Classicals After Smith

1. Classicals After Smith ECON 205W Summer 2006 Prof. Cunningham

2. Jean Baptiste Say(1767-1832) • Background • In 1788, at the age of 21, read Smith’s Wealth of Nations • In 1803 (1814, 1821) wrote Traite d’Economie (Treatise on Political Economy) • Became a popular textbook of economics in Europe and the U.S. • Used at Harvard as late as 1850,Dartmouth as late as 1870 • Jefferson liked the book

3. Say (Continued) • Emphasized that labor, land, and capital are all involved in production. • Thought that counties are rich and powerful in proportion to the lowness of prices. • Equated value with utility

4. Say’s Law • “…it is production which opens a demand for product.” • Supply creates its own demand • No one sells without an intent to buy • Endorsed by Ricardo, attacked by Malthus.

5. William Nassau Senior(1790-1864) • 1825, became the first professor of political economy at Oxford. • Believed we should separate the science of political economy from value judgments, leading to the modern notion of positive economics.

6. Senior (2) • Senior’s four propositions: • People wish to maximize wealth at the lowest sacrifice. (Principle of income or utility maximization) • The population is limited only by moral or physical evil, or by the fear of a deficiency of wealth that each class of inhabitants thinks they need. (Principle of population.) • Labor productivity is not limited, but increases as capital is brought to bear. (Theory of capital accumulation.) • Principle of diminishing returns to agriculture.

7. Senior (3) • Abstinence Theory • Cost is subjective • The costs of production are the labor of workers and the abstinence of capitalists. (People have to be paid to abstain from consumption to give up their buying power to purchase capital.) • This makes saving a function of interest.

8. Senior (4) • Policies: • Favored the Poor Laws of 1834. • Thought that the living conditions of those receiving welfare ought to be worse than those of the lowest paid workers. • Should discourage able-bodied workers from applying for welfare. • Opposed to trade unions because they interfered with the market process and the mobility of labor. • Factory Acts. • Favored child labor laws, but did not favor laws restricting the hours of adults.

9. Thomas Robert Malthus (1766-1834) • Background • An Essay on the Principle of Population, 1798 • Considered the plight of the poor and unemployed • Recessions caused by deficient demand. (Anticipates Keynes) • Principles of Political Economy, 1820.

10. Malthus (2) • Setting • An Essay on the Principle of Population • The population, left unchecked, will grow at an exponential rate.(e.g., 1,2,4,8,16,32, … ) • The food supply will grow at an arithmetic rate.(e.g., 1,2,3,4,5, … ) • Argued that the population, unchecked, doubles every 25 years.

11. Malthus (3) • Offers two different types of checks to population growth: • Preventive checks (reduce the birth rate) • Positive checks (increase the death rate) • Argued that poverty and misery are the natural punishment for the failure of the “lower classes” to exercise moral restraint. • Did not advocate gov’t relief for the poor. • Aid would increase the population growth rate, making matters worse.

12. Malthus (4) • Some of Mathus’ ideas found their way into the harsh Poor Law Amendment of 1834. • Abolished all relief for able-bodied people. • Thomas Carlyle, after reading Mathus’ book, called political economy “the dismal science”.

13. Malthus (5) • Theory of General Gluts • Workers receive a subsistence wage • Their marginal product is more than their wage, so that their employer makes a profit. • This means, he says, that workers do not have the buying power to buy the goods they produce. • Capitalists have more income (profits) than they can spend on consumption goods. The capitalists also spend some of the income on capital goods. All in all, the capitalists do not spend all their income. • This leads to insufficient demand, inventories build up, lay-offs follow  unemployment.

14. Malthus (6) • Policy Recommendation • Force spending by landlords to make up for deficient demand. • Tariffs promote domestic consumption. • Keep taxes low. • Maintain low government debt since high gov’t debt causes inflation. • (Opposed to redistribution of income)

15. Malthus (7) • Summary • Absolves the wealthy and the government for responsibility for the poor. • Focused on rents and spending by landlords. • Diminishing returns in agriculture. • No forethought for technological improvements. • There is still a “Malthusian problem” in developing nations. • Anticipated Keynes in assuming that the difference in employment levels in the macroeconomy was due to insufficient demand. Keynes referred to Malthus as his predecessor.

16. David Ricardo(1772-1823) • Background • 1817, Principles of Political Economy and Taxation • At 27, read Wealth of Nations • Argued for tax on capital, even though it would have cost him personally. • Always focused on gain vs. loss; was able to reduce everything quickly to its essence; thought in terms of rational, economic, profit-maximizing consumers • Used abstract, deductive analysis.

17. Ricardo (2) • Staunch supporter of the classical system. • Recognizes flaws in Smith, but still sees it as the best available theory. • It is clear in his writing that he has different purposes and motivations than does Smith.

18. Ricardo (3) • Smith was a moral philosopher • Ricardo was not a philosopher at all. • In his Principles he uses an abstract presentation to make these key contributions: • Labor Theory of Value • Differential Rent Theory • Falling Rate of Profits • International Trade (Comparative Advantage) • Modifications of Say’s Law • Theory of Employment

19. Ricardo (4) • Currency Question • 1797, in the midst of a panic during a war between England and France, the government suspended the gold standard. • Gold price rose from the official government price of 3.17 pounds to 5.10 per ounce. • The “question” was “Why is the market price of gold was rising?” • Ricardo argues that it is a result of the quantity theory—over-issuance of money. • Paper money had changed value, not gold. • Seigniorage was driving over-issue. • Argued that if the Bank of England reduced its issuance of paper money and moved to a bullion standard, it could resume the gold standard at a favorable rates.

20. Ricardo (5) • Diminishing Returns and Theory of (Differential) Rents (land rent) • First economist to use the marginal principle. • Price of rents related to marginal productivity of the soil.

21. Ricardo (6) • Labor Theory of Value • For a commodity to have exchange value, it must have use value. Possessing utility or use value, commodities derive their exchange value from (1) scarcity and (2) quantity of labor required to produce them. • Argues that raw materials and capital gods used up in the process of production are embodied labor. • Recognized that differing capital-labor ratios in industries could result in different returns to capital if goods were sold at prices related to labor cost. • This could not happen in a market economy because capital would flow toward the higher return and therefore equalize. • Labor time accounts for 93% of the value of a commodity? • Also allows for differential labor productivity.

22. Ricardo (7) • Distribution of Income • His major concern was understanding the forces that determine the shares of the national income accruing as wages, profits, rents (functional distribution of income). Thought this was more important than understanding the nature and causes of wealth. • All things have a natural price and a market price. • The natural price of labor is that price which allows workers to subsist and perpetuate themselves without a change in their numbers. • Market prices depend upon supply and demand.

23. Ricardo (8) • In the long run, the natural price of labor rises because diminishing returns will make food more and more expensive. • In the long run, workers will only make a subsistence wage—this is called “the iron law of wages” • Fertility rises and falls with wages, related to customs and habits, not just biology. • Because of declining fertility of soil, rents will fall. • Profits equalize across industries by attracting capital and labor, but will fall because profit is the residual claimant to revenue.

24. Ricardo (9) • International Economics • Smith and Cantillon argued that absolute advantage was the explanation for trade. • After the industrial revolution in the UK, the UK arguably had an absolute advantage in every manufactured commodity. • Ricardo argues the law of comparative advantage. • Smith had trouble with trade in services, which Ricardo did not suffer.

25. Ricardo (10) • Say’s Law • In the main, Ricardo agreed with Say’s Law. • In his arguments with Malthus, he did back-track on Say’s Law, or at least allowed that Say’s Law might not guarantee full employment equilibrium. • Ricardian Equivalence Theorem.

26. Jeremy Bentham(1748-1832) • Studied history and Latin at age 4. Entered Queen’s College at 12 and graduated at 15. Then he studied law. Moved on to study more broadly. • Left his estate to University College, London. Still present at all board meetings…

27. Bentham (2) • The greatest good for the greatest number. • Individuals are hedonistic. They seek to maximize pleasure and minimize pain. • In seeking individual happiness, they may not necessarily cause the greatest collective happiness. • Gov’t and law, moral and social sanctions, are designed to direct individual pursuit into maximum social utility. • Wealth is a measure of happiness, but has diminishing marginal utility.

28. Bentham (3) • Argues that the state ought to serve the people instead of the people serving the state. • Thought the government ought to have monopolies on: • Issuance of currency • Retirement plans • Life and health insurance • Hoped to make morals an exact science. • Problems of measuring utility cardinally and objectively.

29. Bentham (4) • Criticisms: • Bentham chose money as his cardinal measure. But people have different subjective valuations of things, which cannot be compared. • Many critics claim utilitarianism is deficient as a philosophy. • Perhaps people are not purely hedonistic. • There are other viable theories of human behavior—Freudian psychology, cultural anthropology, etc. • Should government make the pursuit of happiness its guiding principle? • Utility theory did become a foundation of microeconomic theory.

30. John Stuart Mill(1806-73) • Made contributions to economics, philosophy, logic, political science • Broad concerns: • Mankind’s position in the cosmos • Each person’s relationship to society • The rules that govern thought • The natural laws of human action • Not as interested in the growth of production or efficiency as he was interested in the quality of life and the full development of the individual. • More social philosopher than technical economist. • Law of the true classicals

31. Mill (2) • The development of society depends upon the development of the individual. • Optimistic about the economic progress of society • No Malthusian argument • No declining rate of profits • Belief in progress • Softer view on social issues • Classical economist who was a modern liberal?

32. Mill (3) • Autobiography (1873) • Driven by his father • “…grew up in the absence of love and the presence of fear.” • Nervous breakdown at age 20. • One of the greatest geniuses of all time. • Close to Bentham and Ricardo

33. Mill (4) • Utilitarianism (1861, 1863) • Generally supported Bentham’s calculus of pain and pleasure • Modifications • Quality of life is also important • Recognized that pleasure may be subjective • “It is better to be a human being dissatisfied, than a pig satisfied.”

34. Mill (5) • Considerations on Representative Government (1861) • Proposed to give extra votes to individuals possessed of “mental superiority” • Mills’ Market economics was softened by his socialist leanings and sensitivity to social problems • Something of a romantic • From Saint Simon, he learned to favor the emancipation of women, and did not approve of great wealth being inherited. • Sought a philosophy of history

35. Mill (6) • Harriet Taylor • Essays on Some Unsettled Questions of Political Economy, written 1829-30, published in 1844. • First essay: theory of international trade • Develops his theory of “reciprocal demand”, and what is now known as the “terms of trade” • Examined losses due to taxes—who winds up paying a tax (in his example, an import duty)

36. Mill (7) • On Say’s Law • No one sells without an intention to buy; therefore, by definition, a seller must be a buyer. • Mill sees this as incontestable • Money can divide this operation into two different transactions—”you need not buy when you sell.” • Therefore, a general over-supply may be possible. • Builds a theory of business cycles based on expectations.

37. Mill (8) • On Methodology • Uses the term economist, and sees political economy as something different from economics. • Constructs homo economicus • Abstract analysis, testable hypotheses • Need to examine extreme cases. • Preferred a multidisciplinary approach

38. Mill (9) • Logic (1843) • Principles of Political Economy (1848) • Immediately accepted as authoritative • An attempt to write a new Wealth of Nations? • Divided into 5 books (vs. Smith’s 4) • Production, Distribution, Exchange, Dynamics, Influence of Government • The way he distinguishes between production and distribution opens the door to socialism. • Discusses diminishing returns • Views laissez-faire in a different way from Smith

39. Mill (10) • Theory of Value • “There is nothing in the laws of value which remains for the present or any future writer to clear up; the theory of the subject is complete.” • Divides economics into statics and dynamics. • Argued that profits would fall until net capital accumulation would not be profitable; net increases in capital would stop. Growth would stop. The economy would reach a stationary state. • Thought this might be good, liberating.

40. Mill (11) • Considered the future of the labor force • On Liberty (1859) • Skeptical and unenthusiastic about government • Need to safeguard individual freedoms • Conscience • Thought • Discussion • Association • Persuit of preferences • “Society has not warrant to protect the individual from himself; its legitimate function is only the protection of others. • Strict libertarian in many matters, more of a modern liberal in other matters.