disagreed. If Malthus’s economics dominated since the 19th century, then there would be a totally different landscape for the history of economic analysis and certainly less analytical. Keynes had something more to say, and most economists today would agree with it: The idea that we can safely neglect the aggregate demand function is fundamental to the Ricardian economics, which underlie what we have been taught for more than a century. Malthus, indeed, had vehemently opposed Ricardo’s doctrine that it was impossible for effective demand to be deficient; but vainly. For, since Malthus was unable to explain clearly (apart from an appeal to the facts of common observation) how and why effective demand could be deficient or excessive, he failed to furnish an alternative construction; and Ricardo conquered England as completely as the Holy Inquisition conquered Spain. Not only was his theory accepted by the city, by statesmen and by the academic world. (General Theory, the first two paragraphs of Section 3, Chapter 3)

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8 John Stuart Mill and the peak time of the classic school

It is better to be a human being dissatisfied than a pig satisfied; better to be Socrates dissatisfied than a fool satisfied. And if the fool, or the pig, is of a different opinion, it is only because they only know their own side of the question. ―John Stuart Mill, Utilitarianism

For readers in the 1900s China, John Stuart Mill (1806-73) was a well-known name, because the famous Yan Fu (1854-1921) translated his two books in 1903: On Liberty, 1859; A System of Logic, 1843. Mill’s father, James (1773-1836), also was a political economist and closely related to Jeremy Bentham (1748-1832, a famous philosopher, also known for his utility analysis). Mill was educated at home, read Greek when 3-years-old, Latin at 8, logic at 12, Ricardo’s economics at 13, and completed his adult education at 14. In his autobiography, he confessed that he was 25 years older than his cohort, but he was quite isolated from social life on the way to becoming an adult. Before the age of 20, he had edited five volumes of Bentham’s complete works, at the cost of a mental breakdown. He was a kind of Frankenstein in social sciences. Q: Classical economics was at its peak in Mill’s time. What he could he possibly add? A:

By the time of Mill the wave of political economy began to diverge, first turning to

socialism, Marxism, and later the neoclassical school. The classical school did not really end,

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because there is now a famous new classical school, which we shall explain briefly. As you know, Wealth of Nations (1776) is considered to be the birth of the classical school, and the central idea behind it is that the market has an ability to be self-correcting. Thus, it is an efficient mechanism for allocating resources. Problems arose during the 1973-75 recession due to the global oil crisis. Keynesian policies were unable to reduce unemployment, instead leading to stagflation:

high inflation

plus stagnant growth. The New Classical school emerged in the 1970s to explain this puzzle. In particular, Robert Lucas offered a critique that cast doubt on the Keynesian model. The macro-models developed by Lucas and colleagues are based on microeconomic foundations, this New Classical school became dominant in modern macroeconomics until today. Now back to your question. Why was Mill’s Principals of Political Economy (1848, written in 2 years, with 7 revised editions) arrive at the peak of the classical school? One main reason is that Mill inherited the main spirits of Ricardian economics, and based on this he added a new view on trade theory and supply/demand analysis. Moreover, Mill added something important that was lacking in Smith and Ricardo. Mill introduced the progress of technology into his economic growth framework, showing why the Malthusian trap is not a big worry. He developed new issues and ideas, such as the problem of income inequality. Criticizing the drawbacks of capitalism and showing that Smith’s invisible hand does not warrant social harmony, he thought that members of society should cooperate with each other, and he was more inclined to socialism. He refuted the law of diminishing returns, because the U.K. was already undergoing the Industrial Revolution. In short, Mill’s era was quite different from that of Smith and Ricardo, and the classical school needed to be revised substantially. Mill and the neoclassical school that emerged later on in the 1870s, on the other hand, also diverged in several respects. The neoclassical school extensively uses the concept “marginal” with new tools such as calculus and expresses the working mechanism in diagrams. More importantly, it has shifted from the basic orientation of the classical school (macro-policy, money, trade, price, and population), to micro-issues such as consumption,

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utility, industry, competition, and welfare. Mill was at the intersection of the classical and neoclassical schools. Another key feature at his time was the rise of socialism and Marxism, which will be discussed in the next two chapters. Q:

How innovative was Mill’s academic orientation and analytical method?

A:

He grew up in an intellectual family of the upper class. Some people with that

background are sympathetic with the unfortunate people, and so it is not surprising that Mill had a tendency toward socialism. In terms of analysis style, he had affinity with Ricardo’s deductive method:

using rigorous inner logic to deduct in order to reach feasible policies.

The reason is simple:

we cannot better understand the complexity of social and

economic issues simply with the naked eye and subjective intuition. Non-trivial (nononsense) conclusions can be reached through deductive logic tools such as diagrams and mathematics. The conclusions of these purely logical forms of reasoning, in turn, are subject to the test of empirical data. This methodology is still influential today in learned journals. We shall get back to Mill’s methodology later on. Three masterpieces of the classical school are Smith’s Wealth of Nations (1776), Ricardo’s On The Principles of Political Economy, and Taxation (1817), and Mill’s Principles of Political Economy (1848). Mill’s Principles dominated political economy for half a century, until replaced by Principles of Economics (1890) of Alfred Marshall (18421924). Why was Mill’s Principles so popular? In practice, he dealt with issues at that time that readers were concerned about; in theory, he made some important advances, and Mill was able to connect both aspects closely. Q:

Can you offer an example to show Mill’s theoretical development?

A:

Yes. The simple supply/demand curve that you are familiar with from basic

economics (see the figure below), in which the vertical axis denotes price, and the horizontal axis denotes quantity. The demand curve with a negative slope (as the price moves higher, demand turns lower), and there is a supply curve with a positive slope (under higher prices, supply increases).

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The intersection of the supply/demand curve looks like a cross. It is also called “Marshall’s Cross”, because we have been influenced by his usage of it in his famous Principles. In fact, the first person to draw the cross was Fleeming Jenkin (1833-85), a professor of engineering at the University of Edinburgh, who published this diagram in a 1870 paper title, “On the Graphic Representation of the Laws of Supply and Demand, and their Application to Labour.” Based on Jenkin’s cross, Mill further advanced a concept of “joint product”:

a product

that results jointly with other products from processing a common input. Example:

in the

processing of crude oil, we also get naphtha, gasoline, jet fuel, diesel, heavy fuel oil, kerosene, and asphalt, as well as other petrochemical derivatives. This chain of production is too complicated for a simple supply/demand cross, because each individual product has its own cost and separate market. A simple diagram analysis cannot manifest its complexity. Below is a one such diagram that needs no further explanation:

beef and leather (one

animal, two products, two markets).

The applications of Mill’s joint product is useful in the real world: charge for excess baggage? (note:

how does an airline

passenger and baggage are joint product). How should

the pollution made by city bus be charged? The problem is how to find an equilibrium for the joint product, when N > 3 (more than 3 products), because, as the case of the processing of crude oil shows, each individual product has its own market; moreover, its supplies and prices are highly interrelated. Q:

Did Mill also advance Ricardo’s trade theory?

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A:

Ricardo’s comparative advantage is a cornerstone of trade theory. Mill asked a

Malthusian question:

even if the cost of pork is $0.1 per kilogram in country A, but there is

no effectual demand in the Middle East area, then the cost (comparative advantage) alone does not explain everything in foreign trade. The real important thing is effective demand. If the demand is strong, such as for iPhone/iPad, then the product sells well regardless of its real cost. Cost is a (major) factor for trade, but cost alone is not sufficient for a generalized theory. Mill proposed another solution:

mutual elasticity of demand. If a product of country A

is highly demanded by country B (i.e. the elasticity of demand is less than 1), then there will be trade either with or without a comparative advantage. If a product of Country A is not highly demanded (i.e. elasticity is greater than 1), then trade will not take place. In brief, mutual demand elasticity is a more powerful notion than comparative advantage (cost side only). To be fair to Ricardo, the idea of elasticity was not yet mature in his time; Mill enjoyed the advantage of scientific progress. Q:

How did Mill offer new insights into the methodology of economics?

A:

Economic methodology or philosophy of economics is now a separate field, with

two professional journals:

Economics and Philosophy and Journal of Economic

Methodology. There are quite a few collections of representative works in this field, and you certainly will find the name Mill everywhere. For Mill, the main purpose of methodology is to explore the nature and analytical methods of economics. For example, why is economics not an exact science? Because its predictive ability is low, and it lacks universal laws applicable at anytime and anywhere. How to improve this? Mill suggested to use both inductive methods (from many specific facts to reach common features and principles) and deductive methods (logical and abstract reasoning), with an ultimate goal of finding physics-like laws. Today we believe that economics is not physics and need not be. We can learn skills from physics, but not to pursue the same goal. Mill understood this point very early on:

one

is unlikely to grasp the essence of the problem by merely observing specific facts. Theoretical

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deduction needs to be used to gain insights that are not visible to the naked eye. More importantly, let the facts and theories test each other. This is a simplified version, and economic philosophers have deeper insights to tell. Currently, the status of economic methodology is more humble than the history of ideas, but it is a growing field. Q:

Mill was quite frank in Autobiography (1873). Although his mental state is not

ideal, he was strongly concerned with social welfare. Why and how he had this inclination? A:

Yes, he was a gentleman and mild in many respects. Although he lived in an

atmosphere of classical liberalism, he was in favor of a stronger government and supported socialism. For this orientation, Mill greatly diverged from Smith and Ricardo. Smith’s enemy was mercantilism, and so he preferred minimum government. However, in Mill’s time, capitalism had enhanced serious problems:

social injustice, unequal distribution of

income, class conflicts, etc. Mill and his contemporaries thought that was caused by the invisible hands mentality. They expected that government should be more active - to use “visible feet” to deal with social chaos. In Mill’s view, the utility between people is not comparable; your food could be my poison, so to speak. Mill agreed with the idea of Bentham:

the greatest happiness of the

greatest number is the foundation of morals and legislation. Mill opposed the Marxian theory of class struggle and was in favor of moderate reform. Some said that Mill’s position is the rightist in the left side, or the leftist in the right side, because he inherited the classical liberalism, but opposed the idea of minimum State. Laissezfaire sounds attractive, but will attract many demons. A promising government needs to rule out obstacles such as gangsters and corruption; it is unlikely that society can be automatically harmonious, as it requires public power to reinforce it. Mill preferred high taxes for the rich, high taxes on rent and bequest, and for these incomes to be used for national education. Mill said that if he had to choose between communism and an unhealthy society, he would opt for communism; but between a private property system and communism, he would rather choose an improved private property system. He opposed Marx’s claim that private property is the root of all evil and believed that competition has its own right and not the root

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of social chaos. Mill opposed central planning and opposed equality à la communism: equal pay for everyone, without counting the difference of ability, because different rewards for people with different talents would encourage creativity and willingness to work. Q:

Ricardo was a practical economist. As a member of Parliament he engaged deeply

in the financial world and political debates, and so his approach was a combination of abstract deduction with policy implication in mind. While Mill was a typical intellectual, his world views and methodology of analysis must have been very different from Ricardo. Could you contrast them a bit? A:

Ricardo was an engaged political economist, while Mill was more of an armchair

philosopher-economist. Ricardo focused less on historical and institutional aspects, like Wealth of Nations did. In Mill’s view, the economy is only an aspect of social phenomena, and that is why historical facts (past experiences) and customs (social rules) matter a lot. When facing the real complex world, Ricardo’s deductive approach and his economic laws would be impractical. From this viewpoint, Mill was closer to Smith. Q: Before leaving the classical school, in retrospect, what were its overall contributions? A:

The most significant contribution is to complete a system of discourse. Example:

Wealth of Nations began with a basic micro-view on the division of labor and went all the way to the macro-view on the mechanism of economic growth. This approach is still quite appealing nowadays. The classical school had key masters such as Smith, Ricardo, and Mill, and each had constructed an expandable framework. Other economists added a lot of rooms and walls within or around this structure; and more scholars added bricks and many other things. The classical school itself was a fruitful achievement - something similar to the classical physics represented by Copernicus, Galilei, and Newton. As to the achievements of the classical school as a whole, we have six points to make. 1) Theory of labor value:

labor is the main cost that determines the relative price of products.

2) Neutrality of money:

money is a veil; an increase in money supply will only change the

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price level and not real purchasing power nor national wealth. 3) The ratio of labor to capital (L/K ratio) is fixed:

in an era when technological innovation was not obvious, this ratio is

not easy to change within a short period. 4) Marginal return of the agricultural sector is declining, and profits in the industrial sector are roughly fixed. It was not until the mid-19th century that this view changed. 5) Basically, they assumed the economy is under full employment. 6) Malthus’s population theory (or the Malthusian trap) is valid.

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Part IV Socialism and the old historical school

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9 Antagonists to the classic school and the rise of socialism

The inherent vice of capitalism is the unequal sharing of blessings; the inherent virtue of socialism is the equal sharing of miseries. ―Winston Churchill

The 1850s were the peak time of the classical school, as two opposing forces began to emerge: socialism against capitalism; and the rise of protectionism against previous liberalism that considered the free market is the best (invisible hand). This chapter is a brief introduction to the rise of socialism, followed by a chapter on Karl Marx. During the age of high mercantilism, the U.K. had accumulated a large amount of bullion from its trade surplus. In the 1800s the country entered the age of the Industrial Revolution, actively imported raw materials from colonies, and exported industrial products to other continents. The industrial revolution brought prosperity as well as evils:

cities such

as Manchester became over-populated; poor public health, serious work injuries; worsening pollution. Under the mask of laissez-faire and free trade mentality, the capitalists learned better how to exploit workers:

too low wages, too long working hours, and physically abusing

workers. Intellectuals with a moral conscience began to push social reforms to reduce

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injustice and conflict. Inspired by the French Revolution of 1789, several uprisings occurred the U.K. and Prussia. Q:

The views on socialism must have been divergent. Do they have the same root?

A: It was said that “there are 99 kinds of socialism”, meaning there were all kinds of divergent views. Under the umbrella of socialism, some ideas were incompatible with others. Thus, we should not consider any “ism” as a unified or homogenous group, yet it is quite often that the intra-group struggle is fiercer than the inter-group struggle. It is not unusual that social movement leaders/heroes use idealism to realize their own dreams. Like all other “ism”, socialism also has a history of blood and tears. We can briefly explain its roots and economic appeals, plus some key figures. Why did a socialist trend emerge? When the U.K. began to enter the Industrial Revolution around the end of the 18th century, capitalism expanded rapidly with more and more large size factories that generated a new working class. Workers lived in dirty and narrow slums, and the conditions in factories were less than humane. In short, this social bomb was about to burst; social, political, and economic reforms needed to be done immediately. By the middle of the 19th century, some began to become actively engaged in a humanitarian movement, aiming to reexamine current economic ideas and policies. Q:

Among the “99 kinds of socialism”, which were the important ones?

A:

A first one is utopian socialism. Two key figures were Robert Owen (1771-1858) in

the U.K. and Charles Fourier (1772-1837) in France. Initially, Owen was a textile worker, who married his boss’s daughter and became manager of the factory. He saw that the workers labored very long hours, and that there was ignorance about the outside world. He had an intention to build a new village that allowed workers to live together (an early form of a commune). In this new village workers and children would be entitled to a free education and issue their own currency. There would also be a store, self-managed by the workers. Each person would only have one vote, despite gender, age, and income. Owen turned more and

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more enthusiastic about this endeavor. He then went to the U.S. to buy land to promote his ideal “new villages.” However, it all failed after a long period of hard work. Why did this movement rise up? A common reason was they believed that competition inevitably would bring unfair, incorrect, irrational consequences. Thus, they wanted to transform the society from its roots, bringing about a way of life in a peaceful manner and not in a revolutionary nor conflicting manner.

Artist’s rendition of Robert Owen’s theoretical design of a socialist community. Engraving by F. Bate, London 1838. Source: “List of Owenite communities in the United States”, Wikipedia.

Q:

This was very different from the Soviet-style socialism, right?

A: Yes, very different. After the 1917 Revolution, the Russian Soviet Federative Socialist Republic was a kind of “state socialism”. The economy was planned by a central Bureau, and all resources were nationalized. This pattern had a profound impact on Eastern Europe, China, and other socialist countries following World War II. The original aim of State socialism was not to centralize everything, but to build a welfare state: from the uterus to the grave, the state takes care of everyone’s lifelong welfare. Q:

Some religious groups also had socialism claims, why and how?

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A:

Germany has had Christian socialism since mid-19th century, based on religious

ideals, with it moving toward a welfare society, fighting against violence, factory laws, labor laws, etc. Online sources can provide further educational help in this regard. Q:

There was also an anarchy movement, was this also a kind of socialism?

A:

Anarchism is a kind of anti-authoritarian philosophy that advocates self-governed

societies based on voluntary, cooperative institutions. Anarchism held that the State is undesirable, unnecessary and harmful. Citizens live under non-hierarchical or freely associated institutions. Their main appeal was to abolish private property, publicize all property, allow people the right to self-organize groups, and provide mutual assistance and benefit, thus creating an ideal community. Q:

How did Marxist socialism become a dominant power?

A:

This is the topic of the next chapter. Marx’s personal aim was to construct a theory

of “scientific socialism”, or mainly an academic approach. He was not really interested in revolutionary actions. He once told his son-in-law that people were using his name to fight for their own power and interests. Personally, Marx himself was rather bookish, conceptual, analytical, and non-violent, but he was often caricatured with a street-fighting image. His basic doctrine was based on the exploitation of laborers. He believed that class struggle between the oppressor and the oppressed is inevitable; the future world will be ruled by the dictatorship of the proletariat, that would eliminate the fierce free competition via a planned economy. Unlike capitalism, profit maximization was not the goal of communism. Q:

So what does communism mean, economically speaking?

A:

It is based on a set of development theory. Marx said in Critique of the Gotha

Program (1875) that after the long hunting-fishing period, human history entered the following five stages: a society that uses prisoners of war as slaves; a feudal economy dominated by the lords of manor; pursuing great profits in the age of capitalism; enter the socialist stage without private property, and under this system people no longer compete against each other; and finally, the communist stage in which “from each according to his ability, to each according to his needs”.

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Q:

Was the kind of moderate socialism named Fabian Society influential?

A:

It was named after the Roman statesman and general Fabius Maximus (c. 280-203

BC), who advocated a gentle and gradual reform. In January 1884 a Fabian Society was established in London; its two famous leaders were Sidney and Beatrice Webb. They advocated for reform starting from basic things in daily life. The Fabian Society founded the London School of Economics and Political Science (LSE) in 1895. As of 2016, the Society had about 7,000 members. You can find a lot of information about the Fabian Society online. Q:

These 99 kinds of socialism sound quite confusing. Could you summarize their

basic features? A:

1) Against the classical economics, especially Smith’s free market superiority;

socialism believed that society has problems of class conflict and oppression. 2) Against the idea of minimum government and laissez-faire policies; government should safeguard the interests of workers. 3) Against Say’s Law where supply creates its own demand, and the economy will automatically return to stable. On the contrary, socialism believes that the economy is stagnant with a crisis, and government must intervene actively. 4) Against the idea that human nature is good, that humanity can be improved through education. 5) Production tool/equipment should not be privately owned; some also were opposed to individual freedom. 6) Centralized State power, in which people should cooperate and help each other. Q:

Socialism is speaking for the working class, just as the classical school spoke for

the capitalist class. Academically speaking, is such a claim feasible? A:

If there have been 99 kinds of socialism, and each has its own claims, then one can

only roughly divide them into moderate and extreme groups. Moderates prefer graduate/mild reform and promote social welfare. Extremists advocate for class struggle and revolution, with an ultimate goal of dictatorship by the proletariat. Socialism has a clear short-term goal: to overthrow the injustice of capitalism. Yes, it is necessary to establish a fairer society that is more rational and humane. During the 1850-

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1950s, this goal not only attracted many intellectuals, but also inspired the working class. People from a rich family and under a higher social class also participated in socialism. On the other hand, there is a popular saying:

“If you don’t believe in socialism at the

age of 20, you have no heart; if you still believe in socialism at the age of 30, you are irrational.” After World War II, intellectuals in Western Europe were divided into two groups. Marx’s dictum “Religion is the opium of the people” was paraphrased as [Socialism is] The Opium of the Intellectuals, by Raymond Aron, a right-wing French professor in 1955. Q:

The Soviet Union (USSR) and some socialist countries in Eastern Europe collapsed

in the 1990s. Why so soon within a century after its 1917 Revolution? A:

Over the past 150 years, many intellectuals were active in the research of socialist

economics. Soviet mathematician Leonid Kantorovich (1912-86) applied linear programming to study the economics of central planning. Together with Tjalling Koopmans (1910-85) of Yale University, they shared the 1975 Nobel in Economics. From the perspective of real life, many high claims in socialism failed to pass the test of time. For example, workers in Europe and the U.S. were not impoverished, as socialism predicted. From today’s view, a central planned economy often exhibits inefficiency and social unfairness. The market mechanism still has its advantages in freedom and efficiency, but also comes with shortcomings, such as the 2008 global financial crisis.

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10 Karl Marx and the collapse of capitalism

The philosophers have only interpreted the world, in various ways. The point, however, is to change it. ―Karl Marx, Eleven Theses on Feuerbach (These words are also inscribed upon his grave)

As capitalism developed into the mid-19thcentury, it had accumulated considerable social resentment, for two main reasons. With maximizing profits in mind, capitalists tended to invade, plunder, colonize, and exploit workers. When the agricultural sector declined in the mid-1840s, it became known as a period of the “hungry ’40s”. The unemployment rate hit over 10%, and the bomb of social injustice finally burst. During this chaotic period, one of the most influential figures turned out to be Karl Marx (1818-83). Marx is often considered as a leading revolutionary mentor. His most famous slogan was:

“Let the ruling classes tremble at a Communistic revolution. The proletarians have

nothing to lose but their chains. They have a world to win.” On his tombstone is engraved: “Workers of all lands unite.” This chapter deals with Marx’s doctrine. His main goal was to build a system of scientific socialism. Thus, we shall focus only on his economic analysis, i.e. his “nerd” aspect. This dimension alone is big enough, and three issues are selected for discussion: historical materialism; labor value and exploitation theory; and why capitalism will inevitably collapse.

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Q:

Why and how did Marx develop his communism?

A:

He was born in a small town, Trier, on the border of today’s Germany and

Luxembourg. His father was a lawyer, who converted to Lutheran Christianity to help his career before Marx was born. Marx studied law, history, and philosophy in Bonn, Berlin, and Jena. At the age of 23, he obtained a doctorate from Jena University (established 1558). This is a small quiet town in eastern Germany. By American standards, the size of the university is very small, but it had notable faculty and alumni, as well as four famous statues around its main building: Hegel, Fichte, Schelling, and the poet Schiller. Marx worked as a newspaper reporter, and his radical behavior resulted in his exile to France, Belgium, and then finally London where he died. He met Engels in Paris, and afterwards Engels was his financial supporter, co-author, and translator. Three important things in London were essential for Marx. 1) The rich collection of books and free heating at the British Library. 2) London is a tolerant metropolitan for hosting dissidents from various countries. 3) All currents of ideology and groups co-exist, a fertile land for revolutionaries. Marx’s writings are voluminous. Das Kapital (1867) was his most important one on political economy. If you do not want to go deep into these 3 volumes, just look at the footnotes of each page, and you will see how broad his knowledge was and how much detailed evidence it was based. He invented many new ideas and terminology and, most importantly, constructed a new system of interpretation. He was that rare species of a fox (knows many small things) and a hedgehog (knows one big thing in-depth) all rolled into one. His influences are not limited to the academic world, but also affected the lifestyle for almost half of humanity in the 20th century. It would be difficult to other cases as Marx in humanities and social sciences. Q:

Marx was inspired by Hegel’s dialectic philosophy. Who was his mentor in

political economy? A:

Marx lived in the era of the British classical school. By that time, Prussia’s political

economy was not yet well developed. The classical school was his main source of knowledge

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as well as his main target of criticism. Among Smith, Ricard, Malthus, and Mill, he was more sympathetic with Ricardo and critical of all the others. Two factors explain why Ricardo was inspirational for Marx. As discussed in Chapter 7, the deductive approach of Ricardo is both abstract and practical, and this unique style is intellectually instructive. Ricardo was a wealthy landlord and capitalist, but was against the Corn Laws and in favor of the poor class; this left-wing stance and safeguarding of social justice attracted Marx. Darwin’s “natural selection” and “survival of the fittest” also inspired Marx’s idea of class struggle:

the history of social evolution is a history of class struggle,

and class struggle is a dynamic form of social evolution. Q:

Marx’s historical materialism is a common term. What does it mean for

economics? A:

We quote an elegant paragraph from Brue and Grant (2012) The Evolution of

Economic Thought, 8th edition, p. 185. It is somewhat lengthy but complete: In every historical epoch, the prevailing methods or forces of production produce a set of relations of production that support them. But the material forces of production (technology, types of capital, skill level of labor) are dynamic; they are continuously changing. This is to be contrasted with the material relations of production (rules, social relations among people, property relations), which are static and reinforced by the superstructure. This superstructure consists of art, philosophy, religion, literature, music, political thought, and the like. All elements of the superstructure maintain the status quo. For Marx, history is a process through which the static relations of production (the thesis) come into eventual conflict with the dynamic forces of production (the antithesis). The result? Conflict revolutionizes the system so that new relations of production (synthesis and new thesis) permit the higher development of the forces of production. The mechanism for overthrowing old societies is the class struggle.” 13 Q:

One of the main themes in Kapital is to argue the inevitable collapse of capitalism,

what was its inner logic? A:

This is a huge issue. Marx had a logical chain of reasoning, and every step is

closely related to another. We begin with his theory of exploitation. In Marx’s concept, the

13

Marx’s own passage on the materialistic theory of history, see his A Contribution to the Critique of Political

Economy, trans. N. I. Stone (Chicago: Kerr, 1913, 11-12).

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profits of capitalists (such as cotton mill owners) are mainly derived from exploiting workers. A common practice is to cut their wages and to have them work overtime. If they only need 8 hours to earn food and clothing, the capitalist asks for 15 hours. The difference (7 hours) is their “residual value”, and that is the main source of profit - hence, exploitation. Q:

This explains exploitation, how does this lead to the collapse of capitalism?

A:

It involves another notion that Marx asserted:

in the long run, capitalists’ profit

will fall to zero or to negative. We think this assertion is incorrect in theory and in practice, for the following reasons. Marx said that workers tend to be alienated, and so capitalists will replace workers with machines. However, the theory of exploitation tells us that the main source of profit comes from labor’s surplus value. If machines completely replaced workers, then this surplus value of labor is gone. If this logic is correct, then how could the capitalists be so stupid to replace workers with machines? Isn’t that self-defeating? The purpose of machines is of course to reduce costs and increase profits. If my own factory works with 100% machines, then Marx infers that my profit will go down to zero, because no labor value is exploited (which is the main source of profit). The opposite is true! Q:

Marx’s theory explains better for a recession but not good for boom times, right?

A:

Marx was a pathologist, seeing all the diseases, but he was not an expert to explain

the good sides such as inventions and progresses. As long as the economy prospered, people turned to Adam Smith. Q:

Thus, can we say Marx is less appealing in countries like the U.S.?

A:

It is not derogatory to say Marx is a pathologist, because he was the first to provide

important systematic insights into the business cycle. There exists a kind of economic disaster that is purely man-made, such as the Lehman Brothers bankruptcy during the 2008 financial crisis. Capitalism is driven by profit maximization, which will necessarily enhance a variety of misconducts that in the final analysis are rather self-defeating. If you take a look at Chapter 1 of General Theory (only one paragraph, fully quoted in Chapter 20), you will see Keynes acknowledged that Marx also inspired him.

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Q:

Marx emphasizes those ideas such as exploitation, class struggle, and proletariat

dictatorship. Why are these ideas so appealing to many intellectuals? A:

We need to go back to the mid-19th century. Marx and Engels wrote the Communist

Manifesto (1848), which was 20 years earlier than Kapital (1867). Chapter 2 of Manifesto lists 10 goals that “in most advanced countries, the following will be pretty generally applicable.” If you were a victim of the “Hungry 1840s” or a conscientious intellectual, would you not feel the following “welfare state declarations” rather appealing? 1. Abolition of property in land and application of all rents of land to public purposes. 2. A heavy progressive or graduated income tax. 3. Abolition of all rights of inheritance. 4. Confiscation of the property of all emigrants and rebels. 5. Centralization of credit in the hands of the state, by means of a national bank with State capital and an exclusive monopoly. 6. Centralization of the means of communication and transport in the hands of the State. 7. Extension of factories and instruments of production owned by the State; the bringing into cultivation of wastelands, and the improvement of the soil generally in accordance with a common plan. 8. Equal liability of all to work. Establishment of industrial armies, especially for agriculture. 9. Combination of agriculture with manufacturing industries; gradual abolition of all the distinction between town and country by a more equable distribution of the populace over the country. 10. Free education for all children in public schools. Abolition of children’s factory labor in its present form. Combination of education with industrial production, &c, &c. Q:

Have these welfare-state ideals ever realized in any country so far?

A:

No, not even today. Not in socialist countries, nor in most capitalist economies. The

paradise is wishful, but the real world is harsh. Economic historians have many good stories to tell about this issue, but it is not our focus here. Q:

Marx was a combination of hedgehog and fox. Why the interesting metaphor?

A:

A hedgehog describes an intellectual with deep knowledge in a few narrow fields,

but with powerful explanation depth. The fox knows a lot, and nothing can escape its attention and comments. The wide range of Marx’s works and the depth of his analysis are a

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rare combination, it is both hedgehog and fox combined into one: he was a rare species who had extensive knowledge with rich details, at the same time had talent to build such a huge system of interpretation. Other economists also belong to this fox/hedgehog club, such as Smith, Ricardo, Marshall, Keynes, Paul Samuelson (1915-2009), Herbert Simon (1916-2001), Kenneth Arrow (1921-2017), and Amartya Sen (1933-). Why only have a few of them been able to surpass Marx? A simple reason is:

these extraordinary economists are/were influential

within the economics community, while Marx has influenced so many countries spanning now three different centuries, affecting the lifestyle of billions of people around the world. Q:

How can we summarize Marx’s contribution to economic analysis?

A:

Arguably there are two main things. He established a scientific interpretation of the

socialist system, how economic resources can be nationalized (with central planning), and how to reduce income inequality. He offered a dynamic analysis on how capitalism is bound to collapse through exploitation, profit reduction, economic cycle, wealth concentration, and industrial monopoly. It was not an easy task, and we know of no one else who has achieved such an impact so significantly. Q:

Marx was influenced by Ricardo, can you explain this more specifically?

A:

Ricardo was a landlord capitalist, but was eager to repeal the Corn Laws. This can

reduce the general cost of living, and the excessive profits of landlords (due to tariff protection). From this perspective, he was concerned with the issues of class conflicts and income distribution. Both concerns were also that of Marx’s, but their orientation and ideology were completely different. Marx was critical of capitalism, analyzed its intrinsic mistakes and internal conflicts, and predicted that it would collapse. In contrast, Ricardo earned his wealth from the financial market, bought a large amount of land, and got a seat in the Parliament. He was basically at home with capitalism, even a guardian of it, but also critical of the protective policy that would increase all costs and hurt the U.K.’s foreign market competition. Ricardo was policy-

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oriented (free trade), while Marx was much more ambitious:

to construct an alternative

social system. Ricardo basically agreed with Smith’s notion of the invisible hand, and that people’s rational self-interest behavior will lead society toward harmony. Ricardo’s focus was how to remove market dysfunction (e.g. to promote free trade). He agreed that there are many shortcomings in capitalism, but that is not a problem of capitalists themselves, but mainly due to inappropriate policies. Marx’s view was just the opposite:

the root of all problems is the exploitation nature of

capitalism and the replacement of labor by machinery that has caused massive unemployment, concentration of wealth, business cycles, class struggle, and riots. This is a self-destructive system and doomed to collapse. In today’s view, Marx’s analysis has many shortcomings, but it also offers several major advantages. 1) Focus on the long-term historical trend, rather than looking at the recent past. 2) Show the importance of long-term dynamic changes, not myopically target a shortterm equilibrium. 3) Assign the importance of superstructure (institution, law, culture) and not just on cost and profit. Instead of analyzing social problems from a pure economic perspective, Marx was a pathologist who looked at the organic structure of the forest and how the system’s deficiency affected its trees. Marx’s analysis was very different from other scholars. He was quite insightful and proposed new horizons and solutions. His doctrines have been criticized for over 150 years, and historical evidence has proven most of his prophecies were wrong. Personally, we are not Marxist and even do not like very much his ideas and writings. However, if you refrain from judging a hero by his success or failure, then neutrally speaking, Marx has constructed an original dynamic form of macro-analysis. He was a rare species of a systemic constructor, whose originality and importance are no less than that of Smith or Keynes.

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11 The German historical school and protectionism

Finally, a nation should not regard the progress of industries from a purely economic point of view. Manufactures become a very important part of the nation’s political and cultural heritage. ―Friedrich List (1937) The Natural System of Political Economy

By German we also mean Prussian, but use German for the convenience of modern readers. The duration of the German historical school spanned 1840-1917. In the mid-19th century the German economy was dominated by agriculture and required a strong State to protect its infant industries via tariffs. Its basic position was to oppose the ideas of the British classical school of anti-mercantilism, invisible hand, minimum State, free competition, and free trade. In this chapter we briefly present the basic concepts of this school, which influenced two later schools:

the British historical school of economics (not discussed in

this book) and institutional economics, which will be our theme in chapter 19. Q:

Why and how did Germany have such an unusual historical school?

A:

By the mid-19th century, Germany had 38 states that were nearly autonomous both

politically and economically. Neighbor countries such as Austria, France, and the U.K. hoped to maintain this situation to lessen potential military or economic threat. Germany realized this weakness and strived to be unified.

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This goal gradually came true under the leadership of Otto von Bismarck (1815-98). Which policy orientation is the best? The answer is an old one:

mercantilism, through

active State planning and protection to accumulate gold/silver and military strength; to imitate what Queen Elizabeth did for Tudor England. The goals of German nationalism and British liberalism were the same (wealth and power of the nation), their strategies were exactly the opposite. For Bismarck and his followers, they were in search of national supremacy and strong leadership, and individuals were of the least importance. Q:

This kind of social value hurts individual freedom. Who benefits from it?

A:

The ruling class does. Moreover, some economists of the historical school

benefitted a lot, by combining their interest with that of the State:

these economists became

dominant in academia, controlled the Ministry of Education, and had the right to review textbooks. For example, they rejected the “marginal school” that became mainstream in Austria at the time, which was to analyze the marginal utility of consumers, in favor of the free market, echoing the British classical school. Q:

Why has this German school claimed to be “historical”?

A:

It was their conviction that understanding the development process of history can

be useful to explain the current situation. Second, old theories must be tested by new conditions. Thus, history is useful to correct old ideas and to develop new directions. They considered that British liberal economics was not a panacea and cannot be used for all countries at all times. The market system and liberalism do not warrant the best outcomes. Laissez-faire was suitable for the U.K., but not Germany. Adopting historical viewpoints with an inductive approach has a great advantage: extensive knowledge about the past through broad perspectives allows one to obtain insights from historical experiences. Based on this, one can achieve practical rules for current policies. The deductive method such as Smith’s diamond-water paradox or Ricardo’s differential rent is a kind of static and philosophical study; it has no sense of reality, and hence no useful lessons can be gained.

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Historical school economists wanted to be practical in knowledge and policy and to help state administration, tax collection, industrial development, and foreign reserves. Policies must obey the development of historical routes, and empirical research must be based on both historical and present situations. Economic theory is meant to explain the current situation, to re-examine old theories, and to develop the new ones. Everything is aimed at the usefulness to people’s livelihood, and the main duty of leaders is to promote prosperity. Sounds eerily familiar to the Japanese Meiji reform in the 1860s? If so, because Japan was inspired by the rise of Bismarck’s Germany. Q:

Any representative insight of the historical school?

1989 Deutsche Bundespost stamp commemorating the 200th anniversary of List’s birth. Source: Wikipedia

A:

A famous figure was Friedrich List (1789-1846), who was the forefather of the

historical school. His father was a leather worker, while he himself was a civil servant. He became a deputy minister in 1816 and had been a professor at the University of Tübingen. He left in 1819 due to his political opinions. He also served as the head of a business association, aimed at uniting the divided economy, resisting the invasion of foreign products, and actively promoting the “national economy”:

the interests of the State are the first priority, rather

than individual benefits and interests. At that time Germany had 38 tax customs that were quite unfavorable to the development of a national economy. List stated: Thirty-eight customs boundaries cripple inland trade, and produce much the same effect as ligatures [surgical ties] which prevent the free circulation of the blood. The merchant trading between Hamburg and Austria, or Berlin and Switzerland must traverse ten states, must learn ten customs-tariffs, must pay ten successive transit dues. Any one who is so unfortunate as to live on the boundary-line between three or four states spends his days among hostile tax-gatherers and custom-house officials; he is a man without a country. (Friedrich List, as quoted in Margaret E. Hirst, Life of

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Friedrich List and Selections from His Writings (London: Smith, Elder, 1909, p.139) In 1820, List was elected as a member of parliament, and he advocated radical reforms in the administrative and financial systems, but encountered considerable resistance. During the period 1825-32 he emigrated to the U.S., claiming that Germany and the U.S. should adopt protectionism before they would be defeated by the British industrial revolution. His personal life was a tragedy:

poor health, difficult life, and then suicide.

Q:

What were the key arguments of List?

A:

List’s main work was National System of Political Economy (1841), which was

available in English (1856) and translated into other languages, including a Chinese one in Taiwan in the 1960s. In this book List said that Germany is still in a backward stage of agricultural, very different from U.K., and so it is totally unsuitable to adopt the ideas of classical economics. He maintained that each country should develop its own policies suitable for its own conditions and not to follow the classical school blindly. In his view, there are five stages of economic development:

1) primitive; 2) livestock;

3) agriculture; 4) agriculture and manufacturing; 5) agriculture industry and commerce. Free trade during the first three stages can be a significant help, however, tariff protection is required at the transition from stage 4) to stage 5). At this critical period, infant industries should be prevented from foreign products. Germany, France, and the U.S. in the mid-19th century were still at stage 4). Their policies were naturally different from those at stage 5) such as the U.K. If Germany adopted free trade, then workers and industries would be seriously affected. He understood that wealth does not equal national power, and that productivity is the key. Moreover, it is necessary to safeguard natural resources and not allow foreign powers to predate. Q:

What is the most unique idea of List?

A:

He was anti-Smith. He criticized Smith’s Wealth of Nations:

“This system regards

everything from the shopkeeper’s point of view. The value of anything is wealth, according to it, so its sole object is to gain values.” National System of Political Economy, chapter 31 has a harsh comment on Smith:

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… that it is nothing more than a theory of values; a mere shopkeeper’s or individual merchant’s theory—not a scientific doctrine, … in regard to international commerce, is but a continuation of that of the physiocrats. Like the latter, it disregards nationality; it excludes almost entirely politics and government; it supposes the existence of perpetual peace and universal association; it depreciates the advantages of national manufacturing industry, as well as the means of acquiring it; it demands absolute free trade.” He made a similar attack on the French economist J.B. Say in Chapter 32. He said that Smith’s laissez-faire was actually the most treacherous and vicious:

the mercantilism of the

U.K. had accumulated considerable bullion, and their products had the dual advantages of price and quality. After the industrial revolution, the U.K. became the world hegemony. Its avocation of free trade is totally based on self-interest motivation. This seemingly liberal doctrine is to make it easier for Britain to conquer colonies, defeat competitors, and dominate the world’s resources. These penetrating opinions are not totally a prejudice. Q: Max Weber (1864-1920) has a famous book The Protestant Ethic and the Spirit of Capitalism (1904-5) in which he tried to establish a causality between Protestant ethic and capitalism. Is this hypothesis related to or influenced by the historical school? A:

Yes and No. Yes, in that although Weber was a sociologist, he can be regarded a

half-economist:

he once studied with Gustav Schmoller (1838-1917), leader of the

“younger” German historical school of economics; Weber also wrote General Economic History, 1923. No, in that because Protestant Ethic is totally irrelevant to the concern of the historical school, it is more sociological. The Weberian proposition is controversial, and both economists and historians have heatedly debated it. We have something to say about it, but this is a big digression, and so we need your permission if we are to dive into this socioeconomic issue. Q:

OK, as long as it is a treat and not a trick.

A: Certainly a treat; fasten your seatbelt. Marx said that “religion is the opium of the people”. Weber disagreed and believed that religion must has its positive aspects, such as nudging the development of capitalism, which could be an unforeseen result of Martin Luther’s Reformation starting in the 1510-20s.

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Most debates focused on the “post relationship” between religious and capitalism, or on “how the Protestant spirit helped recent capitalism.” Very few targeted a more important angle:

the historical foundation of this Weberian proposition - that is, few have examined if

“Weber’s idea was historically correct.” In other words, Weber was based on what historical facts? Was his understanding of historical facts reliable? Q:

Intriguing. There must be more to the story, right?

A:

Actually, since the 16th century, northern Europe had been affected by the

Reformation, and around the same epoch capitalism began to develop in areas where Protestant prevailed such as Prussia, the Low Countries, and England: there was a considerable degree of overlap between Reformation and the rise of capitalism. Weber hypothesized that this could not be a simple historical coincidence, because Protestant’s new view on usury and the attitude toward profits was a relief from Catholic doctrine of it being immoral to pursuit profits. In Weber’s view, the new Protestant ethic was a kind of mentality that had a causal connection with the rise of modern capitalism. Q:

On what facts did Weber base such an inference?

A:

Around 1895 Martin Offenbacher, a student of Weber, conducted an investigation

in the Baden region. The results showed that Protestants were richer than Catholics and more active in economic activities:

Catholics were relatively relaxed and less ambitious in the

pursuit of profit. Stated differently, Protestants are more inclined to “eat well” while Catholics prefer to “sleep well”. The Catholics desired to be in paradise peacefully while Protestants were encouraged to pursue economic success to glorify the Lord. Q:

Any objection from economists to this “religious beliefs helped capitalism” view?

A:

The famous British economic historian Richard Tawney (1880-1962) had a book

Religion and the Rise of Capitalism (1926) against Weber’s claim. Tawney said that the causality should be the opposite:

religion does affect the value system, but it is economic

and social changes that affect religious views and not the other way around, for an evident reason.

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In 1492 Columbus discovered the New World, which had a great impact on global views and scientific discoveries. The rise of capitalism was mainly due to the rise of the New World, with a large amount of bullion that flowed into Europe, causing a price revolution. This propelled industrial development and promoted the rise of capitalism. Consequently, this helped the Reformation, because the economic power structure also changed. Q:

This sounds a more reasonable argument, but not the end of the story, correct?

A:

Indeed. When large amounts of gold, silver, potatoes, corn, and spices from the

New World flowed into Europe, many places soon became richer. Populations increased and prices soared. Manufacturing and trade followed, and the social status of merchants also improved. On the other hand, landlords and feudal manors became less powerful. In the process of this big flip, the areas previously controlled by the Catholic Church began to rebel: economic growth played a role in the Reformation. Thus, it was not Weber’s view that Protestantism led to capitalism, but that capitalism helped the rise of Protestant. Q:

Anyone historian also against Weber’s view?

A: Fernand Braudel (1902-85), a second-generation leader of the French Annales school of history, also opposed Weber’s view. He avoided the issue of religion and capitalism and instead tried to explain why capitalism mainly developed in the North Sea area, where the Protestants also prospered. Braudel adopted another approach:

economic geography. He

believed that Weber’s historical sociology approach hit the wrong target. Here is Braudel’s basic argument. In the period of the Reformation (early 16th century), the North Sea region replaced the Mediterranean region (especially Italy) as a new center of the “economic world”. This type of “economic center shift” (from Italy to North Sea) was common throughout history. For example, after the rise of Muslims, Byzantium declined, and economic dominance by Islam was later given to Europeans (Spain, Italy). By around 1590, Europe’s economic center of gravity shifted again, this time moving to the North Sea, which was the most prosperous area at that time and which happened to be the area where Protestants were populous.

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The new center of the “economic world” has continued to shift throughout time, from Bruges to Antwerp, to Amsterdam, London, New York, Tokyo, and now towards Shanghai. This is a dynamic process - a very natural tendency if one holds a “longue durée” perspective. Thus, Weber’s observation was more of an historical incidence:

the rise of the North Sea

economy side-by-side with the rise of Protestant power. It was not Protestant ethic that promoted capitalism, but more so that capitalism promoted Protestantism; work ethic had no role to play here. Q:

How did the southern economic centers (Florence, Venice) shift to the North Sea?

A:

There were some simple but important factors: the kings of Spain and Portugal

paid special attention to overseas colonies, which were sources of key revenue for financial deficits. Ships returning from overseas must pay considerable taxes. Businessmen soon realized that if they sail north for a few more days, one can unload the goods in the North Sea ports such as Bruges, Antwerp, and Amsterdam. These places were exempt from the heavy taxes in the Iberian peninsula ports, and one could also sell foreign goods to inland cities via navigable rivers that are widespread in the North Sea area:

the Danube, Rhine, Meuse,

Scheldt, and other waterway networks. The demand for colonial goods in the North Sea area was high and at better prices. The ports in the north were also convenient and less fully explored. With the stimulation of foreign goods and active commercial and financial transactions, the North Sea region soon became a new economic center. Q:

Okay. Spain and Portugal actually “pushed away” their treasures, and the North

benefitted. Let me ask it inversely:

How did the North attract economic resources? What

made the “magnetic force” in northern Europe so strong? A:

Another key factor was the poor development stage of the North, with lower living

standards and wages than the South (Mediterranean area). Industries in the South gradually lost their advantageous conditions through lower costs and higher demand in the North: large potential markets, cheap river networks, and efficient coastal fleets. In addition, resources in the north (wood, grain, wool) were abundant and cheaper. The northerners worked harder (relative to the “lazy” south), and so industrial production shifted to the

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north. Around the 1590s, the whole European economy was going downward that hurt the South seriously, but it was a good opportunity for the North to rise. The above arguments can be simplified as follows. Among the many factors that arose in the North:

1) was it the economic factors (bountiful resources, low wages, large market,

cheap freight, free or low tax trade zone) that were important for the rise of capitalism? or 2) was it Weber’s Protestant ethic that contributed more to the rise of capitalism? Q:

This economic geography interpretation does not rule out that religious reforms

also helped the rise of capitalism in the North. Do you have other counter-examples? A:

Before the economic center moved to the North, Venice was the capital of

capitalism, but the Venetians were not Protestant. The Byzantine and Islamic countries once dominated the Mediterranean world with strong economic achievements, but they were not Protestant either. Religious ethic is not a necessary condition for economic growth, but it could be a sufficient condition at best. Weber’s Protestant ethic hypothesis was a-historical:

it is a kind

of “correlation” and not “causality” as Weber asserted. Protestantism could have encouraged a diligent people, but contributed little to create attractive conditions for the rise of the North. Capitalism was not invented by anyone, just like Einstein did not invent physics. An economic system can be designed but not invented; it is always an evolutionary process. Q:

There is another argument that modern capitalism is related to rationalism. For

instance, some have said that double-entry bookkeeping and cross-country remittance helped capitalism to develop. Is this logic valid? A:

This is like saying that the X-ray helped the development of medicine. No, the

reverse is true:

the development of medicine induced its invention. By the same token, it

was the development of capitalism that helped the spread of double-entry bookkeeping. If Protestant ethic contributed to the development of capitalism, then why was socialism (think of Karl Marx, Robert Owen, and the Fabian Society) also born in the Protestant area? One final piece of evidence. Davide Cantoni, an economic historian at the University of Munich, collected data related to religious and economic variables for a long period (AD

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1300-1900) in 272 cities that belonged to the Holy Roman Empire, such as Hamburg, Berlin, Vienna, Munich, and Frankfurt. Why did he choose the Holy Roman Empire? Because there existed many religions in the Empire for comparison. 14 He tried to verify the statistical relationship between Protestant ethic and economic growth, urban size, fertility, and literacy. In the vast Holy Roman Empire, Cantoni’s 600-year evidence definitely rejected Weber’s proposition:

“I find no effects of Protestantism on

economic growth. The finding is precisely estimated, robust to the inclusion of various controls, and does not depend on data selection or small sample size. Denominational differences in fertility behavior and literacy are unlikely to be major confounding factors. Protestantism has no effect when interacted with other likely determinants of economic development.” (Cantoni 2015, p. 561, Abstract)

14

Davide Cantoni (2015): “The economic effects of the protestant reformation: testing the Weber hypothesis in the German lands”, Journal of the European Economic Association, 13(4):561-98.

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Part V Marginal analysis and the neo-classical school

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12 The marginal school in France

Those skilled in mathematical analysis know that its object is not simply to calculate numbers, but that it is also employed to find the relations between magnitudes which cannot be expressed in numbers and between functions whose law is not capable of algebraic expression. ―Antoine Cournot (1897) Researches into the Mathematical Principles of the Theory of Wealth, pp. 3-4.

This chapter has two parts:

historical background and features of the marginal school

and the development of this marginal school in France. The next two chapters will be on the cases of Germany, Austria, and the U.K. Smith’s Wealth of Nations, Malthus’s Population, and Marx’s Das Kapital have a few common features in writing style:

they use plain words with some basic statistics, and most

importantly, on issues such as price level, money supply, foreign trade, population, growth, etc., these issues are now named as macroeconomics. By contrast, the marginal school has two distinct features. They began to use diagrams and calculus as tools of analysis; and they were concerned less with macro-aspect issues and instead focused on micro-aspect issues such as the utility of the individual, consumption, competition, and of course supply and demand. Most basic textbooks today begin with the marginal school (microeconomics), which is now also named as the “neoclassical school”, because it followed the spirit of the classical school, but worked with new topics and new analytical tools. This phenomenon happened

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almost simultaneously in the second half of the 19th century, first in France, then Germany, Austria, and the U.K. Each country has its own path, but they all belonged to the common umbrella of this marginal school, because they used similar mathematical tools to analyze similar subjects (utility, consumption, competition). This is a kind of “multiple discoveries” (independent but simultaneous), as often observed in the process of scientific discovery. Q:

I have a conjecture about these multiple discoveries. In the second half of the 19th

century, structurally speaking, Western European countries encountered similar economic problems. On the other hand, the progress in physics and mathematics, such as Newtonian calculus, were widespread and accepted by the scientific community. Applying diagrams and calculus in economic analysis was a kind of physics envy - that is, under that scientific influence, there was a natural tendency to turn the classic political economy into a kind of social physics. These multiple discoveries are explainables with this scientific background. Let me complete the other side of the argument:

since the “marginal” school focused on

“incremental” analysis, calculus was a first choice. This explains why supply/demand, utility, and consumption (microeconomics) became their main targets; otherwise, how can you use calculus to analyze foreign trade, income inequality, and price level (macroeconomics)? A:

Bravo. Here are some details to support your view. When Malthus published

Population in 1798, socio-economic problems were severe. When Marx published the Communist Manifesto (1848), the situation was worse. The classical school, whose analytical tools (inductive and/or deductive) were basically verbal, became insufficient to deal with serious problems of recession. Laissez-faire, minimum government, socialism - all these could not save the starved. Political economy needed a big change and needed a more scientific approach. This awareness was evident across European countries. Q:

Conceptually speaking, what were the main features of the marginal school?

A:

The most important one is of course the concept of “marginal”:

how much more

output will be produced by adding one extra unit of labor or fertilizer; how much utility can be added if it costs $10 more. A second feature is the notion of rationality:

you are willing

to spend $100 more, because it is worth it. The marginal positive effect of satisfaction is

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greater than the marginal negative effect of spending $100. A third feature is the emphasis on market competition. In the early stage of marginal analysis, in order to be concrete and conclusive, one needs some strong assumptions such as perfect competition, perfect and symmetric information, no advertising, homogeneous product, etc.

Total utility (TU, curve) and marginal utility (MU, line)

A fourth feature is “subjective utility” (my own satisfaction about something). In this case, utility is no longer a neutral thing; rather, it is personal and cannot be compared (your food could be my poison). A fifth feature is the notion of equilibrium, apparently borrowed from physics as it is suitable for mathematical demonstration. This paved an important step for static and comparative static analyses in the early 20th century, as well as general equilibrium analysis after the 1950s. Q:

Smith’s market competition was said to be speaking for capitalists, and Marx spoke

for the working class. In this sense, which class did the marginal school speak for? A:

The marginal school was proud to be scientific, using calculus and geometry, and

so it is neutral school. According to this, a person’s salary should be equal to his marginal productivity, profit is the marginal productivity of capital, and rent is the marginal productivity of land. This is a pure academic analysis with no consideration in the interest of any particular party. It was meant to minimize personal factors and to be as objective as possible. The question becomes:

Do you believe in this statement? Homo sapiens are quite

skillful in using tools, but weapons are not limited to knives and arrows, whereas ideas and thoughts are a more subtle choice. Capitalists mostly welcomed the marginal doctrines, because this rigorous analysis can prove that they are rich, because their talents and endeavors deserve significant marginal output. People are socially disadvantaged, because

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their marginal productivity is low. If you want the rose to be gorgeous and colorful, you should cut off the bad leaves and buds (that is, the socially vulnerable ones). Do you agree with this scientific marginal doctrine? Q:

Scientific analysis can be used for inhuman interpretation. Yet, why is the concept

of marginality still in the first chapter of basic economics? A:

Pedagogically, students understand more quickly with diagrams and equations,

which are more concise and logic than plain text. This kind of precise analysis, though, explores only a small aspect of the whole issue under examination. That is why marginal analysis always needs an important but implicit assumption:

ceteris paribus. This means

“other things being equal”; do not ask further, we assume everything else remain the same; otherwise, we cannot handle them all at the same time. This type of analysis is known as “partial equilibrium”. Marginal analysis has several drawbacks. It can deal with only a well defined part of the problem. Assumptions are often too strong or unreal - for example, assuming the market is completely competitive, has perfect information, etc. It can explain the consumption and competition behaviors of individuals, but not the big issues such as wealth of nations. Marginal analysis is not useful for decision makers, especially in developing countries. Despite these shortcomings, marginal analysis is a cornerstone of the neoclassical school. With sophisticated and rigorous mathematical analysis, marginal analysis remains a mainstream today. Q:

Why did marginal analysis originate in France, not in the U.K., like the classical

school? A:

Recall that many insights of Wealth of Nations were inspired by the French

physiocrats. In the 19th century, French political economy was not inferior to the U.K. For example, Jean-Baptiste Say (1767-1832) for Say’s Law, Léon Walras (1834-1910) for general equilibrium analysis, and Vilfredo Pareto (1848-1923) for the notion of optimality. As the next two chapters will show, continental Europe was more advanced in marginal

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analysis, but the situation changed in the late 19th century when Alfred Marshall championed at Cambridge (see chapter 15). Q:

Who were the leaders of this French marginal school?

A:

Two. One is mathematician-turned-economist Antoine Cournot (1801-77), and the

other is Jules Dupuit (1804-66), an engineer by training, but who also was a major contribution to economic analysis. Now you can smell how exact science entered the world of political economy. Cournot was a pioneer in applying mathematics to economic issues. His work was ignored before his death, but later he was recognized as the founder of market competition (the Cournot equilibrium). He proposed several terms and concepts that we still use today: marginal cost, marginal income, and derived demand. At the age of 20, Cournot was admitted to the École normale supérieure in Paris (one of the elite universities) and majored in mathematics. Later he received two doctoral degrees, one in mechanics and one in astronomy. In addition, he published a number of articles and even acquired a degree in law. Several of his papers led to the attention of Siménon Poisson (1781-1840, well-known for Poisson probability distribution), which helped Cournot to earn a professorship in mathematics at the University of Lyon (1834). Q:

What has Cournot left behind in today’s economic analysis?

A:

This can be divided into several aspects.The first is that he was able to formulate a

useful equation:

How do monopolists know they have maximized their profits? There are

several well-known mineral water companies in France, each owning an important mineral spring. Water is not a product of monopoly, but mineral water could be, because each brand has different tastes with faithful fans. Under what conditions can the profits of these monopolists be maximized? Mineral water monopolists can produce an unlimited quantity, but no one will do that. The first question is:

What is the quantity that can assure maximization of monopoly profit? Cournot

found a practical and simple answer:

when the marginal income (MR) is equal to the

marginal cost (MC), the monopolist’s profit is maximized (MR = MC).

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Q:

I often heard the term Cournot-Nash equilibrium. How are both persons related?

A:

We quote a brief explanation from OECD’s “Glossary of statistical terms”:

“The

Cournot model of oligopoly assumes that rival firms produce a homogenous product, and each attempts to maximize profits by choosing how much to produce. All firms choose output (quantity) simultaneously. The basic Cournot assumption is that each firm chooses its quantity, taking as given the quantity of its rivals. The resulting equilibrium is a Nash equilibrium in quantities, called a Cournot (Nash) equilibrium.” This definition also confirmed what was said above. Now, you may be curious:

“Who

was Nash? Why put the two names together?” Well, this is a 1940-50s issue, we will discuss Nash’s contribution to game theory briefly in Chapter 18 on mathematical economics. Back to Cournot’s original story. Suppose there are two mineral water companies: one with bubbles (some people love it), and the other is conventional plain water. Both monopolists want to invade each other’s territory, offering a variety of attractions. Now there is a new situation between the two competitors, called “rival’s reaction function”. In other words, monopolist A’s strategy is no longer to follow MR=MC passively - it has to adopt a new strategy vis-à-vis the rival’s reaction. This is a common type of market competition in daily life: each monopolist needs to “conjecture” (guess) the rival’s new strategies (maybe more than two), in order to adjust its own. We now term this as “conjecture variation”: he guesses what you will do, you guess what he might do, and he doubts if you will do, etc., etc. This is quite a complex game. Cournot was unable to handle such a complex situation, as he was limited to the simplest case of 2 players. We have to wait until the game theory developed in the 1950s to analyze more complex strategies. The importance of Cournot was to propose the “rival’s reaction curve”, also called the reaction function. Initially, he made a strong assumption:

when monopolist A adopts a new

strategy, it is assumed that B’s strategy (price and quantity) remains unchanged. Similarly, B also assumes that the strategy of A is unchanged. After years of observations, both rivals know each other better and better. Decades later, each competitor knows each other’s tactics

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(reaction pattern). In the long run we can describe the reaction curves of A and B. When A and B are tired or exhausted, they will stop using a new strategy at the intersection of the two reaction curves. As shown in the following diagram, Point E is the equilibrium point of monopolists A and B.

The reaction function and equilibrium point E of two monopolists (competitors)

Q:

This is a basic equilibrium solution, but the real world does not work so neat, right?

A:

Yes. This notion opened up a large new field of competition theory, laying an

important foundation for future research on monopoly, duopoly, oligopoly, and monopolistic competition. For future generations, however, Cournot’s basic model has two shortcomings. 1) Assuming that the product is homogeneous; in fact some mineral water has bubbles and some do not. 2) The monopolist should have the ability to charge different prices, such as the price of electricity varying according to volume and time (peak or off-peak). Cournot’s model lacks these two important aspects. What is important is not its perfection, but its beginning. The discovery of DNA’s double helix structure in the early 1950s had many blind points by today’s standard. Q:

What was his main work that may still interest us?

A: Cournot married in 1838, the same year he published Recherches sur les principes mathématiques de la théorie des richesses (Researches on the Mathematical Principles of the Theory of Wealth), followed by Principes de la théorie des richesses (The Principles of Wealth Theory) in 1863, and finally Revue sommaire des doctrines économiques (Review of Economic Doctrines) in 1877. He died in that year at age 76. These books are available online. It’s fun to take a look, even just for curiosity.

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Augustin Cournot lived and died here: 2 rue de Tournon, Paris 6e (close to le Sénat). Source: Wikipedia.

By that time, political economy was mainly expressed in prose. It was strange to see someone apply mathematics to economic issues. Cournot was a lonely bird, never having dreamed of becoming a pioneer of competition theories in the 20th century. The goal of physics is not “to find out how Nature is. Physics concerns what we say about Nature” (Niels Bohr). This is what Cournot did for market competition:

to describe

its mechanism. The mathematical form is like a picture worth a thousand words. Symbols, equations, and diagrams make it easier to describe their functional relationships. Q:

Was there another important person in the French marginal school?

A:

Yes, Jules Dupuit (1804-66). He was born in Fossano (Italy), then under the rule

of Napoleon Bonaparte. At the age of ten he moved to France (Versailles) with his family, winning a Physics prize at graduation. He then studied at École Polytechnique as a civil engineer. He received a Légion d’honneur in 1843 for his work on the French road system. He also studied flood management in 1848 and supervised the construction of Paris’s sewer system. He was promoted to chief engineer of Paris in 1850 and to the general supervision of the French civil engineering community in 1855. Dupuit was a pure engineer, having nothing to do with economics. How was he involved then? Well, after the construction of roads, a related important issue is pricing:

How to

charge for different kinds of vehicles? Historically, this is a common issue for State enterprises in France, especially in public utilities. The golden rule is:

Not too expensive to

scare off potential users, and expensive enough to compensate all the construction costs and earn something for the State. It is the “art of plucking the goose without making it squeal”.

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Dupuit’s main contribution was to use the principle of marginal utility to analyze “consumer surplus” and applying the theory of “price discrimination” to reach its goal. This involves several basic theories:

the law of decreasing (or increasing) utility, how to

calculate consumer surplus (how the users feel profitable), how to charge small vehicles and big ones, and at the same time how to maximize the number of passengers. His work on economic analysis was published during 1844-53. A representative one was “De la mesure de l’utilité des travaux publics” (1844, translated by R.H. Barback as “On the measurement of the utility of public works”, 1952; reprinted in Kenneth Arrow and Tibor Scitovsky eds. Readings in Welfare Economics, Richard D. Irwin, 1969, pp. 255-83). Dupuit’s analytical approach is similar to that of Cournot: demonstrate the logic and argument. This is a key point:

using equations and diagrams to the French marginal school was

established by a mathematician (Cournot) and an engineer (Dupuit). This technical approach influenced the neoclassical school toward the late 19th century. Q:

In plain language, what is price discrimination?

A:

Its core concept is consumer surplus. Here is an example. Why were you willing to

spend money (or time) to buy (or read) this book? Because you estimate it to be worth more in something that you will gain (perhaps knowledge or insight). Between the gain and expenditure (monetary or otherwise) is consumer surplus. If the surplus is negative (paying $15, but feeling it is worth less than $10), then nobody will buy. Producer surplus similarly means profit. One is willing to produce something, because he expects to earn profit. When Dupuit’s roads and bridges were constructed, he considered several factors:

this is a good road and State owned, but there also exist other roads; so, this

new road has to be competitive. It must be no cheaper than others, but cannot scare off most users. Dupuit thus needed to consider the user’s perspective:

What are the benefits of taking

it? The new road saves time, but it is more expensive. Is that worthwhile? Some other minor variables appear:

Should it be charged by passenger or by vehicle or by other criteria (such

as identity or occupation).

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The overall purpose is simple, but not easy to do in practice:

maximize consumer

surplus and producer surplus at the same time. How? Simple, by price discrimination. We can explain it in three simple ways. The “first degree of price discrimination” is charge price according to age or occupation. Example:

movie theater tickets offer several types, one for military, one for teenagers, one

for adults, one for early show (matinee), etc. The “second degree of price discrimination” is charge price according to the volume or amount used. Example:

if you buy less than 100 dozen, no discount; for 100-500 dozen,

10% discount, etc. Another example:

one-way ticket, no discount; monthly ticket, 75% of

the full price; yearly rate, 50%. The “third degree of price discrimination” is charge price according to a user’s ability to pay. Example:

airplane or train ticket (first class for the rich, business class for CEO,

economy class for general public). These three examples are common in our daily life. They were not invented by Dupuit. Every society has known the concepts since the stone age, but it was this French engineer who put them up mathematically and in diagrams for public utility pricing. Cournot’s and Dupuit’s approach taken together has something in common. Apply scientific tools to analyze issues with key economic issues. Distill abstract principles from specific facts and statistics and then generalize the theory with diagrams and equations. They had a practical issue in mind, and from their scientific training they used deductive logic reasoning and mathematical form to reach “non-trivial insights”. If this story intrigues you, take a look at Secret Origins of Modern Microeconomics: Dupuit and the Engineers (1999).

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13 The Marginal school in Germany, Austria, and the U.K.

It is clear that economics, if it is to be a science at all, must be a mathematical science. ―William Stanley Jevons

We continue on in the same theme, but shift over to Germany, Austria, and the U.K. Germany and Austria speak the same language, but their respective marginal schools show different routes. As shall be made clear in this chapter, Austria’s marginal school was very different from the French one, both conceptually and analytically. From today’s perspective, we still live under the influence of the marginal schools of France and U.K., with the shadows of the Austria and Germany marginal schools relatively less conspicuous. You may wonder if Austria’s marginal school had anything related to the now famous “Austrian school.” Yes and No:

Yes, because if Austria’s marginal school in the late 19th

century was the grandparent, then the famous “Austrian school” since the 1930s represents the second and third generations. No, because their influence was on two distinct aspects. In this chapter we focus on their contributions to “marginal analysis”. In Chapter 21 we look at their “free market and anti-central planning” arguments. Q:

In Chapter 12 you mentioned that Cournot and Dupuit were a mathematician and

engineer. Their contributions greatly stimulated economic theories and applications. We also

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heard something about the German historical school in Chapter 11, but that school was using the macro-history-policy approach, which is unlikely to be a source of inspiration for marginal analysis, correct? A:

Right. As presented in Chapter 11, Germany in the mid-19th century was more in

the old political economy tradition, not yet having entered the stage of scientific analysis. Our two German scholars in this chapter did not belong to this mainstream, They were isolated, but original. Their works were ignored when alive, but like Cournot, they set the cornerstones for today’s microeconomic analysis. We first meet Hermann Gossen (1810-58), an ordinary civil servant. His only book Die Entwickelung der Gesetze des menschlichen Verkehrs, und der daraus fließenden Regeln für menschliches Handeln (The Development of the Laws of Human Intercourse and the Consequent Rules of Human Action, 1854) explicitly developed a theory of marginal utility. William Stanley Jevons (1835-82, also a part of the U.K. marginal school, see later) remarked that “it is quite apparent that Gossen has completely anticipated me as regards the general principles and method of the theory of Economics. So far as I can gather, his treatment of the fundamental theory is even more general and thorough than what I was able to scheme out.” His book sold very few copies. Disappointed, Gossen destroyed all the remaining stock. Jevons, after the publication of his The Theory of Political Economy (1871), was surprised to find that Gossen has foreseen his own theory. Jevons credited Gossen with an earlier discovery of marginal theory. Thus, Gossen’s destroyed book (1854) was reprinted in 1889 (in German). Gossen’s main contributions are twofold. One, the law of diminishing marginal utility: the more water you drink, the less you are satisfied, until you finally vomit if you drink way too much; then, the utility becomes negative. Two, the law of equal marginal utility or “equimarginal utility law.” This second law says that when the marginal utility of each dollar is equal, the total utility of your spending is maximized. MU1 MU 2 MU 3 = = P1 P2 P3

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∂U / ∂xi ∂U / ∂x j = ∀(i, j ) pi pj Gossen’s second law: equi-marginal utility law.

Q:

That is what we learned in the early chapters of basic economics, but I still do not

quite understand its importance. Can you tell us its secret? A:

This law is important in the sense that it provides, at the same time, a notion of

“equilibrium” and “maximization”; hence, “optimization”. This is a small but significant equation for analytical economics. Elegantly, it can be expressed in a clear-cut form by using basic calculus, instead of lengthy prose and examples. Gossen did it alone in Germany (actually Prussia) and died lonely, pardon the pun. Q:

Did another scholar also made an important contribution in Germany?

A:

Yes, Johann von Thünen (1783-1850). His main work was Der isolirte Staat in

Beziehung auf Landwirtschaft und Nationalökonomie (The Isolated State, Vol. 1, 1826, vol. 2, 1850). He developed a marginal productivity theory in this form: R=Y(p-c)-YFm, where R = land rent; Y = yield per unit of land; c = production expenses per unit of commodity; p = market price per unit of commodity; F = freight rate (per agricultural unit, per mile); m = distance to market. Q:

Why is this equation so special? Seems not.

A:

Yes, your feeling is the same when modern physicists read Newton’s Principia

Mathematica (1687). Two novelties appear though:

von Thünen expressed this relationship

in a functional form; he added two new variables in economic analysis: F = freight, m = distance to market. Both variables were often neglected in economic analysis, and this reminded economists about the importance of “distance”, which will be a key variable in the 20th century’s spatial economics, as the following diagram shows. Why was his book titled Isolated State? Because these concentric circles look like an isolated country: common structure of a European feudal economy.

it was a

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von Thünen used concentric circles to describe the location of economic activities

Q:

I still do not see its importance. Can you delve deeper?

A:

Of course. The classical school was concerned with three factors of production

(land, capital, labor) and three classes (landlord, artisan, farmer). von Thünen reminded us of an important variable that has long been neglected in economic activities:

distance. What

are the three most important factors for the value of a house? Location, location, location (sounds like a mantra). Location, distance, and freight are key elements in transportation economics and spatial economics. Q:

Was von Thünen famous among economists?

A:

He was highly admired by Alfred Marshall (Cambridge, U.K.) who once said:

“I loved von Thünen above all my other masters.” Recall that in Chapter 7 we discussed differential rent? In retrospect, von Thünen and Ricardo have a common concept:

Ricardo

said that difference in land productivity is the source of rent. Von Thünen explained that lands in different locations have different rents (economic value). Q:

Why do basic textbooks rarely mention Gossen and von Thünen?

A: Their personal lives were modest. A main reason was that their ideas were ahead of their times, and no one cared. Similarly, Léon Walras (1834-1910), another more important mathematical economist, could not find a job in France and emigrated to teach in (remote) Lausanne, Switzerland. He is now famous for general equilibrium analysis, but was totally

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neglected when alive (see Chapter 16). These early mathematical economists had a lot of troubles before the 20th century, but the situation now has totally reversed. Q:

Marginal analysis in Austria must be luckier, no?

A:

The Austrian school indeed had several masters, such as Joseph Schumpeter (1899-

1950), Ludwig von Mises (1881-1973), and Friedrich von Hayek (1899-1992). They belonged to the second generation (see Chapter 21), but our focus here is the first generation. The first representative figure is Carl Menger (1840-1921). He studied law at the University of Vienna and Prague University. In 1870 he published Grundsätze (Principles of Economics) and taught at the University of Vienna until his retirement in 1903. In 1876-78 he served as tutor to Prince Rudolf. His whole personal library is now at Hitotsubashi University (Tokyo), where one can see his meticulous notes (see Chapter 2 footnote 3). Q:

What made Menger original?

A:

We begin with his basic ideas and style of analysis. He believed that economic

behavior should start from the perspectives of subjective, atomic, and self-interest. The purpose of economic behavior is to maximize utility. Sound familiar? He agreed with Smith’s basic orientation:

freedom and self-interest. This explains why he was against collective

economy and central planning. Q:

What did he say about marginal analysis?

A: His famous example is what you are already familiar:

when very thirsty, the first

cup of water is highly useful. After three cups, the utility decreases quickly. Utility of the fifth cup might be zero or negative. Thus, we can assign a numerical value to each cup of water and rank their relative order. We term this as “cardinal ranking”. Since most utility cannot be expressed by numerical values, such as the satisfaction of meditation and the shocking feeling of witnessing an accident, economists abandoned Menger’s “numerical” utility approach and adopted another “ordinal ranking”, based on subjective preference. For example, someone may be very fond of counting money; the next thing is to be with handsome persons; the third is to buy luxuries. Vulgar? Yes, but that is his true preference order. Another person’s order may be different:

reading, praying, sleeping.

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You do not need to assign a utility value (such as 100, 80, 60) to anything; you only need to show their order (1, 2, 3), from best to worst. This approach is easier and more reasonable. Now you can see that Menger’s (numerical) marginal utility is not practical. Menger did have a useful concept:

opportunity cost. How do you know if it is a

blessing or a curse to do something? Your brain will calculate the cost and benefit. This kind of calculation cannot be converted into money, because it has no market, and everyone’s value system is different. It is all subjective. Opportunity cost is a kind of “imputed price” or “cost of choice” - it cannot be exchanged in the market. Q:

Did the marginal school in Austria propose other important theories?

A: Some of the Austrian school economists think so. We are in the opinion of No, because their ideas were not visible in today’s textbook. Here we only mention two key figures. Friedrich von Wieser (1851-1926) was born into a noble family. He studied law at Vienna University and became a public servant upon graduation. His main interest, however, was in academic research. He and his childhood friend Eugen Böhm von Bawerk (18511914, another figure of the marginal school) went to Heidelberg, Jena, and Leipzig Universities in Germany to study economics. Later on, they became brothers-in-law, marrying two daughters of their teacher. Böhm von Bawerk was active in politics and served as finance minister for ten years before returning to academia. Incidentally, he had a student named Joseph Schumpeter. In Ten Great Economists (1952) Schumpeter said that Böhm von Bawerk’s contribution to economic analysis was at the highest level as David Ricardo. If so, why did few economists recognize his originality? Q:

What about the British marginal school?

A:

An important one was William Stanley Jevons (1835-82). He was born into a

Christian family, who were concerned with socio-economic issues. At age 18 he went to Sydney to work in a mint, but went back in 1859 to study at the University of London and graduated in 1865. His education was science and engineer oriented, including mathematics,

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biology, chemistry, and metallurgy. In 1862 he published two economic analyses at the British Association:

one on the structure of utility theory and another on statistical analysis

of business. He published Pure Logic or, the Logic of Quality apart from Quantity (1863) and The Coal Question (1865), which attracted attention from the economics community. By that time he was 30 years old, and his main job was teaching at the University of Manchester. At age 36 he collapsed due to excessive stress. In August 1882, he tragically drowned in the south of England (aged 47). His personality was lonely and indifferent. He had profound knowledge and insights into classical music and believed that his talent and originality were close to the German composer Wagner. Two pieces of evidence show Jevons was a remarkable economist. It was estimated that by 1936, his nine major works totally sold out nearly 40,000 copies, which is a large amount given that time period. In 1936 Keynes dedicated to him a 52-page biography, reprinted in The Collected Writings of John Maynard Keynes, vol. 10:109-60.

Logic piano created by Jevons, 1869. Source: Wikipedia.

Q:

He was quite young and prolific. How did he contribute to marginal analysis?

A:

His insights on this issue are mainly in The Theory of Political Economy (1871),

which is a fully independent work and not influenced by anyone. He proposed four factors when measuring utility: intensity; durability; certainty/uncertainty; and close or remote. Trained in science and engineering, he stayed at home, using diagrams and equations to show different shapes of utility. He also discovered Gossen’s second law (see above), surprised to find that Gossen already did it, but more elegantly and sophisticated.

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Jevons showed how to calculate pain and happiness (utility)

The above diagram shows his marginal utility theory:

how to calculate pain and

happiness. There is a negative slope utility curve. A key novelty is that he used this curve to express the joy and pain of work. Based on that, he derived a utility curve that is above and below the horizontal OM line. It looks like a “backward bending labor supply curve”, which has been well explained in every economics textbook. Here is its basic idea. The labor supply curve is similar to the curve of “joy and pain of work”:

even if you

do not need to earn a living, most people still want to work; for some, 3 hours a day would be wonderful. In case you have a whole family to support that requires 15 hours per day, the desire to work (utility) will drop sharply after the 8th hour and be very painful after the 12th hour. Thus, your labor supply curve is backward bending. This figure was first proposed by Jevons. Although the form is somewhat different now, its basic spirit remains the same. His analytical skills were no better than the future Alfred Marshall (see Chapter 15), but matched those of the French engineer Dupuit. Jevons was skillful at constructing statistical data. Based on his meteorological knowledge, in 1862 he wrote an article to show how sunspot activities affected the business cycle. He tried to find the correlation between the years in which the sunspots were active, and the years in which crops were poorly harvested, and the years in which many commercial companies went bankrupt. His results showed that the sunspot activity cycle is 10.44 years on average, rather than 11.11 years as estimated by other scientists. He was excited about this, but this business cycle theory received little attention before and after his death. 15

15 To learn more, see Harro Maas (2005): William Stanley Jevons and the Making of Modern Economics; and Ivan Moscati (2019): Measuring Utility: From the Marginal Revolution to Behavioral Economics.

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14 Application and extension of the marginal school

Economic controversy is generally a thankless task. You cannot hope to make any impression on your opponent. Yet he is the only reader on whose interest you can count. ―Francis Edgeworth

The previous two chapters focused on the birth of the marginal school in France, Germany, Austria, and the U.K. We now turn to its application and extension by the second generation. Geographically, unlike the first generation, the key figures in this chapter are mainly in English-speaking areas, more in the U.K. and less in the U.S. Of course, the marginal school in France, Germany, and Austria continued, but in today’s view its impact was decreasing. Q:

How to distinguish the two generations?

A:

Some features are the same. Both used calculus and diagrams as the main analytical

tools; their interested issues were micro-level subjects like utility, consumption, industry, and competition. The first generation mainly worked on the demand side:

law of diminishing utility,

consumer surplus, and price discrimination; they treated supply as if “given.” The second generation pushed everything further:

considered both supply and demand at the same time;

the speed of internationalization was impressive, particularly in Western Europe and North

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America; Political Economy was now called Economics and became an independent field taught at major universities such as Oxbridge; academic journals emerged together with some research institutes. Q:

How did U.K. become a leader of the marginal school?

A:

It did so, mainly because there were several important innovators:

we have seen

Jevons in the previous chapter, and in the next chapter we will meet a landmark master Alfred Marshall, who promoted marginal analysis into what is now called the neoclassical school. His analytical techniques and the issues he treated have become the first chapters of today’s textbooks. Our theme here covers some other representative figures (mainly in the U.K.). We begin with Francis Edgeworth (1845-1926), who is famous for the Edgeworth Box.

The Edgeworth Box. Source: Wikipedia.

Its basic principle is simple:

when Abby and Octavio exchange their products X

(computer) and Y (banana) for three times (January, May, September), the traded price and quantity both vary. There are three intersection points in this diagram, representing their three transactions. Connecting these three points, we see an AO “transaction curve” (or contract curve). This is an important development in economic analysis, because we clearly note the price, time, and quantity of their exchanges. However, its limitation is also evident:

the Box

is helpless when there are more than four traders A, B, C, D with goods W, X, Y, Z. Q:

Edgeworth was also a scientist. Did he use mathematics like Cournot and Dupuit?

A:

He was an Irishman, who graduated from Trinity College (Dublin), went to Oxford,

and later became a professor of political economy. He was one of the founders of the Royal Economic Society (RES), a professional association that promotes the study of economic

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science in academia, government service, banking, industry, and public affairs. Originally established in 1890 as the British Economic Association, it was incorporated by Royal charter in 1902. Edgeworth was the founding editor of Economic Journal (an official publication of RES, first published in 1891) for 35 years until his death. His early main contribution was Mathematical Physics (1881), but not to be fooled by the title, it applied mathematics to economic issues. Another notable work was Papers Relating to Political Economy (1925). His basic concept came from “felicific calculus”. It was an algorithm formulated by utilitarian philosopher Jeremy Bentham (1748-1832) for calculating the degree or amount of pleasure that a specific action is likely to cause. The algorithm is also known as utility calculus or hedonic calculus. This inspired Edgeworth to formulate human behavior as a machine of utility with given resources to pursue greatest happiness. Three of his contributions are still widely used today: indifference curve, 16 the pricing strategy of the oligopolistic competitor, and a diagram to show the relationship between marginal and average output. Edgeworth initially used the example of Robinson Crusoe and Friday (an escaped prisoner that Crusoe helped, naming his new companion “Friday” after the day of the week he appeared). To survive better together, each has three ways to cooperate with one another. This early version conveyed three simple but important concepts: everyone has several indifference curves; they mutually benefit (win-win) when in equilibrium; connecting these equilibrium points gets a contract line. An earlier version of the contract line is straight, but the current version is in non-linear form (see the Edgeworth Box diagram above). In Chapter 12 we discussed Cournot’s competition theory concerning two monopolists of mineral water. This decision-making model assumes that the rival’s strategy (reaction function) is fixed (not adjustable), and so there is always an equilibrium solution. Edgeworth

16

A curve connects points on a graph representing different quantities of two goods that will provide the consumer with equal levels of utility. The consumer has no preference for one combination or bundle of goods over a different combination on the same curve; hence, the term “indifferent curve”.

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disagreed, because in real life monopolists will adjust dynamically, vis-à-vis a rival’s strategy:

it is unlikely to have only one single equilibrium solution.

Edgeworth revised Cournot’s two hypotheses:

strategically, the monopolist is able to

adjust the output, which can be more or less than market demand; the monopolist is able to discriminate by price, by quantity, by contract, by identity (military or student), or by any other means. Under these complex strategies, there will be no single equilibrium point in the market. Instead, after long-term competition there will be a “equilibrium zone”, which Edgeworth named the “price war zone”. Q:

It sounds closer to the reality than Cournot’s model. How was it criticized?

A:

No theory is without criticism. The following three seem reasonable, but it is not

fair to Edgeworth - even if his model has these shortcomings, it was important that he provided new and useful basic properties. 1) In Edgeworth’s duopoly model, it seems that there is only one market for both monopolists. This is an unreal implicit assumption. A real market competition is, taking Coca-Cola and Pepsi-Cola as an example, that both sell drinks in the same market area (Boston for instance); there is no difference in distance and location, but each has its own loyal fans. The markets for Coca-Cola and for Pepsi-Cola are in reality distinct (not by location, but by fans). In other words, usually the cola market is in plural form and not a single one as Edgeworth assumed. 2) In his model it seems that both competitors are unaware of each other’s reactions (functions) and pattern of past strategy. Since both competitors have been fighting each other over a long time, the information on both sides should be nearly symmetrical. 3) It is reasonable to assume both competitors do not adjust their strategy in the short run, but in the long run each player will develop new products and hire new CEOs to design new advantages. Therefore, market competition is bound to be complex and unstable. Q:

It is amazing that the theory of competition was well developed so early. Any other

similar competition theory toward the end of the 19th century?

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A:

Chapter 17 will discuss the theory of imperfect competition, where the concepts of

increasing returnss to scale, external economy, and monopolistic competition will appear. All these will advance the analysis greatly. Its progress is amazing, as competition theory today has to be expressed in game theory via complicated mathematical formulation. Now how about a quick look at another contribution of Edgeworth. This issue is widely taught in freshman economics. Our point here is not what it means, but to show his skillful presentation of their essential relationship in production theory. You may have heard of total product (TP), marginal product (MP), and average product (AP). Indeed, it was Edgeworth who showed their relationship in diagram.

Relationship between total product (TP), marginal product (MP), and average product (AP)

Q:

This reminds me of the idea of the envelope curve, also taught in basic economics.

It has two features: 1) The producer’s short-term marginal cost (MC) will be “touched” at the lowest point of the short-term average cost (AC). 2) Linking these lowest points (envelope) brings about the long-term average cost curve. Is this an extension of Edgeworth?

Envelope curve

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A:

No, that is a much later idea. The envelope curve was proposed by Jacob Viner

(1892-1970), when he was teaching at the University of Chicago. His main contribution was theory of international trade and history of economic thought, as well as a famous biography on Adam Smith. When he had the idea for the envelope curve (about 1931), he initially thought that the long-term average cost curve (LAC) should connect “all the lowest points” of the short-term average cost curve (SAC). Viner asked a Chinese graduate student in mathematics to draw a diagram for publication, but that student said is was impossible: LAC cannot connect “all the lowest points” of SAC. Viner was astonished. What went wrong? Why is the LAC curve not the connection of the lowest point of SAC? Viner tried to extend Edgeworth’s short-term analysis to a longterm case, but got an unexpected result. This episode and the “un-smoothness” made the envelope curve famous. Q:

Okay, so the American economists also played a role in the marginal analysis.

Something important happened in the U.S. economics before the 20th century? A:

Not yet as significant as in the U.K., but some deserve a brief discussion. One is

John Bates Clark (1847-1938). In his honor the American Economic Association established a Clark medal in 1947 to award economists for their work in the U.S. under the age of 40 every two years, but now annualized since 2009. Among those who were awarded before 2009, 12 also obtained the Nobel prize. One of Clark’s contributions was to explain income (salary, profit, rent) under a marginal framework. Why do you earn $5,000 per month? That is because your marginal output is valued at $5,000. This statement seems scientific as it can be expressed in calculus, but it does not fit with reality. Most junior scholars work almost 12 hours a day and 7 days a week with a modest salary. As a professor is approaching retirement, both his working hours and ideas have decreased sharply, but his salary is much higher than his junior colleagues. How can we explain this “negative correlation” with Clark’s theory of marginal productivity? The real world does not work like that, as most salaries are set “institutionally”, either by the State or

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enterprises, adjusted according to age and rank, not productivity. Is the President of the U.S. and other countries paid by their marginal productivities? If so, how do we measure and compare them scientifically? Q:

Why have economists accepted this theory?

A:

Partly because it is a scientific form expressed in calculus, and partly because this

is in the best interest of capitalism. Economic tycoons embraced this theory, because it can explain the legitimacy of their huge wealth:

their marginal productivity is very high. Why

are some people poor? Their marginal contributions are not good enough. If so, then the second generation of tycoons must have very high productivity when they were born. Q:

Reminds me of a theory called social Darwinism. Is that related to marginal

productivity? A:

You are familiar with Darwin’s dictum such as natural selection and survival of the

fittest. Social Darwinism is a kind of application of this idea:

how to prove which one is

suitable for surviving? Marginal productivity would be a good indicator, because it is a neutral notion; it has nothing to do with social background. As long as you work hard or are smart enough (lawful or not) to work out something useful, the marginal productivity theory supposes that you deserve that fortune. When Clark proposed his marginal doctrines at the turn of the 20th century, the U.S. economy was on the upswing, with its population and capital expanding rapidly. By the time of the 1929 Great Depression, few believed in this explanation. Q: Was there any objection to this doctrine before 1929? A:

Certainly. One example is Henry George (1839-97). He believed that some profits

are unreasonable, such as the soaring value of land in Manhattan, which has nothing to do with the marginal contribution of the owners. Rather, the high land price is the result of social progress and economic growth, not any individual’s contribution. Q:

We often see that CEOs of big corporation earn millions of dollars a year or more,

plus huge dividends and fringe benefits. If the marginal productivity is incorrect, why does it work all the time?

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A:

Extraordinary CEO packages have attracted many outstanding people to pay the

high tuition for an MBA degree. This American model is now almost a worldwide phenomenon. In Asia the supply of people with an MBA has long exceeded the demand, so much so that people now believe MBA stands for More Bitterness Ahead. CEOs of large companies only sign short-term contracts, and they can be replaced by their board of directors when necessary. CEOs have to maintain high self-productivity, but few can keep the same pace for decades. This kind of short-term excessive reward is called “efficiency wage”:

it is paid for the best part of your productivity; when your productivity

goes down, it is time to appoint a new replacement. To be a bit off-topic, professional hitmen and commissioned special agents are often rewarded with an efficiency wage, for their single and dangerous task (with very high marginal productivity) that they must achieve. The salary of most ordinary people does not work in this way:

it is basic pay plus year-

end bonus. Why? Because it is not easy to measure an employee’s marginal productivity objectively and precisely. The overall marginal productivity of an enterprise is a complex combination of manpower, capital, equipment, and external factors (such as trade wars, fuel costs, etc.). That is why most salaries are set institutionally. Marginal theory is scientific, objective, and reasonable in analysis, but hard to fit in the real world.

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15 Alfred Marshall and the foundation of the neoclassical school

Jevons saw the kettle boil and cried out with the delighted voice of a child; Marshal too had seen the kettle boil and sat down silently to build an engine. ―Collected Writings of Keynes, volume X: Essays in Biography

As the analysis of political economy progressed toward the late 19th century, the dominance of English-speaking countries became evident. This chapter focuses on a landmark figure:

Alfred Marshall (1842-1924), University of Cambridge. On the one hand,

he inherited both the spirits of the classical school and the scientific methods of the marginal school; on the other hand, and more importantly, he proposed original concepts and analytical tools that are still widely used. Marshall influenced generations of economist at home and abroad and also paved the way for the future John Maynard Keynes to rise up, who became even more influential around the world, both in theory and in policy. Together with many of their colleagues and students, Marshall and Keynes marked an epoch of Cambridge economics in the 1890s1940s. Q:

What made Marshall’s analysis unusual?

A:

His father was a cashier at the Bank of England and often pushed his son to study

late into the night, but he felt uncomfortable with his father. Marshall read mathematics at

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Cambridge and was nicknamed “white candle” since a young age due to his gray and old face. His personality is sorrowful, he showed great concern for the poor, and he even tried to be a pastor. After graduating, he worked as a mathematics teacher and showed interests in ethics, metaphysics, and political economy. He began to teach political economy at Cambridge in the late 1860s. Inspired by the works of Cournot and von Thünen, he realized the potentiality of using mathematic on economic analysis and tried to render the works of David Ricardo and J.S. Mill into mathematical form. Stimulated by the concepts and analysis from physics, biology, and mathematics, economic analysis reached a new point of explosion; Marshall was a bright star at this historical turning point. Marshall did not rush himself to get published; quite often when economists have some good ideas to announce, their first worry, funnily enough, is whether Marshall had already done them, but just kept the papers in his drawers. This scared off many people to publish. Marshall was asked why he published so little? He once said that it was too early for J.S. Mill to declared in 1848 that the theory of value has been constructed; he also felt that Jevons made too many claims of originality. Marshall did not think that getting published was so essential. He began to construct the mathematical foundations of economic theory in the 1870s, but only published them 20 years later. He put all mathematical analyses in footnotes and appendices for experts only. The main text is for general readers to understand the messages and examples extracted from rigorous analysis. Marshall was knowledgeable in scope and scale and was an economic theorist, humanitarian caretaker, mathematician, and historian. He believed that the most important field for economics to “imitate” was biology (not mathematics nor physics), because biology reveals the best mechanism of Mother Nature. Economic theory does not reflect reality; it is just a simplified way to describe an economic phenomenon. Biology understands how Nature has evolved: same thing.

it is a way of seeing, not a prescription to change. Economics should do the

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Q:

Marshall changed the term Political Economy to Economics. Why?

A:

Possibly to avoid connection with the Marxian political economy that emphasizes

class struggle and ideology. Marshall tried to establish a kind of scientific neutral analysis as an independent professional field. Of course, he understood that economic behavior cannot be detached from society, politics, psychology, and history. In his own words: “Nature draws no such sharp lines.” Why promote economics as a separate field? He thought that the wider a field is, the lower is its scientific precision, and vice versa. Economic analysis must be detached from politics and society, in order to become a precise and professional subject. He thought that the main purpose of economics is not to study currency, price, income, GNP, utility, competition, etc. Rather, economics 1) is “a study of mankind in the ordinary business of life,” which can be understood as studying behavior in daily life; 2) “examines that part of individual and social action which is mostly connected with the attainment and with the use of the material requisites of well being.” This can be restated as:

economics

explores the individual and social behavior, how to get what you want, and using the necessary things to improve welfare. In this definition, Marshall was concerned not about cost and benefit, nor efficient use or distribution of resources, let alone GNP and income distribution, nor international trade or industrial competition. All these aspects have been elegantly and implicitly implied in the above two small sentences. Q:

Isn’t Marshall’s definition too broad?

A:

He was open-minded and allowed everyone to define economics. In his mind, the

primary goal of economics is to eradicate poverty. Economics is the study of “practice”; theory is useful for thinking and being logically correct; a means rather than an end. He was excellent in theoretical deduction, but that is only a process, not a goal. Most economists focus on the study of “needs”, while Marshall valued more on “behavior”. This realistic attitude combined with the superiority of his skills, plus those manuscripts kept in drawers, made him the most “feared” person in the economics world.

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Q:

What does “Natura non facit saltus” mean, as it appeared on the title page of his

Principles of Economics? A:

We begin with Principles of Economics. Marshall started it in 1881, and when it

was published in 1890 he became a leader of this field. It was revised eight times before his death. The Royal Economic Society commissioned C.W. Guillebaud (Marshall’s nephew) to edit a 2-volume “ninth variorum”, published in 1961 by Macmillan. Guillebaud’s detailed index was very helpful for researchers to observe the evolution of Marshall’s ideas and concepts. Now coming back to Natura non facit saltus (Nature does not leap), what does this mean? Marshall’s undergraduate education was mathematics, but he believed that biology (natural evolution) is the best model for economics. In mathematics, Marshall admired the calculus created by Gottfried Leibniz (1646-1716) and Isaac Newton (1642-1726), and in biology he admired Darwin (1809-82) the most. All these three heroes of his quoted that dictum (above) from Aristotle (384-322 BC). Its central message is that Mother Nature evolves slow rather than drastic; it is a Darwinian notion. Using mathematics language, changes are continuous and differentiable. In the context of physics, Einstein said that “God does not play dice with the universe.” In the context of biology, genes “mutate”, but not “jump”, because the scale is so small and the pace is slow enough. Q:

Why he used to put mathematics and diagrams as footnotes and appendices?

A:

On 27 February 1906 Marshall wrote to statistician Arthur Bowley (1869-1957): I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypothesis was very well unlikely to be good economics: and I went more and more on the rules - (1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I do often.

Why was Marshall able to conquer his readers overwhelmingly? A key factor is (3) and (4). In the main text he preferred to use plain prose and avoided technical terms. He was

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also good at using examples from current events and history. For expert readers, they certainly sensed its importance behind these obvious examples and thus admired its deep meaning and the author’s power of abstract reasoning. Q:

These six steps are impressive. Are they applicable to our 21st century world?

A:

Cambridge Journal of Economics (founded in 1977, bimonthly), quoted these six

rules in Notes for contributors before 1987, but then removed them. Editors of major journals often remind authors not to be too technical in the main text; and it is better to put mathematic proofs as an (online) appendix. Marshall understood the usefulness and limits of mathematics:

for readers who are not expert on that issue, what is important are the fruits

(findings), while leaving the technical online for experts to verify. Mathematics is like a sword:

very sharp and unarguable; it is a good weapon, but not

the final goal. Good stories and concepts are more important than good mathematics; just like good news is more important than a good smartphone. If economics is simply a kind of applied mathematics, then Marshall would use prose to convey inspiring messages. Q:

Was Marshall ambitious to integrate mathematics, theory, and history?

A:

Schumpeter had a similar idea many years later. He said that a “scientific”

economist is competent in three techniques:

theory, history, and statistics. Marshall was a

mathematician, but he was aware that history played a major role in the classical school, as evident from Wealth of Nations. Marshall’s theoretical and deductive logic was mainly influenced by Ricardo (see Chapter 7), whose deep insights impressed Marshall. Looking back, the macro-vision of the classical school and the mathematical skill of the marginal school were combined and reincarnated in Marshall. Q:

Is there evidence to support this claim?

A:

Look at his Principles of Economics:

1) “Appendix B The Growth of Economic

Science” demonstrated his familiarity with and commentary on history of thought. 2) “Appendix C The Scope and Method of Economics.” 3) “Appendix D Uses of Abstract Reasoning in Economics.”

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Marshall did have a drawback:

he often did not provide a clear definition for a

concept. If you read “quasi-rental” from Guillebaud’s “ninth variorum” index, you will find that Marshall provided 26 different ways to express this new notion. Why was he so inaccurate? Probably, when he put forward a new concept, the mathematical expression was not ready to be described exactly. He was trying to capture the possibilities from various angles, but the results were confusing for readers. Researchers on Marshall could also have observed this phenomenon. It is a kind of “ambiguous originality”. Q:

Was Marshall not proud of his best mathematical analysis?

A:

No, if you closely read Principles of Economics, it has a long Mathematical

Appendix (pp. 690-706), which is hard to believe considering this was done in the 19th century. Take Note XXI (pp. 703-4) as an example. It deals with the following issues:

1)

joint demand; 2) composite demand; 3) joint supply; 4) composite supply. In 1908 Marshall wrote to American economist J.B. Clark (see previous chapter), revealing his concern for this Note XXI:

“My whole life has been and will be given to presenting in realistic form as

much as I can of my note 21”. Marshall wrote to Bowley on 27 February 1906 as cited earlier, in which “(5) Burn the mathematics”. The long Mathematical Appendix (pp. 690-706) is a kind of “unburned pearl”: it is an essential foundation of modern mathematical economics. Marshall perceived that the external world is changing all the time, and it is impossible to have a complete theory to grasp such complex reality. He believes that “A man is likely to be a better economist if he trusts to his common sense, and practical instincts, than if he professes to study the theory of value and is resolved to find it easy.” Q:

In this view, it sounds like economic theory is useless, right?

A:

In his view economic analysis has four difficulties. 1) Interdependency among

related factors; one mutation will affect others, and so essentially it is non-stationary. 2) As time progresses, it brings changes, and so it is also dynamic. 3) There are also unexpected external disturbances that make the analysis inherently risky. 4) To obtain accurate results in

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physics, one is allowed to control other factors, but human society and economic issues are different:

accuracy and reproducibility are unlikely.

Given these four qualities, economics can only rely on the “ceteris paribus” (other things being equal) clause, assuming everything else is unchanged, and that is why it is called partial equilibrium analysis. Despite this shortcoming, it is the best way to approximate the facts and has predictive power within a short period of time. Stated differently, Marshall adopted this “one-step and partial analysis”, narrowing the problem down to be more manageable. He treated issues in a “small but powerful” manner. Q:

Is this related to his notions about “time in economic analysis”?

A:

Yes, he divided economic time into four categories. 1) Market period:

short trading time in which supply is fixed or completely inelastic. 2) Short run:

A very producers

can change quantity, but cannot change the equipment. 3) Long run: plant and equipment can be adjusted, as well as all other costs. 4) Secular period: everything such as price, technology, population are changing. The length of time is not the same for all industries. The steel industry finds it difficult to adjust in five years, but three years or shorter is normal for the computer industry to do so. Hence, the long term and short term are not calendar time, but rather the speed of adjustment in that industry. Marshall was very interested in the time aspect. In 1908 he wrote to Clark that he had five major problems yet to be resolved:

the first thing was the analysis of time.

Q:

He invented the supply and demand curves, right?

A:

This is the most well-known figure in basic economics, nicknamed as Marshall’s

cross for its appearance. The earliest presentation of this curve was from Fleeming Jenkin (1833-85), an engineering professor at the University of Edinburgh, Scotland. In 1870 Jenkin published a paper “On the Graphic Representation of the Laws of Supply and Demand, and

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their Application to Labour”, in which he clearly defined:

1) supply and demand are

functions of price; 2) demand curve has a negative slope, supply curve has a positive slope; 3) their intersection is an equilibrium point of price and quantity; and 4) this equilibrium point is achieved through market competition. Q:

Did Marshall add anything new to this Cross?

A:

It was mainly interpretive. One wonders if it is the supply curve or the demand

curve that determines the equilibrium point. Marshall had a good metaphor:

when the tailor

cuts the cloth, is it the upper blade or the lower blade doing the cutting? Both blades move up and down at the same time; the same is for the demand and supply curves. Economic behavior is not an isolated action; just like three dices in a bowl, they will collide with each other with different results. Marshall tried to say that supply, demand, and price are three interactive dices; when the power is stopped (when marginal utility = 0), the equilibrium point will appear (stable state). A:

If price is the independent variable, why is it on the y-axis?

Q:

Good question. Scott Gordon in his “Why Did Marshall Transpose the Axes?”

Eastern Economic Journal, 1982, 8(1):31-45, offered a useful answer. Doing it that way (on the y-axis) allows for a better explanation of the welfare implications (consumer and producer surplus) and hence more relevancy for policy. Q:

Are any of Marshall’s original concepts still useful today?

A:

Yes. Elasticity, usually defined as “the variation in demand in response to a

variation in price. It may also be defined as the ratio of the percentage change in demand to the percentage change in price of a particular commodity” (see below). = Ed

% change in quantity demanded ∆Qd / Qd = % change in price ∆P / P E= d

∆Qd / Qd P dQd = × ∆P / P Qd dP

You likely know there are three cases: elasticity =1, >1, and