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More Adam Smith Problems

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1 More Adam Smith Problems
Division of labor  Alienation Economic progress  Moral decay & economic stagnation Division of labor = Increasing Returns  Monopoly Industrial Age  concentration Globalization and information age  Agglomeration and networking, not concentration Smith: opposition to monopoly  egalitarian tilt Government support of labor unions as counterweight to monopsony power of employers Competition resolves all problems Competition über alles

2 An extinguished Sun … in the very long-run
Smith: Spiraling progress … or stationary state? It is in the progressive state, while society is advancing toward further acquisition, rather than when it has acquired its full complement of riches, that the condition of the great body of people seems to be happiest and most comfortable. It is hard in the stationary state and miserable in the declining state. …that full complement of riches which the nature of its soil and climate and its situation with respect to other countries allows it to acquire. In a country fully peopled in proportion to what either its territory could maintain or its stock employ … In a country fully stocked in proportion to all the business it had to transact … the competition would be great and the ordinary profit as low as possible. An extinguished Sun … in the very long-run But until then, Smith prophesies progress for the commercial age (he does not see beyond that age). So…Don’t worry! Be happy!

3 Heimann on Natural Order and Progress
Enlightened, rational man working within laws of nature can achieve a harmonious state without the dictate of an overbearing authority scientific understanding and an inner impulse to contribute to universal harmony he intends only his own gain, and is… led by an invisible hand to promote an end which was no part of his intention The dynamics of Smith’s system are mechanical No “spontaneous progress”... No critical junctures Intervention by an authority is disruptive of natural harmony. Liberal democracy and laissez-faire economy  Freedom Natural harmony is an ideal that is approached Natural harmony is self-perpetuating Don’t mess with enterprise economy

4 Adam Smith: A Summation
Moral sentiments a first principle. Market coordination of self – interested individuals “Economic man” led by an “invisible hand” Competition  Efficiency and Equity Guard against monopoly Laissez – faire! Restricted government trumps government restrictions Labor theory of value Progress through specialization and exchange The division of labor is limited by the extent of the market. Spiraling progressImproved rule of lawProgress Stagnation and decline in the future Enter Malthus Enter Ricardo

5 Ricardo & Malthus: Welcome to the Dismal Science
David Ricardo, 1772 – 1823 Stockbroker/Dealer/Pampleteer Abstraction  Economic Science Championed capitalists Opposed Corn Law Advanced Say’s Law Major contributions Differential rent Labor theory of value Theory of distribution Comparative advantage Quantity Theory Thomas Malthus,1766 – 1834 Parson/Professor of History&PolEcon Intuitive approach/empiricist Championed landlords Favored Corn Law Advanced Theory of Gluts Macro failure  Keynes Capitalism needs unproductive consumers Major contribution Law of population  Darwin Whoever wins, workers get dry crust…not quite, as we’ll see Diminishing Returns Prevail

6 no limit to knowledge  shared affluence beckons Condorcet:
Thomas Malthus, An Essay on the Principle of Population, as it Affects the Future Improvement of Society with Remarks on the Speculations of Mr. Godwin, M. Condorcet, and Other Writers, 1st ed., 1798 Godwin: faith in reason no limit to knowledge  shared affluence beckons Condorcet: faith in technology & education shared affluence, leisure Malthus’ precursors: Cantillon: men multiply like mice Quesnay: propagation has no limit but subsistence Franklin: American vs. European fertility/rural vs. urban fertility Smith: Wage increase  Population increase Godwin/Condorcet: reason would restrain propagation Malthus’ insight: Diminishing Returns

7 Malthus, An Essay on the Principle of Population, as it Affects the Future Improvement of Society with Remarks on the Speculations of Mr. Godwin, M. Condorcet, and Other Writers, 1st ed., 1798 First principles Food Passion Population, when unchecked, increases in a geometric ratio 1, 2, 4, 8, …[25 year doubling time] Subsistence increases in an arithmetic ratio 1, 2, 3, 4, … Subsistence checks population (“Subsistence” adjusts to experience) Positive checks: Vice Misery: War, pestilence, famine Preventive check: Moral restraint Law of Diminishing Returns in proportion as cultivation is extended … additions to average produce must be gradually and regularly diminishing Hint of an externality in Malthus’ Law of Population: Your use of resources reduces my wellbeing  Today’s environmental movement

8 Why no apocalypse? What did Malthus miss?
From An Essay in Population…Malthus as ogre Famine seems to be the last, the most dreadful resource of nature. The power of population is so superior to the power in the earth to produce subsistence for man, that premature death must in some shape or other visit the human race. The vices of mankind are active and able ministers of depopulation. They are the precursors in the great army of destruction. But should they fail in this war of extermination, sickly seasons, epidemics, pestilence, and plague, advance in terrific array, and sweep off their thousands and ten thousands. Should success be still incomplete, gigantic inevitable famine stalks in the rear, and with one mighty blow levels the population with the food of the world. … to better the condition of the laboring classes [we should cultivate] a spirit of independence, a decent pride, and a taste for cleanliness and comfort. The effect of a good government in increasing the prudential habits and personal respectability of the lower classes … will always be incomplete without a good system of education…The benefits derived from education are among those, which may be enjoyed without restriction of numbers; and, as it is in the power of governments to confer these benefits, it is … their duty to do it. Why no apocalypse? What did Malthus miss?

9 The Dismal Science of David Ricardo
… Ricardo offers us the supreme intellectual achievement, unattainable by weaker spirits, of adopting a hypothetical world remote from experience as though it were the world of experience and then living in it consistently. With most of his successors, common sense cannot help breaking in – with injury to their logical consistency. John Maynard Keynes, The General Theory of Employment, Interest, and Money Prototypes, not people Laws of behavior, not lives Long-run equilibrium…Production cost  Natural price Dismissed Supply-Demand as championed by Malthus: …ephemeral and transient Ricardo, The High Price of Bullion, 1810 Paper money  Wartime inflation Regulate paper currency (so its value corresponds to its gold “content”) Stick to metallic money…Private enterprise “controls” money supply Ricardo  Currency School  Monetarism Influence of a Low Price of Corn on the Profits of Stock, 1814 Discussed with Malthus Ricardo, Principles of Political Economy and Taxation, 1817 Encouraged by James Mill (another East India functionary…and mutual friend)

10 Ricardo on Money: …put the mass of commodities (Y) on one side of the line and the amount of money (M) multiplied by the rapidity of its turnover (V) on the other. Is not this in all cases the regulator of prices? [P = MV/Y] …Money cannot call forth goods. …Productions are always bought by productions. Money is only the medium by which exchange is effected. …To save is to spend … a general glut is evidently impossible Say’s Law: Supply creates its own demand! …every part of the income, whether entirely consumed or invested, will always produce an equal demand for goods, although not the same kind of goods. Ricardo’s preferred monetary regime: paper money freely convertible into gold at a fixed rate.

11 The economic way of thinking:
Ricardo to Malthus: Our differences may … be ascribed to your considering my book more practical than I intended it to be. My object was to elucidate principles, and to do this I imagined strong cases that I might show the operation of those. Comparative advantage  international division of labor Low wages restore competitiveness of country with absolute disadvantage When there’s a bad harvest, gold becomes the cheapest commodity to export. Validity of Say’s Law? If workers paid little, who buys? Malthus on gluts: focus on effectual demand (Smith also used term) Growing Supply Satiation Excess Supply Decline in Profits Stable Demand General Glut Stagnation (Why invest if demand is down?) Ways out: Redistribution? No! The poor would only multiply Unproductive consumers? Yes! Clergy, landlords, public works…military-industrial complex Create new demands? A modern safety valve.

12 Malthus on Gluts: Anticipation of Keynes???
We see in almost every part of the world vast powers of production which are not put into action…[F]rom the want of a proper distribution of the actual produce adequate motives are not furnished to continue production…the grand question is whether it is distributed in such a manner…as to occasion the most effective demand for future produce: and I distinctly maintain that an attempt to accumulate very rapidly which necessarily implies a diminution of unproductive consumption, by greatly impairing the usual motives to production must prematurely check the progress of wealth. Letter from Malthus to Ricardo, July 7, 1821 Too much saving  Glut  pro-Keynes Too much investment  Glut???...anti-Keynes Need for “unproductive consumption”  pro-Keynes Mandeville’s Fable of the Bees (the Knaves turned Honest): ...Bare virtue can’t make Nations live in Splendor

13 Ricardo defended Say’s Law: to save is to spend
..but in an afterthought, unemployment could result from progress: “On Machinery” (Principles, Chapter 31, 1821) If machines substitute for labor rather than complement labor, unemployment is possible with accumulation… Say’s Law. When will technological advance result in unemployment? If interest rate is high Capitalist expansion won’t offset reduced labor input If machines are long-lived  Low replacement demand for machines  Low demand for labor

14 Say’s Law: The Beat Goes On
Which Law? Baumol, 1977…The are really eight Say’s Laws. The simple version, per James Mill (1808): The production of commodities creates…a market for the commodities produced…When goods are carried to market, what is wanted is someone to buy. But to buy one must have the wherewithal to pay…But wherein consist the collective means of payment of the whole nation? Do they not consist of its annual produce?...[So] the more you increase the annual produce, the more by that very act you extend the national market…and the actual purchases of the nation…[T]he demand of a nation is always equal to the produce of a nation. A clearer version per John Stuart Mill (1844): [the proposition that supply is at the same time demand is]…evidently founded on the supposition of a state of barter…One [person] cannot sell without buying. If, however, we suppose that money is used, …, although he who sells, really sells only to buy, he need not buy at the same moment when he sells…[T]o render the argument for the impossibility of an excess of all commodities applicable to the case in which [money] is employed, money itself must be considered as a commodity.  High demand for money  Short-run glut. J.S. Mill sketches a business cycle with fluctuations in Md

15 Ricardo’s Theory of Distribution
Differential rent: rent built up from zero-rent margin As push out to worse and worse land, owners of better land command bigger and bigger premiums (rents) Extensive margin / Intensive margingets rid of rent from distribution Only scarcity of fertile land yields rent Rent is a sign of poverty, not prosperity Interest of landlord is always opposed to interest of society Only landlord could gain from progress Importing grain serves like a technological advance in agriculture It makes as much sense to limit imports as to forbid agricultural improvements Wages ~ Natural price of labor = what’s required for (socially necessary) subsistence & reproduction: dry crust Malthusian Law of Population  Iron Law of Wages Poor Law (Speenhamland System) only increases number of poor but does not improve their well-being Dole (wage subsidy)  Population growth  Lower wage  Dole Malthus: the poor are themselves the cause of their own poverty Population changes slowly “natural” wage adapts to market wage (high wagehabits) Idea picked up from Malthus

16 Ricardo’s Theory of Distribution
Profits ~ equalized and eliminated by competition …nothing can increase profits permanently …but a really cheaper mode of obtaining food  profits depend inversely on wages Class Conflict: Theme picked up my Marx …profits of capitalist farmer regulate the profits of all other trades  corn-ratio theory of profits (corn is capital stock…wage fund) Diminishing returns  Profit squeezed as economy grows Wage Fund  Labor employed  Wage Bill Wage Fund  Labor employed  Profit (return on funds advanced) Rent = 0 on the margin ___________________________________________________________________________________________________________________________________________ Labor Theory of Value Breakdown of labor theory: industries with different capital intensities Recognized by Ricardo in On Machinery

17 Wage Rate = Dry Crust? Profit Rate = “Zero”???
Hollander and Hicks: Ricardo not as dismal as you’d think In expanding economy (point A) Profit exceeds bare minimum  incentive to accumulate Wage exceeds bare minimum  population growth to meet increased demand for labor Ricardo “does not dispute Malthus’s view that the stationary state is remote. Wage .A “subsistence” profit Curvature reflects diminishing returns subsistence wage long-run equilibrium stationary state Labor

18 Ricardo’s Labor Theory of Value
Assuming constant proportions Abstracting from disutility of labor in different occupations Abstracting from different inherent qualities/skills of labor Abstracting from different qualities of land Abstracting from different quantities of capital Assume (circulating) capital:labor ratio the same for all goods Assume capital inputs relatively small  “Ricardo’s 93% labor theory of value” Stigler Then Smith’s Beaver:Deer labor theory of value applies Ricardo’s Labor Theory of Value does not apply to Goods in inelastic supply (Old Masters/Positional Goods) Paper money Monopolized products Goods in international trade Owing to immobile factors of production, can only speak of comparative labor costs, not absolute labor costs

19 Prices not uniformly in proportion to “labor values”
The problem with the labor theory of value… Competition equates profit rates across industries Some industries more ‘capital intensive’ than others Costs of production, including normal rate of profit, in capital intensive industries are greater relative to labor inputs than costs of production relative to labor inputs in less capital intensive industries. Higher prices relative to labor input costs in capital intensive industries Prices not uniformly in proportion to “labor values” Berries (L1 labor input;T1 to ripen) – Berry Liqueur (L2 labor input;T2 to distill) P1 / P2 = {w L1 (1+i) T1 } / {w L2 (1+i) T2 } = {L1 / L2 } (1+i) (T1 – T2) Relative prices independent of wage…but not of i … unless T1 = T2 Ricardo: assumed equal ratios of fixed capital (machines) to working capital (wage fund) across all products …not rigidly true, but I say it is the nearest approximation to the truth Malthus: Ricardo’s rule may be considered as the exception, and the exceptions the rule.

20 Ricardo: Value, Distribution, and Growth
Price of product determines how far cultivation is pushed. Price  Rent More fertile/better situated land commands rent to extent output can be produced with less labor.  Rent measured in units of labor Rent Marginal Product (corn) Product of worst land only divided between capitalist and labor…gets rid of rent Profit is a residual Profit w* Wage Bill Workers paid “price” of own production/reproduction.  Subsistence wage K1 Capital-Labor Input (Capital and Labor are Complements)

21 Ricardo: Value, Distribution, and Growth
Marginal product declines as economy grows. Profit is squeezed by increasing rent. Marginal Product (corn) Rent Profit w* Wage Bill K1 K2 Capital-Labor Input (Capital and Labor are Complements)

22 Ricardo: Value, Distribution, and Growth
Marginal Product (corn) Profit squeezed to zero  Growth ceases Rent w* Wage Bill Malthus: Perhaps, but only in the v e r y L o n g R u n K* K1 Capital-Labor Input (Capital and Labor are Complements)

23 Ricardo: Value, Distribution, and Growth
Free trade effectively extends the margin of cultivation, reduces rent and postpones the dismal stationary state. Additional fertile land made available to economy Agricultural & transportation technology also serve. Marginal Product (corn) Rent Profit w* Wage Bill K1 K2 Capital-Labor Input (Capital and Labor are Complements)

24 Ricardo’s parting words to Malthus:
And now, my dear Malthus, I have done. Like other disputants, after much discussion, we each retain our own opinion. These discussions, however, never influence our friendship; I should not like you more than I do if you agreed in opinion with me. Homage to Malthus: If only 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 today. John Maynard Keynes

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