Lecture Two

1. Lecture Two Economic Thought from Mercantilists to Adam Smith

2. Recap • Feudal ideology significantly anti-capitalist, anti-financier. But • Merchants essential • “Exotic” commodities from other lands • Trade between different fiefs/kingdoms • Finance essential • Merchant activity • Wars • Merchants tolerated (but controlled, taxed) • Usury laws circumvented:

3. A B Pays A-C costs C Medieval fiction to circumvent anti-usury laws Same religion Lends at no interest B fails to repay A Insures A in case B fails to repay Pays C interest rate for insurance • Effectively, a “different set of books” to disguise breaching the laws against usury

4. Medieval Breakdown • Feudal system imposed many imposts upon merchants/tradesmen/moneylenders; but social change went against feudalism: • Growth of specialist manufactures in towns: the guilds • Growth of specialist traders between nations: the Mercantilists • Revolt against religious strictures against merchants/lending, church hypocrisy • Religious revolts: beginnings of Protestantism bound up with growth of merchants/financiers • A new ideology/analysis struggled for dominance: Mercantilism

5. Mercantilism • Justice out the window: the aim is gain • Buy cheap and sell dear; sell lots and buy little • “suppose Pepper to be worth here two Shillings the pound constantly, if then it be brought from the Dutch at Amsterdam, the Merchant may give there twenty pence the pound, and gain well by the bargain; but if he fetch this Pepper from the East-Indies, he must not give above three pence the pound at the most, which is a mighty advantage…” [Mun, OREF 18]

6. Mercantilism • Focus is international trade, rather than internal commerce • Nationalism essential: promote nation by gain from trade • Trade imbalance the object: export more than import • Self-sufficiency the domestic object • Pro-commerce and finance, but many contradictions • Promoted exports, restricted imports, no attention to system of production. A trader, rather than producer, perspective

7. Mercantilism • “It is needful also not to charge the native commodities with too great customes, lest by indearing them to the strangers use, it hinder their vent. And especially forraign wares brought in to be transported again should be favoured, for otherwise that manner of trading ... cannot prosper nor subsist. But the Consumption of such forraign wares in the Realm may be the more charged, which will turn to the profit of the kingdom in the Ballance of the Trade, and ... enable the King to lay up the more Treasure…” [Mun OREF]

8. Mercantilism • Leading intellect: Petty (1623-1687) • Strong advocate of quantitative analysis • Considered production (unlike many Mercantilists) • Had cost-based theory of value (rather than utility-based) • Did not believe that economy would automatically reach full employment (unlike later Smith, Say, Ricardo) • Advocated public works to reduce unemployment • Had concept of surplus, though no systematic analysis • Regarded by Marx as “father of political economy (over 100 years before Smith)

9. Mercantilism • Foreign trade as the source of surplus • No analysis of production • In practice • Added to feudal imposts on commerce • Created government-sanctioned monopolies • ostensibly to increase national wealth; but • often in practice enriched favoured individuals • Point of criticism and departure for later Physiocrats & Classical Economists, with emphasis upon “laisser-faire, laisser-passer”

10. Pre-Classicals: Conclusion • Pre-classical economists’ views on free exchange hampered by non-capitalist nature of production during their epochs • Two concepts muddled: • That fairness in exchange meant commodities should exchange on the basis of the effort they embodied • That fairness in exchange should reflect the buyer’s need for the product • Concept of surplus barely appreciated (except for Petty) • First systematic analysis of production undertaken by Physiocrats

11. Early Classicism • The Physiocrats • Developed in pre-capitalist, agricultural France • Smith, Ricardo, Malthus and Say • Development dominated by capitalist, Industrial Revolution England

12. The Environment of Physiocracy • Feudal system (like England) but • All-powerful king (vs. Magna Carta) • Feudal lords concentrated at Versailles: absentee landlords, no interest in farming • Taxes used to extract surplus for consumption by lords/King • Rural sector dominated by small peasant-owner farms (unlike rural estate England) • Few capitalist farmers, investment discouraged by taxes; many feudal/mercantilist imposts on trade (like England) • Stagnant agriculture, vs England which had been transformed into capitalist farming system

13. Physiocracy • Precursors Petty, Cantillon (see OREF) • Founder Quesnay, doctor to Royal Court • Underlying concepts of: • “flows”, as in blood in human body • surplus • Economy must produce a surplus for discretionary consumption & growth • Sought to promote capitalist farmers to increase output and available surplus • First systematic analysis of economy • Laid down in tabular form of flows from one sector to another:

14. The “Tableau Economique” • Explaining this…

15. The “Tableau Economique” Previous harvest Rent to landlord Landlord buys wheat and “carriages” Farmer buys tools to grow wheat Surplus product goes to landlord as rent Process continues... Artisans buy wheat Recoups initial surplus

16. The “Tableau Economique”

17. Basic Features of Physiocracy • Focus on production; trade as component of production • Key aspect of production: the generation of a net surplus (“produit net”) • Agriculture the only source of surplus; farmers “the productive class” • Manufacturing simply transforms agricultural surplus into different forms; workers “the sterile class” • Feudal lords/clerics sustained by share of surplus: “the proprietor class” • Outputs of manufactures needed to generate rural net product: interdependence (multiplier, input-output concepts)

18. Basic Propositions of Physiocracy • Agriculture only source of new value: • Land pre-dates man • For man to survive, food must exist first • Therefore land is the source of value • Agriculture generates a surplus • 1 unit of output requires < 1 unit of input • Sew 1 kilo of wheat as seed, get 10 kilos of wheat as crop • Manufacturing simply converts form • 1 unit of input, 1 unit of output (but in different form) • Surplus key to wealth: Wealth can be increased if gap between inputs and output in agriculture can be increased.

19. Input-Output • Example: • System 1 with 100 hectares of land: • 1 hectare land + 7/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat • 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel • 70 wheat + 10 steel -> 100 wheat • 10 wheat + 90 steel -> 100 steel • Net output 20 bushels wheat, 0 kilos steel

20. Input-Output • System 2 with 100 hectares of land: • 1 hectare land + 6/10 bushels wheat + 1/10 kilo steel produces 1 bushel wheat • 0 hectare land + 1/10 bushel wheat + 9/10 kilo steel produces 1 kilo steel • 60 wheat + 10 steel -> 100 wheat • 10 wheat + 90 steel -> 100 steel • Net output 30 bushels wheat, 0 kilos steel • Benefits of improved technology • 16% reduction in necessary inputs • 50% increase in net product

21. Physiocratic Policy • Net produit of contemporary France limited by: • Small landholdings, absentee landlords, primitive techniques • Heavy & arbitrary feudal taxation • Mercantilist restrictions on trade in rural produce • Physiocrats • favoured commercial farmers, • single tax on land rent • High “corn” price, free movement of rural goods, no manufacturing “monopolies” • Object to encourage improved techniques in agriculture, hence higher surplus

22. Strengths & Weaknesses of Physiocracy • In many ways far ahead of their time: • Concept of surplus • Input-output concepts • Major advance over previous economists; • “Lost” until modern times (except for Marx) • Aggregate level of output depended on re-investment of net surplus: an investment-driven perspective • Contraction of net surplus means contraction of economy: an aggregate-demand perspective • Belief that agriculture only source of surplus • Development of input-output analysis hobbled by views on value • Politically unpalatable advice meant early downfall

23. From Physiocracy to Adam Smith • Focus upon domestic production (unlike Mercantilists: international trade focus) • Cost of production explanation for prices • Search for the source of value: • Physiocrats nomination: land • Smith: labour, and division of labour for its increase • Beginnings of emphasis upon freedom of commerce (unlike Mercantilists: government monopolies, duties on imports, etc.) • Input-output aspects lost (until Marx) • Concern for aggregate demand lost to “Say’s Law” (except for Malthus, Marx)

24. 1776 & “The Wealth of Nations” • Writing less than 10 years after Watt devised his steam engine (1769); year first Watt engine installed (1776) • Agriculture already capitalist via “enclosure” movement • Crops for sale rather than consumption on feudal estate • Serfs evicted from land • class of “landless labourers” • no rights to land (like serfs), no assets (like guildsmen) • must work for a living: wage labour • Industry becoming capitalist: factories, labourers displacing guilds, craftsmen

25. 1776 & “The Wealth of Nations” • Domestic production now much more important than foreign trade • Focus foremost on production, rather than exchange • Early stage of capitalist development causes confusion: • Role of machinery not yet pervasive • Class structure capitalist, but not yet clear

26. Basic Propositions • Labour, not land, is the primary source of value: • “The annual labour of every nation is the fund which originally supplies it with all the necessaries and conveniences of life” [OREF] (Differs with Physiocrats) • Increase in value from specialisation & division of labour; economies of scale essential part of his analysis • Acknowledges role of machinery: • “This great increase of the quantity of work ... is owing to … the increase in the dexterity in every particular workman; … the saving of time which is commonly lost in passing from one species of work to another; ... the invention of a great number of machines which facilitate and abridge labour, and enable one man to do the work of many.” [OREF]

27. Basic Propositions • But subsumes this too under division of labour: • “(T)he invention of all those machines ... seems to have been originally owing to the division of labour. Men are much more likely to discover easier and readier methods of attaining any object, when the whole attention of their minds is directed towards that single object” [OREF] • Clarifies ancient dispute over role of utility in determining value/price: • “The word VALUE ... has two different meanings, ... the utility of some particular object, and ... the power of purchasing other goods... The one may be called ‘value in use’, the other, ‘value in exchange’”. [OREF]

28. Source of Value • No role for “value in use” in determining price • Commences with the “diamond/water paradox” • Water has great “value in use”, but very low price • Diamonds have little utility, but very high price: • “The things which have the greatest value in use have frequently little or no value in exchange; and, on the contrary, those which have the greatest value in exchange have frequently little or no value in use. Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it.” [OREF 85]

29. Source of Value • Resolution of “paradox”: • Price reflects relative difficulty of “manufacture” • Abundant water involves little effort • Scarce diamonds take much effort • “Labour, therefore, is the real measure of the exchangeable value of all commodities.” [OREF] • “Effort determines value” perspective: “The real price of everything, ..., is the toil and trouble of acquiring it” [OREF] • Price reflects labour embodied in commodity: “If among a nation of hunters.., it usually costs twice the labour to kill a beaver which it does to kill a deer, one beaver should naturally exchange for or be worth two deer.” [OREF]

30. Value and Price Problems • What about capital? • “As soon as stock has accumulated in the hands of particular persons, some of them will naturally employ it in setting to work industrious people, ..., in order to make a profit by the sale of … what their labour adds to the value of the materials… something must be given for the profits of the undertaker of the work who hazards his stock in this adventure.” [OREF 90] • So two determinants of price?: • “The value which the workmen add to the materials, therefore, resolves itself ... into two parts, of which the one pays their wages, the other the profits of their employer upon the whole stock of materials and wages which he advanced.” [OREF 90]

31. Value and Price Problems • What about land? • “As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce... (A)ll the natural fruits of the earth, which, when land was in common, cost the labourer only the trouble of gathering them, come, ..., to have an additional price fixed upon them. He must then pay for the licence to gather them; and must give up to the landlord a portion of what his labour either collects or produces. ... (T)he price of this portion, constitutes the rent of land, and in the price of the greater part of commodities makes a third component part.” [OREF 91] • “Adding up” “theory” of costs/price

32. Value and Price Problems • What measure of labour? • Labour embodied?: • Hours of labour a commodity contains • 40 hours to make a chair • embodies 1 working week • but price includes profit, rent, as well as wage • Labor commanded?: • Hours of labour a commodity can buy • Chair costs workers 2 weeks wages • Commands 80 hours of labour • What is labour?: “Not only his labouring servants, but his labouring cattle, are productive labourers.”

33. Smith’s Scorecard • Gained (w.r.t. Physiocrats) • Appreciation of labor/industrialisation • Notions of capital, profit, rent • Perceptive cynicism re landlords, merchants • (?) Labour as source of value • Lost • Analysis of flows, input-output • Notion of surplus • Role of investment • Analytic rigour • “Macroeconomic” concerns: investment, aggregate demand, employment • Next week: Smith’s successors Ricardo & Marx