Notes History of Economic Thought

Lecture 1
Period
Main focus
Starting point
Characteristi
c

Classical period
Wealth
1776
Wealth of Nations

Neoclassical period
Allocation of scarce resources
1870
Marginal revolution

Modern economics
Modeling
1940/50

In the 19th century, the adequacy and importance of classical economics decline. The alternatives
were:
- Marx and socialism
- Historical economics
- Marginalism: mainstream of neoclassical period
- Institutionalism
- Keynesian economics
There are two types of explanation for the transition of economic ideas/schools.
- External factors: changes in societal circumstances.
- Internal factors: failure of consistency of theories; increasingly instruments and
techniques prove inadequate.
Change from classicism to marginalism: Industrial revolution, classical economics was not
appropriate for this.
Why did economics start as a science in 1776? What was so special about Adam Smiths Wealth
of Nations?
The Wealth of Nations stated that the division of labour will make wealth grow. People are
constantly trying to improve their conditions. People advance together, yet primarily out of selfinterest. However, this self-interest does not mean that some people benefit while others are hurt.
Interdependence results in mutual adjustments in behavior and such patterns channel passions in
socially desirable directions. Not all rules need to be imposed to reach agreement and to promote
coordination. The main idea behind this is that people cant live without social interaction.
Smith: self-interest yields a better societal result than acting out of social interest. This is in
contradiction to the common opinion that wanted to suppress self-interest to promote the general
interest. Besides self-interest, appropriate institutions are required for advancement of
individuals:
- Directing behavior of individuals into a contribution to the general interest.
- Offer opportunities and limitations; not necessarily a positive outcome for everyone.
Goal: to improve ones condition.
Means: wealth
How to accumulate wealth: division of labor and thus trade/exchange.
We should all benefit: room for self-interest and institutions.
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Smiths ideas were in complete contrast with previous ideas.

Before 1776: Pre-classical period.
Early pre-classical period: Greek philosophers and scholastic writers. Economics from an
ethical/religious point of view.
Later pre-classical period: 1500-1776: Mercantilists and forerunners of classical school.
In the middle ages, importance of the market, wage labor, and growth of economic activity
became more important. As a result, society transformed. Economics became subordinated to
political objectives, to increase state power.
Who?
Focus
Objectives

Greek
philosophers
scholastic writers
Community
Ethical/religious

and Mercantilists
State
Political

Smith/classical
school
Market
Economic

The Mercantilist School (1500-1776)

Political objectives were to increase wealth and power. Mercantilists were no longer
philosophers, but government officials and merchants. Growth of wealth and trade in a time of
increasing trade, emerging cities, and state building. Economics was the management of the
national household.
1. Wealth. Money = power. Wealth = stock of gold and silver (also wealth of the nation
itself). Wealth was strongly linked to political/state power. A surplus of export was
necessary to generate payments in hard money.

2. Sources of wealth.
- Natural resources
- Stealing from others
- Foreign trade: E > M (Thomas Mun)
3. Zero-sum game. Total world amount of wealth is fixed. One countrys gain is another
countrys loss. Economic warfare. All countries could not simultaneously export
more than they imported. Therefore ones own country should promote export
and gain wealth at the expense of its neighbors. Mercantilist nationalism quite
naturally led to militarism.

4. Government. Necessity of regulation

- Individual interest conflict with national interest
- Market induces conflicts
- Advancing political objectives.
5. Duty-free importation of raw materials that could not be produced
domestically, protection for manufactured goods and raw materials that could
be produced domestically and export restriction on raw materials. This was
called the fear of goods. The interest of merchants was more important than that of

the consumer (cuz they had limited variety of goods).

6. Colonization
and
monopolization
of

colonial
trade.
Merchant capitalists favored colonization and wanted to keep the colonies
eternally dependent upon and subservient to the mother country.

7. Opposition to internal tolls, taxes and other restrictions on the

movement
of
goods.
They thought it could increase prices on export. However, they did not favor
free internal trade, they preferred monopoly grants and exclusive trading
privileges whenever they could acquire them.
8. A strong central government was needed to promote mercantilist
goals.
A strong national government was required to ensure uniform regulation.
Central governments were also necessary to achieve the following goals:
nationalism, protectionism, colonialism, and internal trade unhampered by
tolls and excessive taxes.
9. Importance of a large, hard-working population. Would keep labor
supply high and wages low, also provide an abundance of soldiers if needed
for war. Low wages would enable lower prices on export and increase inflow of
gold and reduce idleness and promote greater participation in the labor force.
Idleness, thievery and begging were dealt with mercilessly.

An important point of mercantilism is the regulation of the economy. Strengthening the economy
by a positive balance of trade.
1. Facilitating production, transport, and export
2. Measures to keep products cheap in comparison to foreign products. Low wages = low
cost of production = competitive advantage in foreign trade. Low wages also encourage
labor supply. How: large population, regulation of food prices. Utility of poverty
doctrine.
3. Improve tax revenues
4. Trading companies and colonies
5. Military.
People:
Thomas Mun: (1571-1641). Published A discourse of trade from England into the
east indes, in which he argued that as long as total exports exceeded total imports,
the drain of species from a country in any one trade area did not matter. Most
important for a countrys wealth was surplus of exports
Gerard Malynes (died 1641). Considered trade to be too low for the aristocracy.
He also advanced the idea that regulation of goods, He developed the notion that
more money in a country would raise prices and stimulate business.
Charles Davenant (1656-1714). Dealt with taxes, imports and exports, was a
member of parliament. Foreshadowed more of the argument of laissez-faire than
any other influential mercantilist. In An essay on the probably means of making the
people gainers in the balance of trade he argues that a kingdom can reap the
benefits of the entire value of an exported product if it is made from domestic raw
materials. He thought the wealth of a country was that it produces, not its gold or
silver.
Jean Baptiste Colbert (1619-4683). He was a bullionist who believed that the
strength of a state depends on its finances which rest on its collection of taxes,
which is greatest if money were abundant. He favored expanded exports, reduced
imports and laws preventing the outflow of bullion from the country. He thought
agriculture, trade, war on land and from the sea was the most important
professions.
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Sir William Petty (1623-1687) He offered some new ideas that foreshadowed
classical economics. Petty favored freer foreign trade than many of the mercantilists,
partly because he felt it would circumvent the widespread smuggling that was
occurring. He wanted imported goods taxed so that they may be somewhat dearer
than the same things grown or made at home, and imports of raw materials should
be lightly taxed. Petty opposed laws prohibiting the export of money. Petty favored
large populations for increasing returns to the government, which would reduce unit
costs of governing a larger population. In A treatise of taxes and contributions Petty
expressed his enthusiasm for the mercantilist vision of full employment Children
should be put to employment at their first capacity. He thought thieves shouldnt be
hanged but instead to be slaves and add to the commonwealth. Everyone out of
work should be hired by the state to work on roads and planting trees.
Petty recognized the velocity of circulation, the rate at which money changes hand
can be as important as the quantity of money.
Division of labor. He did not develop this idea in detail but recognized the economics
of specialization and division of tasks.
Other things he thought of: Rent theory, Importance of labor, labour theory of value
Who did they seek to benefit? The merchant capitalists, the kings and
government officials, especially those who were most powerful and entrenched and
had the most favored monopoles and privileges. Mercantilist can be understood as
an example of rent seeking behavior (= attempt by private parties to increase their
profits by securing favorable laws from GOV).
Which tenets of the mercantilist school became lasting contributions? Made
a lasting contribution to economics by emphasizing the importance of international
trade. They developed the economic and accounting notion of what today is termed
the balance of payments. Indirectly contributed to economics and economic
development.

Wealth
Sources
Economic game
Government and interests

Mercantilism
Money
Foreign trade

Classicism
Consumer goods
Division of labor and
accumulation of capital
Zero-sum
Positive-sum
National
interest
and National interest is sum of
individual interests conflict
individual interests

Why was mercantilism inadequate?

Transition feudal commercial society.
- Shifts from services to goods
- Changes in level of aggregate demand
- Changes in patterns of production, distribution, and consumption
- Shift in power
- Profit as distinctive source of income.
Classical economics: Independence
1. Market as principle of organization
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2. Economic process governed by laws of nature.

Forerunners: Marchants

Sir Dudley North (1641 1691) Sir Dudley North, living during the height of the
mercantilist period, struck hard at the heart of mercantilist doctrine. He emphasized
that trade is not a one-sided benefit to whichever country realizes a surplus of
exports but rather is an act of mutual advantage to both sides. Also he argued for
laissez-faire as the way to achieve maximum gains from both intra- and international
trade. He believed that free trade would help both traders and the country
Richard Cantillon (1680 1734) Cantillon developed a theory of value and price.
His emphasis on the role of land and labor, on supply and demand, and on the
fluctuations of price around intrinsic value makes him a direct forerunner of classical
economics
Charles Davenant: Wealth as money is an inadequate concept of wealth. Dealt with taxes,
imports and exports, was a member of parliament. Foreshadowed more of the
argument of laissez-faire than any other influential mercantilist. He argued that a
kingdom can reap the benefits of the entire value of an exported product if it is
made from domestic raw materials. He thought the wealth of a country was that it
produces, not its gold or silver.

William Petty: Quantification of causal relationships between economic variables. Political

arithmetic. Importance of division of labor, effect on capital accumulation.

Petty favored freer foreign trade than many of the mercantilists, partly because he
felt it would circumvent the widespread smuggling that was occurring. He wanted
imported goods taxed so that they may be somewhat dearer than the same things
grown or made at home, and imports of raw materials should be lightly taxed. Petty
opposed laws prohibiting the export of money. Petty favored large populations for
increasing returns to the government, which would reduce unit costs of governing a
larger population. Petty expressed his enthusiasm for the mercantilist vision of full
employment Children should be put to employment at their first capacity. He
thought thieves shouldnt be hanged but instead to be slaves and add to the
commonwealth. Everyone out of work should be hired by the state to work on roads
and planting trees. Petty recognized the velocity of circulation, the rate at which
money changes hand can be as important as the quantity of money. Division of
labor. He did not develop this idea in detail but recognized the economics of
specialization and division of tasks.

The Physiocratic School (1756 1776)

Major tenets
Natural order: Physiocrat = rule of nature. Laws of nature govern human societies
just as those discovered by Newton govern the physical world. All human activities
should be brought into harmony with these natural laws.
Laissez-faire, laissez-passer: Let people do as they please without government
interference. The physiocrats were opposed to almost all feudal, mercantilist and
government restrictions, favoring freedom of business enterprise at home and free
trade abroad. They thought that government should never extend their interference
in economic affairs beyond the minimum absolutely essential to protect life and
property and to maintain freedom of contract.

Emphasis on agriculture: The physiocrats thought that industry, trade, and

professions were useful but sterile, simply reproducing the value consumed in the
form of raw materials and subsistence for the workers. Only agriculture was
productive, because it produced a surplus, a net product above the value of the
resourced used in production.
Taxation of the landowner: Physiocrats thought that because only agriculture
produced a surplus, which the landowner received in the form of rent, only the
landowner should be taxed.
Interrelatedness of the economy: Quesnay, in particular, and the physiocrats in
general, analyzed the circular flow of goods and money within the economy.
Whom did the Physiocratic School benefit? The peasants/farmers would
ultimately gain.
Francois Quesnay (1694 1774) was the founder and leader of the Physiocratic
school. He believed that laws made by people should be in harmony with natural
laws. His famous Tableau Economique depicted the circular flow of goods and money
in an ideal, freely competitive economy. Although Quesnay called nonagricultural
production sterile, he did not question the right of the proprietors to receive rent.
Nature, not the worker, produces the surplus, he said.
Anne Robert Jacques Turgot (1727 1781) Turgots greatest contribution in the
realm of economic theory was in correctly presenting the law of diminishing returns.

The Classical School (1776 1871)

Major Tenets
Minimal government intervention: Forces of the free competitive market would
guide production, exchange and distribution. The economy was self-adjusting and
heading towards full employment without GOV intervention. Government activity
should be confined to enforcing property rights, providing for the national defense
and providing public education.
Self-interested economic behavior: All economic activity is based on selfinterest, producers and merchants provide goods out of a desire to make profits,
workers offered their labor services to obtain wages and consumers purchased
products as a way to satisfy their wants.
Harmony of interests: Natural harmony of interest in a market economy. By
pursuing their own individual interests, people served the best interests of society.
Importance of all economic resources and activities: All economic resources
(fop) and activities (agriculture, production..) contribute to a nations wealth.
Economic laws: The classical school made tremendous contributions to economics
by focusing analysis upon explicit economic theories or laws: law of diminishing
returns, law of comparative advantage, law of markets.. The classicists believes that
the laws of economics are universal and immutable.
Whom did the Classical School benefit? In the long run classical economics
served all society because the application of its theories promoted capital
accumulation and economic growth. In the short run however it was the wage
earners that bore the heaviest burden.
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Which tenets of the Classical School became lasting contributions? The

classical economists gave the best analysis of the economic world up to their time,
far surpassing the analyses of the mercantilists and physiocrats. They laid the
foundation of modern economics as a social science, and generations who followed
built upon their insights and achievements. Tenets that became lasting contributions
include the following; (1) the law of diminishing returns, (2) the law of comparative
advantage, (3) the notion of consumer sovereignty, (4) the importance of capital
accumulation to economic growth, and (5) the market as a mechanism for
reconciling the interests of individuals with those of society.

Forerunners: Classicists
Dudley North (1641-1691): Trade as a positive-sum game. Plea for free trade. He emphasized
that trade is not a one-sided benefit to whichever country realizes a surplus of
exports but rather is an act of mutual advantage to both sides. Also he argued for
laissez-faire as the way to achieve maximum gains from both intra- and international
trade. He believed that free trade would help both traders and the country.
David Hume (1711-1776): Hume came closest to the ideas of Smith. His greatest
contribution as an economist was in presenting what has since been called the price
specie-flow mechanism. He said that international trade is a positive sum game, one
in which the payoffs sum to a positive number. There is no need for jealousy of trade:

1. Fear that money supply will be depleted. 2. Trading nations as rivals (there is no zero-sum
game)
Price-specie flow mechanism: Trade surplus inflow of gold and silver (specie)
prices increase prices in export sector increase export decreases and import increases
trade surplus turns into a deficit outflow of gold and silver (money) quantity of money
decreases prices decrease etc.
Richard Cantillon: role of entrepreneur, role of market. Abstraction as method. However: still a
large role for government. Economy as a system of interdependencies. Discrepancies between
market prices and costs lead to adjustments in markets. Cantillon developed a theory of
value and price. His emphasis on the role of land and labor, on supply and demand,
and on the fluctuations of price around intrinsic value makes him a direct forerunner
of classical economics.

Mercantilism vs Classical school

Wealth: money vs consumer goods

Sources of wealth: `foreign trade vs division of labour and accumulation
Economic game: zero vs positive sum game
Government and interests: national interest individual interest vs general interest =
individual interests

Lecture 2
Analysis of Wealth of Nations
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Paradox: In an advanced societies, the worker and the landlord have to pay a large part of their
income to taxes. However, theyre better off in the advanced society compared to the primitive
society.
Explanation: Division of labor, specialization (is something natural, which can be traced to mans
desire to better his condition). Condition: extent of the market, and the use of money. Division of
labor implies exchange and thus the question of relative value of commodities.
Value
-

Use value
Exchange value: specialization and thus Smiths focus is on exchange value of real
price of a good
1 How to measure exchange value? Disutility of labor (effort): as index of wealth, to know
whether wealth has increased. Money is not an appropriate measure of value, because it
fluctuates.
2 What determines exchange value?
- Market price: depends on short run supply and demand. Tends to fluctuate around
the natural price. Market prices are short run prices and can deviate from natural
prices
- Natural price: Long run price below which entrepreneurs would no longer sell their
goods.
Distinction between primitive and advanced society. Primitive society: only 1 factor of
production: labor. Commodities exchange on the basis of the ratio of labor costs.
Advanced society: 3 factors of production: wage, rent, and profit. Wage + rent + profit = value of
good (costs of production) = sum of average rewards of factors of production = natural price,
stable in the long run.
-

Demand > Supply Market price > natural price

Demand < Supply Market price < natural price
Demand = Supply Market price = natural price

As long as market price is not equal to the natural price, market adjustment process starts, driven
by self-interest of consumers/producers.
Suppose demand > supply
1. Price of good X increases
2. Higher reward for labor and capital
3. Profit opportunity arises, reallocation or resources
4. Supply of good X increases
5. Price of good X decreases
6. Lower reward for labor and capital
Results of the market process:
- Equilibrium between market price and natural price is restored
- Natural rate of return of factors of production is equalized
- Supply = demand
- Efficient allocation of resources
- Price = real costs.
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Driven by self-interest. (not destructive) Market power distorts market adjustments and
accumulation of wealth.
Interplay of passions and institutions (government, judicial system, church): trend of growth of
liberty and wealth. Requires appropriate institutions as interplay of interests and institutions may
also have negative consequences.
Growth of wealth
- Division of labor labor productivity increases.
- Capital (accumulation): stock can be used in two ways
- As capital to make a profit
- For consumption purposes.
Productive labor (stock increases) vs. unproductive labor (stock decreases).
Growth of stock by productive labor: the larger the part of stock used as capital, the more labor
can be used productively, and the more the stock can be increased.
Labor production increases (increasing labour productivity) surplus increases capital
accumulation ratio of productive/unproductive labor increases.
Growth: increasing rent/wage/profit income + falling prices. If wealth increases population
increases extent of market enlarges division of labor increases labor productivity
increases.
Appropriate laws and institutions are needed as to make efforts pay off. However, it is possible
that some groups do not gain from the growth of wealth.
3 classes in society:
1. Capitalists: profit-income. Clever constructions at the expense of others, class interest
interest of society.
2. Landowners: rent-income. Foolish and conservative, class interest = interest of society.
3. Laborers: wage-income. No power or notion, active and frugal, class interest = interest of
society.
Obstruction and inequalities
- Merchants with privileged positions are backed by government
- Market hindrances
- Processes of adjustment in markets not optimal
- Inefficient allocation
- No incentive for innovation
- All detrimental to growth.
Wealth of nations: optimism on long-run trend of growth of productivity, which would improve
the position of laborers.
However, in the 19th century, a more negative view developed. Due to population growth, profits
declined, capital accumulation declined, growth decline. Labor supply increased, wages
decreased. Demand for food increased, prices increased, which would lead to poverty. The only
class to benefit from population growth were the land-owners.
Population factor: key factor in the development of societies: ratio between population size and
means of subsistence.
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Classical School Adam Smith (1723-1790)

Both Moral Sentiments and Wealth of Nations reconcile the individual with the social
interest through the principle of the invisible hand, or natural harmony, and the
principle of natural liberty of the individual, or the right to justice.
The Theory of Moral Sentiments - sympathy and benevolence restrain selfishness
The Wealth of Nations - competition channels economic self-interest towards the
social good.
(1) The Division of Labor. The division of labor increases the quantity of output
produces for three reasons. First, each worker develops increased dexterity in
performing one single task repeatedly. Second, time is saved if the worker need not
go from one kind of work to another. Third, machinery can be invented to increase
productivity once tasks have been simplified and made routine through the division
of labor.
(2) The Harmony of Interests and Limited Government. There is an invisible
hand that channels self-interested behavior in such a way that the social good
emerges. The pursuit of self-interest, restrained by competition, thus tends to
produce Smiths social good maximum output and economic growth. This harmony
of interests implies that intrusion by government into the economy is unneeded and
undesirable. Smith did see a significant albeit limited role for the state: (1) to protect
society from foreign attack, (2) to establish the administration of justice, and (3) to
erect and maintain the public works and institutions that private entrepreneurs
cannot undertake profitable.
Economic Development: Smith viewed the economy as a whole and emphasized
growth and economic development. The division of labor and the accumulation of
capital as the primary factors that promote a growing stock of the nations wealth.
The division of labor together with an enlargement of the capital stock increases
productivity, which in turn increases national output. Greater national output
enables higher levels of consumption within the society, and the latter, according to
Smith, constitutes a rise in the true wealth of the nation.
Value: Smith observed 2 kinds of value: Value in use and Value in exchange. Things
that have greatest value in use have no value in exchange and vice versa. He said
that pearls have value because people need to dive for them, thus the costs of
production determine a goods exchange value or relative price.
Labor cost theory of value: Smith argued that in a society where labor is the only
resource, relative value of good is determined by the amount of labor used to
produce it. In a primitive society, labor is both the source and the measure of
exchange value.
Cost of production (wages, rent, profits) are only determinants of value (in long run)!
Wages: Wages fund idea implies that there is a stock of circulating capital out of
which present wages are paid. This stock consists of savings of capitalists and is
dependent on revenue from previous production and sales. The fund is fixed in short
run but can increase from year to year.
Average annual wage= Wages fund/Number of laborers.
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The minimum wage must enable a worker with family to survive and perpetuate
labor supply. But when demand for labor rises, wages will rise above minimum.
Rent: is the price paid for use of land.

Classical School - Thomas Malthus (1766-1834)

Malthus population theory
1. Size of population is always determined by the available means of subsistence.
2. Growth rate of population always outruns the growth rate of production.
Claim: if population growth is larger than growth means of subsistence, checks come into
operation
Checks: Population grows geometrically, food production arithmetically.
Checks balance these unequal forces.
1. Positive checks (increase death rate): food shortages, famines, epidemics, and wars. But if
these checks would be overcome, people would face starvation.
2. Preventive checks (reduce birth rate). Approved: moral restraint (= people who couldnt
afford children should postpone marriage or never marry). Disproved: Vice (= prostitution
and birth control).
Population theory was the perfect theory which was formulated at the exact moment that the
theory was superseded by the industrial revolution with the rise of a new type of economy based
on: -Innovations -rising productivity development non-agrarian, industrial production and
-reallocation of resources
Population, when unchecked, increases geometrically; subsistence increases at best
only arithmetically. According to Malthus, poverty and misery are the natural
punishment for the failure by the lower classes to restrain their reproduction.
There must be no GOV relief for the poor, because to give them air meant more
children to survive, which would worsen the problem of hunger. Some of his ideas
were adopted in the harsh Poor Law Amendment of 1834, where all relief for ablebodied people outside workhouses was abolished.

Irish famine: seemed like evidence for Malthusian theory. However, this led to half-hearted
reactions, because they thought of it as something natural, inevitable.
Poor laws increased population size, which increased labour supply, which decreased wages,
although food prices were rising due to increased demand for food by the bigger population,
leading to more poverty. According to Malthus, poor laws should be abolished.
The Theory of Market Gluts
This state of disequilibrium and resulting crises would occur, held Malthus, because
there would always be problems of having insufficient effective aggregate demand
for all the commodities to be sold. Insufficient effective aggregate demand, in turn,
would have the effect of leaving inventories piled high. This, of course, would result
in a decrease in producer profit, an increase in the unemployment rate (as many
workers would need to be layed off), poverty to worsen, and general social unrest to
be aroused.

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Rent: According to Malthus, is a surplus based on difference between the price of agricultural
produce and costs of production (wages, interest, profits).
According to him, corn laws should be kept.

Classical School - David Ricardo (1772-1823)

Was a leading figure in further developing the ideas of the classical school. Ricardo
was an outstanding example of a deductive thinker. He began with basic premises
and used logic to deduce generalizations. Ricardo called his broad generalizations
economic laws, and he considered their operation to be as valid in economics as are
the laws of physics in the natural sciences.

His rent theory followed from the debate on Corn Laws, which were designed to regulate imports
in times of shortages.
The Corn Laws failed after 1790, because of Napoleonic wars, and population growth. However,
the debate started again in 1815.
Ricardos rent theory
1. Population growth: necessity for increase in food production.
2. More land exploitation / imports.
3. With further growth: there was a need to use less fertile land / more labor and capital =
diminishing returns.
4. Cost advantage of fertile land.
5. Competition among farmers for cost advantage.
6. Because of this competition, cost advantage or surplus was claimed by the landowners in
the form of rent.
7. Cost advantage = price cost of production
8. Price = cost of production of last unit of corn on the least fertile land in exploitation (P =
MC).
9. On marginal (least fertile land in use) land: price cost of production = 0.
10. On fertile land: price costs of production = cost advantage/surplus = rent > 0.
11. If price of corn increases, the cost advantage increases and thus also rent increases.

Rent
-

Originates in difference in cost of production as a consequence of differences in

fertility of land.
It is not a reward for the use of a scarce resource.
Is price-determined, not price-determining.
If corn prices increase, rent increases.
The Corn Laws created an artificial scarcity to the advantage of landowners.

(1) The Theory of Diminishing Returns and Rent. First, the extensive margin of
cultivation states that the trade of land partly determines the rent, and that
extensive use of the land, will yield diminishing returns of rent. Second, the
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intensive margin of cultivation states that if successive units of labor and capital are
added to a piece of land while technology remains constant, each added unit of
investment will add less to the output than previous units.
(2) The Theory of Exchange Value and Relative Prices. Ricardo wrote that, for
a commodity to have exchange value, it must have use value. Utility is not the
measure of exchangeable value, although it is essential to it. Possessing utility, or
use value, commodities derive their exchange value from two sources: (1) their
scarcity and (2) the quantity of labor required to obtain them.
(3) The Distribution of Income.
-Wages. The natural price of labor is that price that, given the habits and customs of
the people, enables workers to subsist and to perpetuate themselves without a
change in their numbers. Ricardos idea that in the long-run the worker gets only a
minimum wage came to be known as iron law of wages. When the market price of
labor rises above the natural price, a worker can rear a large and healthy family. As
population increases, wages fall to their natural price or even below. When market
price of labor is below the natural price, misery reduces the working population and
wages rise. Thus workers should receive the subsistence minimum!
-Profits. Ricardo felt that the rates of profit in different fields on enterprise within a
country tend to equalize. The free, competitive market and the actions of individuals
tend to produce rates of profit that are equal or equally advantageous, on balance,
for all types of businesses. Furthermore, Ricardo emphasized that profits and wages
vary inversely; one increases at the expense of the other.
Contemporary representation
As population and the labor force increase, diminishing marginal returns within
agriculture mean that total product increases at a diminishing rate. Thus total rent
received by landlords rises with population. Because wages remain at the
subsistence level while profits are squeezed out, the landlords are the sole
beneficiaries of the long-run expansion process. Their numbers remain constant, and
their rents grow.
The Theory of Comparative Costs
Ricardo made a brilliant and lasting contribution to economic thought, by showing
that even if one country is more efficient than another in producing all commodities,
trade between the two nevertheless can be of mutual benefit. His theory of
comparative costs is now known as the law of comparative advantage.
Rent: According to Ricardo, is the 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.
He called for the return of the gold standard so that currency would be redeemed
to gold.

Tutorial 1 Physiocracy
Between Mercantilist School and Classical School!
According to physiocrats, agriculture is the only source of wealth.
13

Surplus is originated during production

Laissez-faire, government intervention distorts the economy; agents should be able to
pursue their own interests.
Wealth = production
Natural order of economy (Tableau Economique p. 41 Brue & Grant).

The emphasis was on agriculture, the only source of surplus. Landowners should be taxed,
because rents are the surplus the landowners get. All taxes imposed on others would be passed on
to the landowner anyway.
The physiocratic school was wrong to consider industry and trade as sterile, this led also to the
false belief that only landowners should be taxed because only land could yield a surplus.
However, by studying society as a whole and circulation of goods and wealth, they founded
economics as a social science. Quesnays tableau economique is a precursor to later economic
flow diagrams and national income accounting. The law of diminishing returns was stated first by
Turgot. Furthermore, they also originated the analysis of tax shifting and incidence. Finally, the
physiocrats turned the attention of economists to the question of the proper role of government in
the economy.
Physiocrats on low wages
Due to low wages, poor farmers had a low income; therefore they had no means for investments,
or only for very low investments. Consequently, the production in agriculture didnt grow at a
high rate. According to the physiocrats, agriculture was the sole source of wealth. Low wages
imply low investments, which implies low productivity growth in agriculture. Therefore low
wages had a negative effect on the growth of wealth.
Mercantilism
Physiocracy
Classicism

Wealth
Gold and silver
Consumption goods
Stock of (consumption) goods

Sources
Foreign trade
Agriculture (land)
Labor, capital and land (total production)

Lecture 3
According to Ricardo, the aim of political economy is to determine the laws which regulate the
distribution of income.
Societal developments

Distribution of income
Rent, wages, profit

Growth and distribution of wealth

Due to population growth and rising food prices, rent incomes increased. On marginal land: price
= cost of production = costs of labor + costs of capital = wages + profits, no rent is paid on
marginal land. Profit is a residue, the difference between the value of output of the last unit of
labor and the costs of that last unit of labor (costs of subsistence). Because of diminishing
marginal returns, the marginal output tends to fall to the level of subsistence, less and less room
for profits. Marginal output marginal costs.

14

Tendency of declining rate of profit

Population food production (diminishing returns) costs price of subsistence
wages , rents profits
Savings and investments rate of accumulation of capital economic growth
stationary state of economy. In the long run there is a declining rate of profit due to population
growth.
Ricardo was against the Corn Laws for two reasons:
1. Income (in this case of landowners) should not be regulated by law. Corn laws,
prohibiting cheap imports of corn accelerate the stationary state.
2. Restrictions on foreign trade are always at the cost of the wealth of all trading partners
(law of comparative advantage).
General Glut controversy (Malthus)
There is a possibility of depression if effective demand is too low. Labor receives part of the
product of labor. Capitalists save, which leads to overproduction (deflation and depression as
consequence). Unproductive demand is very important, to prevent overproduction.
The economy needs a class that spends a lot to keep the economy going, the size of the effective
demand should be maintained. This is the task of landowners, rent incomes are thus important,
therefore the Corn Laws are a good thing to ensure the rent income for landowners, whose
unproductive demand keeps an economy going.
This theory was rejected after Says Law.
Says Law
- General overproduction is impossible
- Production creates income
- Production factors receive a reward and the sum of rewards = value of produced
output
- Purchasing power = value of output
- Supply creates its own demand. As economy grows, supply of goods increases and
payments of its fop increase, thus higher wages and in turn increased demand for
goods. Same thing with international trade country that exports more has more money
for its imports. Overproduction is no problem: rejection of Malthus theory.
However, Says Law does not account for savings. It doesnt hold true in the short run in marketbased economies because there is no guarantee that the recipients of the income payments will
spend them on the existing output.
Says law of markets: general overproduction is impossible. Keynes highlighted its weaknesses.
After Ricardo
First half 19th century: dominance of Ricardian model; surplus approach:
Value is created in production: value theory in terms of costs of production
Production = expenses + surplus; surplus is source of accumulation and growth:
foundation of regularities and laws in economics
Population growth and diminishing returns in agriculture: distribution
1. Ricardians: McCulloch, John Stuart Mill.
2. Anti-Ricardo: theoretical objections: value theory; objections regarding methods.
15

3. Ricardian socialists: distribution.

Development and refinement of classic system:
1. Utilitarianism
2. Value theory
3. Methodology
4. Distribution.
1 Utilitarianism
Jeremy Bentham (1748-1832). Utilitarianism (the principle of great happiness): ethical
arithmetics. It promoted the greatest happiness of the greatest number of people.
Consequentialism: consequences of an action determine whether an action is good or bad.
Utilitarianism had an egalitarian doctrine: everyones interests are equally important.
- Human action is motivated by the desire to obtain pleasure and to avoid pain.
- Principle of utility: tendency to promote happiness.
- Science of human happiness.
Benthams utilitarianism:
1. An action is not in itself good or bad
2. Consequences: how it affects happiness
3. Positive and negative consequences: pleasures and pains
4. Maximization of surplus: the principle of utility.
The focus is on social utility/collective happiness, it is the greatest happiness for the greatest
number of people that is the measure of right and wrong (example with saving 1 or 6 people from
getting killed by tram). There is also diminishing marginal utility of money: redistribution from
the rich to the poor would increase social utility (egalitarian nature). However, in redistribution,
the principle of security (being rich and feeling secured by possessions) should come before
equality, because there should be an incentive to exert effort for everyone.
Benthams concept of human nature (but not his utilitarianism) became the foundation for the
economic systems of Ricardo, Mill and early marginalists, such as William Stanley Jevons.
Task of GOV: be quiet.
2 Value theory
Bentham predicted marginalism.
Likewise John Stuart Mill: revision of Ricardos value theory. Importance of utility and costs in
determining exchange value. Factors of supply and demand (elasticity).
3 Method
William Nassau Senior: in political economy there is a distinction between science and art. The
science of political economy should be purely positive, not normative. Economists should
concern themselves with analyzing the production and distribution of wealth and not the
promotion of happiness.
John Stuart Mill: Economics is a separate science. Abstraction and empirical research should be
used as method. No economic requirements or absolute rules regarding distribution of wealth.
16

But there are conditions: equality must be compatible with growth and incentives. Process of
growth promotes equality and softens competition: reform of society not necessary.
4 Distribution
Mill was no advocate of equality of property of income, but that all start fair.
Task of government is to promote equality of opportunity.
Distribution law of nature.
The distinction between production and distribution is also important (Mill failed to recognize
that production and distribution are interrelated). Production is characterized by laws and
absolute character. Distribution depends on laws and customs and can thus be changed. There are
no economic requirements or absolute rules regarding the distribution of wealth. However, there
are conditions, equality must be compatible with growth and incentives. Process of growth
promotes equality and softens competition, therefore reform of society is not necessary.
Mill on the Wages Fund: Wages depend mainly upon labor demand and supply. Unitary
elasticity of demand for labor; no matter what the wage rate, the same sum is expended for labor.
The GOV can increase the size of the wages fund by forced saving through taxation. His
conclusion was that there comes a point where the employer would be ruined financially or
driven to abandon the business if wages increase further. Profit has 3 pars: interest, insurance and
wages superintendence.
After 1850, the classical school declined. The alternatives that arose were marginalism, the
historical school, and socialism: utopian writers and Marx.

The German Historical School (1840 1917)

-

Approach to economics which rejects the abstract-deductive method of the classical

economists
Emphasis on context of economic phenomena, changes in economy and structure are
always explained by societal factors, therefore not every economic law is applicable to
every country.

Major tenets:
- Evolutionary approach to economics. Dynamic and evolutionary perspective in

the study of society. It concentrated on cumulative development and growth.

As society is constantly changing, what is relevant economic doctrine for one
country at a particular time may be irrelevant for another country or another
age.
Positive role of the GOV. This school was nationalistic, whereas classical
economics was individualistic and cosmopolitan. They gave great prominence
to the need for state intervention in economic affairs and emphasized that the
community has interests of its own that are quite distinct from those of the
individual.
Inductive/Historical approach. They emphasized the importance of studying the
economy historically, as part of an integrated whole. Because economic and
other social phenomena are interdependent, political economy cannot be

17

treated adequately except in combination with other branches of social

science.
Advocacy of conservative reform. Political economy must not merely analyze
motives that prompt economic activity but must weigh and compare the
moral merit of these actions and their outcomes. It must determine a
standard of the proper production and distribution of wealth so that the
demands of justice and morality are satisfied.

Three objections against classical approach:

Isolation of economic phenomena
Universal validity of conclusions
Laissez-faire policy

Economic phenomena inseparable from social phenomena

Abstraction does not produce conclusion with universal
validity
Laissez-faire policy also depends on the societal structure;
it is not applicable to every country. It may not produce
the best possible results for society as a whole.

Whom did the Historical School benefit?

First, the member of the German historical school benefited themselves and also the
German imperial government by defending its role in a nationalistic state. Second,
the historical economists served the dominant business, financial, and landowning
groups by promoting moderate reforms that frustrated the drive for a more radical
democratization of society.
Which tenets of the Historical School became lasting contributions?
The historical inductive method has become generally accepted as complementary
to the abstract deductive approach. Economists of various persuasions agreed that
historical empirical studies are required to explain the present, to test old theories,
and to develop new ones.
Another lasting contribution of the school was its attack on laissez-faire. The
members of the historical school recognized that unrestricted free enterprise does
not necessarily produce the best possible results for society as a whole.
(Note the link between the historical economists and their ideas to the climate in
Germany which led to World Wars I and II. Ideas presented in their doctrine could be
interpreted as detrimental to societys progress.)

In the historical school, there were conflicting opinions on the methods of political economy.
Schmoller (1838 1917)
1. Economic relationships can only be understood in their socio-historical context.
2. Economics is an empirical (and no abstract) science.
3. Inductive method: facts starting-point for discovery of interrelations.
Schmoller wanted to develop economics exclusively on the basis of historical
monographs. He believed that ethical value judgements are to be encouraged.
Justice in the economic system is to be realized through a paternalistic policy of
social reform furthered by the state and all social groups.
Late in life Schmoller changed his views on protectionism. In his younger years he
18

had been an ardent advocate of free trade, but by 1901 he favored a protective
tariff for Germany by justifying it on the basis of Lists infant industry argument and
that tariffs were international weapons that might benefit a country if used skillfully.

Roscher (1817 1894)

1. The study of contemporary facts and periods is an essential adjunct to the classical
deductive method.
2. Supplement classical theory.
He was one of the founders of the older historical school. This group wanted to
supplement classical theory, whereas the younger school wished to supersede it
entirely with historical studies and policy considerations. Instead of disdaining
abstract theory, he sought to discover its historical basis. He asserted that the study
of contemporary facts and opinions is an essential adjunct to the classical deductive
method.

Menger
1. Economics is an abstract science.
2. Builds from assumptions and essences to deduce conclusions.
3. Deductive method.
Menger equated exchange value with total utility (unlike Jevons who equated it with MU).
Mengers theory of imputation: A thimble made of iron the iron has usefulness imputed to it by
the usefulness of the timble (indirectly).

Socialism
Socialism has had several meanings
- Capitalism has moral flaws (excesses, inequality of wealth, income, power) need for
socio-economic reforms to remedy these flaws.
- Socialism as economic system: state property of means of production, directive control of
investments, more equality.
- Socialism as stage in the development of society.
In general:
- Free operation of the market not beneficent to society.
- Conflicting interests of individuals and society.
- Regulating function of government to protect interests of society.
- Crises and depressions
19

View of man and society: a mans character is formed by his environment (society).

Characteristics of socialism:
Society is composed of distinct classes whose interests were often opposed to one another.
Against laissez-faire. They viewed the GOV as being a potential progressive
representative of the interests of the working class.
Rejected Says law of markets, claiming instead that capitalism is given to either
periodic
crisis or to general stagnation.

Denied the concept of humanity and believed in perfectibility of people. Self-interested

behavior with emphasis on making profits and accumulating wealth.
Aimed for collective action and public ownership by central/local GOV of enterprise to
improve conditions of classes.

Whom did Socialism benefit?

The moderate groups claimed to represent everybodys interests, with primary
emphasis on the needs and interests of workers.
The more extreme socialist groups proclaimed class warfare against the rich. Their
sole aim was to promote the interests of the working class

Utopian socialist: Robert Owen

- Environment molds human nature for better or worse: human beings cant form their
characters, their characters are formed for them, thus they arent truly responsible for their
actions.
- Improving life/work circumstances improves character: providing better working
conditions would produce better people.
- Reforms: New Lanark Mills:
- No child labor (until the age of 10, encouraged not to work until 12)
- Free schooling for all ages
- Food, clothes, fuel sold at cost
- Shorter workdays, wages relatively high
- Payment during sickness, old age insurance, recreational facilities
Even with these measures, which dont seem profit maximizing, he still made positive profits,
although his companions were not always satisfied with him. All of Owens theories, dreams
and programs were based on the belief that providing better working conditions
would produce better people.

Simonde De Sismondi (1773-1842)

- Among the first to launch a direct attack on classical economics.
- Unrestricted capitalistic enterprise is bound to lead to widespread misery and
unemployment criticism of Says law of markets and denial that free enterprise
economy leads to full employment.
20

Early contributor to business cycle theory: when wages are at the subsistence level, more
capital funds become available for investment in machines. There is increase in output of
manufactured goods, while demand for consumption is limited. Consequences are
overproduction and periodic crisis and unemployment.
Only GOV intervention would ensure the worker a living wage and a minimum social
security. The state should enact laws regulating distribution. Instead of largest possible
aggregate production, which coincides with the greatest happiness of the people; smaller
output well distributed is preferable.
Individual self-interest need not coincide with the social interest.

Robert Owen (1771 1858) was the most spectacular and most famous
of the utopian socialists. His central thesis was that the environment
molds human character for better or worse. Human beings cannot form
their own characters; their characters are without exception formed for
them. All of Owens theories, dreams and programs were based on the
belief that providing better working conditions would produce better
people.

Lecture 4
Marx was a leading theoretician of scientific socialism and he wanted to show that capitalism
had internal contradictions that would ensure its eventual demise.
Karl Marx
Materialist theory of history: Forces of production determine relations of production. Relations of
production and needs determine economic structure. Economic structure determines political,
ideological, and legal structure (superstructure).
The more advanced the society becomes the more we need means of production
(forces of production) in order to provide for that society. The forces of production
together are the material structure of society, which determines the ideological
structure of society.

Legal, social, political structures

Relations of production
Propertied class non-propertied class

Forces of production needs

- Labor
- Capital
- Land
- Technology
- Production techniques

} Economic structure
}
}
}
}
21

Resources

Forces of production constantly change due to changes in population, technology, education,

division of labor, and innovations. These forces of productions also influence relations of
productions (rules, social relationships between people, property relations), although these are
less flexible to change (static).
For Marx, history is a process through which the static relations of production come into conflict
with the dynamic forces of production. Result: new relations permit higher development of
forces.
In order to provide we need to produce, and methods for production are called by
Marx forces of production. Marx stated that history says that these forces of
production divide people between owners and non-owners. This distinction gives rise
to these relations of production. The non-owners have to get into relationship with
owners in order to provide for their means. They are put in a dependent position in
relation to the owners. The owners claim for that reason part of the revenue that the
non-owners produce. All of this together is the economic structure.
The economic structure develops the superstructure. For Marx economic structure
determines the ideological (super)structure. materialist point of view. NOT THE
OTHER WAY AROUND.
Marx uses Hegels theory: at some point in the development of the society there is a
conflict between thesis and anti thesis Marx uses it to describe the conflict forces
and relations of production (which are not flexible).

Hegel: In society there is a thesis and an antithesis. The conflict between these two builds up until
it explodes and a new equilibrium develops. This new equilibrium is the synthesis.
Thesis: Forces of production
}
Synthesis: new superstructure
Antithesis: Relations of production }
In capitalism there is a conflict between capitalists and workers. Capitalists appropriate the fruits
of cooperation at the expense of workers, which have a weaker position. This conflict develops,
and as a result, there will be a new synthesis: socialist society.
Marx aimed to identify laws of motion (characteristics) of capitalism that lead to an explosion of
the conflict, which would lead to socialism and communism.
Influence of classicism:
- Labor theory of value
- Law of declining rate of profit
Features of capitalism
1. Money-making
2. Labor is a commodity
1 Money-making

Natural exchange: commodity money commodity

Capitalism: money commodity new money
new money > money
22

Capitalism: money is used to make commodities, and they are used for exchange
value to make profit.
Marx made a distinction between exchange value and goods/commodities.
Production = the creation of exchange value for profit.
Exchange value = no intrinsic exchange value; value only exists in the comparison
between goods.

Exchange value = quantitative relationship between two different things which save something in
common of the same magnitude.
Common element in goods: labor (labor theory of value). Labor is what creates value, capital and
land are unproductive. This theory is somewhat similar to physiocracy, which also saw only one
factor which creates value. However, physiocrats thought it was land, Marx thought it was labor.
Labor Theory of Value: Marx stated that the (exchange) value of a
commodity is determined by the socially necessary labor time embodied in
the commodity. Marxs labor theory of value differed from Ricardos in an
important way: To Marx, labor time determines the absolute value of goods
and services; Ricardo believed that the relative values of different
commodities are proportional to the labor time embodies within each.
2 Labor as a commodity
- Labor is a marketable commodity.
- You could buy it and put it in productive activity in order to exchange value and make a
profit.
- Capitalism is a perverted system, because it purchases labor to make money. Because it
uses human beings, labor, as means to create profit and that is against human dignity.
- Labor is abstract labor = average, homogeneous, simple labor = labor which only varies in
quantity: labor time.
- Value of a commodity is determined by labor time needed to produce a commodity under
normal conditions (=socially necessary labor time).
- Marx believed that owners of land and capital do not contribute to a commoditys value
theory of exploitation of labor.
The Theory of Exploitation The capitalist pays labor the value of its labor power.
This amount is less that the value of the output, the difference being surplus value
expropriated by the capitalist in the form of property income.
Capital Accumulation and the Falling Rate of Profit
Surplus value is the source of capital accumulation. As capitalists invest relatively
more in machinery and less in labor power, which causes the surplus value, or
profits, to decrease.

Surplus value
Labor is the only commodity that creates value over own and above its own value (exchange
value = labor costs (wage), use value = value of output of labor - product).
Surplus S = use value of labour exchange value of labour = value of output of labor wage
costs
Workers work longer than necessary to produce value equal to wage costs, because the capitalists
appropriates surplus, it exploits labor. Exploitation of labor: when workers produce more in a day
than they must consume in order to maintain themselves and their families. All property income
23

arises from the unknowing exploitation of labor in the productive process. Capitalists are
interested in surplus value, in creating as much as they can get

Production depends on capital and labor (Distinction between:)

1. Constant capital C: resources, land, machines
2. Variable capital V: labor costs
Surplus value rate S= S/V (ratio between surplus and variable capital, payments to labour)
Organic composition of capital = C/V
S is the extra value that capital produces greater than his own, which capitalist takes without
compensating the workers who produce it, it is called surplus value.
Surplus value = value output of labour wage costs
Increasing surplus value S:
- Hours worked
(is limited, market-determined)
- Productivity of labor per hour
Typically in order to increase labor productivity investments in C (constant capital) is used by
capitalists: machines, technologies, economies of scale, substitution of labor.
Organic composition of capital C/V . Internal inconsistency of capitalism: falling rate of profit
(P )
Rate of profit P = S/(C + V) = (S/V)/(C/V + 1) = surplus value rate / organic composition of
capital. C/V Profits
Marx assumes that investment in C is labor saving which means that the organic
composition of capital increases. This increases the internal consistency in
capitalism by falling rate of profit.
Capitalists define profits as surplus value.
Capitalists throw out the very thing that creates value and profits. Why do they use
this strategy when they know that it has a negative impact on the rate of profit?
Marx answers that they have no choice they have to use this strategy, because they
are forced to this strategy by competition. Thus competition among capitalists
causes falling rate of profit, business crisis and technological unemployment. These
outcomes lead to centralization of capital and concentration of wealth, also rising
unemployment and poverty and class conflict and overthrow of capitalism LAW OF
MOTION.

Capitalists intention to increase S leads to a decrease in profits. Decreasing labor: decreasing

source of value. Why do capitalists do this? Marx: they have no choice, its a law of motion:
capital accumulation forces down the rate of profit.
Why?
Competition between capitalists:
1. Labor market: drives up wages at expense of profits substitution: Since wages are
increasing capitalists react by trying to throw out labor and use more
machines instead substitution, but in the end they put pressure on the rate
of profit.

2. Commodity markets: competition forces capitalists to reduce costs to sell at lower prices
in order to keep up more efficient production techniques organic composition of
24

capital increases.
Capitalists have to follow (2), otherwise they lose market share. This is an internal contradiction
of capitalism.
However, this is not inevitable, falling wages: S/V . This was acknowledged by Marx, but he
just assumed a falling rate of profit.
Laws of motion in capitalism
Inevitable collapse of capitalism:
- Law of declining rate of profit
- Theory of business crises
- Concentration of capital
- Rise of the reserve army of the unemployed
- Law of increasing misery.
Smith:
Capital accumulation }
Division of labor
}
Innovation
}
Ricardo:

Marx:
Laborproductivity

Limits
Diminishing returns
due to the exhaustion

of resources and land

as population increases
with wages at subsistence-level

Growth
laborproductivity
+
Wages at
subsistence
level

Business crises and reserve army of the unemployed

Value theory
Aristotle: distinction between exchange value and use value.
Scholastic writers
1. Demand factors: indigentia, need, utility in relation to scarcity
2. Supply factor: costs of production (labor and expenses)
Marginalism focuses on demand factors. Neoclassicism combined classicism (supply) and
marginalism (demand).
Classical value theory: value paradox
- Water is most useful but a free good; diamonds are pretty useless but expensive.
- Value cannot be a matter of usefulness
- Value is determined by relative scarcity. What determines relative scarcity?
- Demand in relation to supply; ratio between quantities price
- Underneath price there is a natural value, long run-price determined by costs of
production. Classicism was interested in this real long-run price.
25

Smith
1. Focus on exchange value
2. Distinction between a primitive (labor) and an advanced economy (rewards for the use of
the factor of production)
3. Two questions mixed up:
How does value arise (production; costs; distinction market and natural prices)
How to measure value? (Labor).
Ricardo
1. Distinction primitive/advanced artificial
2. Use value condition for exchange value
3. Exchange value determined by scarcity and labor:
- Non reproducible commodities: scarcity
- Reproducible commodities: labor
4. Labor theory of value: the value of a commodity is determined by the amount of labor
time necessary to produce that commodity
Ricardo was more aware of importance of use value, use value is necessary for exchange value to
exist: scarcity or labor.
Problems labor theory of value:
1. How to take into account that industries differ in the ratio between labor and capital?
- Influence of the rate of profit on relative prices relatively small
2. What about rent and profit?
- Rent is price determined
- Capital is stored-up labor
3. Heterogeneity of labor:
- Translation of differences in productivity to differences in labor time.
J.S. Mill had more a Smithian view on value: cost approach, focus on utility.
Classic value theory
- Value is created in production
- Wealth defined in terms of commodities
- Commodities embody value because production required effort/disutility/costs (objective
measure)
- Focus on the long-run; growth/distribution of wealth
One-sided supply approach.
Summary Law of motion of Capitalist Development.
The labor theory of value is the starting point for the entire theory. Workers are the
source of all value, but do not receive all the value. Instead, the capitalist pays labor
the value of its labor power. This amount is less than the value of the output, the
difference being surplus value expropriated by the capitalist in the form of property
income. Surplus value is the source of capital accumulation, which in turn produces
26

a falling rate of profit, worsening business crises, and technological unemployment.

All three bolster the size of the industrial reserve army of the unemployed and either
directly or indirectly add to the immiserization of the proletariat. The declining rate
of profit and worsening business crises also cause a centralization of capital and
concentration of wealth. The eventual result of the process is class conflict. (Figure
10-2)

Marginalism (1871 present)

Classical economics: production distribution exchange consumption

Marginalists: Consumption exchange distribution and production.
Focus on utility, satisfying wants. Utility or want is no condition for exchange value; utility is the
source of value. Use value is the cause of exchange value. Value no characteristic of a commodity
but a subjective estimation of the contribution of a commodity to want satisfaction (marginal
utility). Utility, demand and price can be related, if a distinction is made between total utility and
marginal utility: X MUX P
Marginalism tried to model economics after natural sciences, to make it more scientific.
Shortcoming of classic value theory: different value theories for different types of commodities,
no distinction between total and marginal utility, and prices are not determined by historical costs.
Law of diminishing marginal utility: Gossens first law: X MUX (dTU/dX)
Equimarginal rule (Jevons): Gossens second law: MUA/PA = MUB/PB = = MUN/PN
Utility is maximized if money income is allocated in such a way that the marginal utility of the
last unit of money spent on all commodities is equal.
Unlike Ricardo who is saying that pearls have value because people need to dive for them, Jevons
is saying that pearls have value because buyers get utility from them and that people dive for
pearls because pearls have such value.
Jevons THEORY OF DIMINISHING MARGINAL UTILITY. He said that utility cant be
measured directly, but it can only be estimated by observing human behavior and noting human
preferences. He rejected comparing the intensity of pleasures and pains among different people.
But he said that a single human can compare utilities of successive units of a single good and can
compare marginal utilities of several goods. Marginal utility declines as more of commodity X is
consumed.
He solved the value paradox: Total utility of water is larger than total utility of diamonds, but MU
of diamonds is greater than MC of water. We would prefer water over diamonds but we would
rather have one more diamond than one more unit of water.
RATIONAL CHOICE: EQUIMARGINAL RULE: If the ratio of MU of X to its price is larger
than that for other commodities, then the rational consumer will purchase more of X and less of
other goods. As more X is obtained, its MU decreases, as fewer other goods are consumed their
MU rises. Eventually the ratios of MUs to the respective prices of goods will equalize and the
consumers total utility is maximized.
Tenets of Marginalist School:
- Focus on the margin: point of change where decisions are made.
- Rational economic behavior: People act rationally in balancing pleasures and pains, in
measuring marginal utilities of different goods, and in balancing present against future
27

needs. They assumed that the dominant drive of human action is to seek utility and avoid
disutility (Jeremy Bentham)
Microeconomic emphasis: individual person and a firm are central. Marginalists
considered individual decision making, market conditions for a single type of good, the
output of specific firms, and so forth
Use of abstract, deductive method: rejected historical method in favour of the
analytical, abstract approach
Pure competition emphasis: perfect competition
Demand-oriented price theory: Demand is primarily source in price determination and
demand depends on marginal utility, as opposed to the classical schools interpretation
that cost of production (supply) was the significant determinant of exchange value.
Equilibrium approach: economic forces tend towards equilibrium a balancing of
opposing forces. Whenever disturbances cause dislocations, new movements toward
equilibrium
Merger of land with capital goods: The marginalists lumped land and capital resourced
together in their analysis and spoke of interest, rent, and profits as being the return on
property resources.
Minimal GOV involvement: In most cases, no interference with natural economic laws
was in order if maximum social benefits were to be realized (such as classical school)

Marginal revolution
1. Modeling of economics after the natural sciences
2. Consumers
Producers
Demand
Prices
Supply Allocation of means

Wants/Income
3. In a way equally one-sided. Only second generation applies marginal analysis to supplyside.
Whom did the marginalists benefit? The marginalists sought to advance the
interest of all of humankind through promoting a better understanding of how a
market system efficiently allocated resources and promotes economic liberty.
William Stanley Jevons (1835 1882) equated exchange value with marginal
utility.
Jevons on Value Theory:
Unlike Ricardo, who might say that pearls have value because people need to dive
for them, Jevons is saying that pearls have value because buyers get utility form
them and that people dive for them because pearls have such value. The specific
level of utility associated with the pearls depends on the number of pearls people
presently possess.
Theory of diminishing marginal utility cant be measured directly, but an
individual can compare marginal utilities of several goods. Whereas total utility
of water is greater than the total utility of diamonds, the marginal utility of
diamonds is far greater than the marginal utility of water.
28

 Rational choice: the equimarginal rule MUx/Px=MUy/Py The consumer

wishing to maximize utility will allocate money in such a way that the marginal
utility of the last dollar spent on all goods is equal.
Theory of exchange Jevens also used the principle of utility maximization to
explain the gains from exchange
Jevens on Labour According to him, labour cant be the regulator of value
because labour itself has unequal value; it differs in quality and efficiency.
Jevons theorized that the worker compares the marginal utility of earnings from
the job (MUe) with the marginal disutility of work (MDUw).
Other topics addressed by Jevons:
First, even though he didnt fully develop a theory he understood the theory of
distribution based on marginal productivity. Second, he contributed to the theory of
insurance and gambling. Fourth, he got attracted by the phenomenon of business
cycles. Fourth, he started to develop index numbers, in particular the price index.
Jevons on Public Policy:
He favoured free public museums, concerts, libraries and so on. He believed that
child labour should be restricted. He accepted trade unions, but he said that they
should leave the wage rate because a wage increase results into higher prices and
therefore hurts other workers.
Carl Menger (1840 1921) equated exchange value with total utility.
Mengers Value Theory:
Like Jevons, Menger based his theories on the concept of utility. Yet, he refused to
use mathematics in his analysis and he avoided constructing it upon Benthams
base. As opposed to Jevons he equated exchange value with total utility. (Jevons:
marginal utility) Nowadays economists would agree on Jevons method. He stated
that value is very subjective; a good can be valuable to one person and useless to
another. It has nothing to do with the cost of production. Exchange value is the
difference in relative subjective valuations of the same good by different individuals.
Hence, trading is undertaking to increase satisfaction by both parties.
The Theory of Imputation:
What governs the prices of higher order goods used in production? Menger, in his
theory of imputation, held that such goods also yield satisfaction to consumers,
though only indirectly, by helping to produce things that do satisfy consumer wants
directly.
Friedrich von Wieser (1851 1926) introduced the concept of natural value
versus exchange value, where the distinction between the two lays in exchange
value also being determined by the purchasing power of consumers. He also
formulated the opportunity cost-principle.
Exchange Value vs. Natural Value:
Von Wieser stated that there is no objective exchange value, because its roots are
bedded in the subjective estimates of individuals, grouped to determine the results.
He introduced the concept of natural value as the sum of the marginal utilities of all
29

goods obtained. In natural value goods are estimated simply according to their
marginal utility; in exchange value, according to a combination of marginal utility
and purchasing power. He agreed with Menger that each additional value of goods
brings with it a diminishing incremental value. (Paradox of value)
Opportunity Costs: He was the founder of the term opportunity cost.
Eugen von Bhm-Bawerk (1851 1914) contributed to economics with his
analysis to the element of time.
Theory of Interest:
Interest arises for three reasons, of which the first to are subjective: (1) present
orientation, (2) expectation of rising wealth and (3) roundabout production (process
of production is lengthened and more capital goods are produced and then used to
make final goods) To summarize: Interest can be paid by the entrepreneur, because
the more roundabout the process of production, the more productive and efficient it
becomes. Interest must be paid because people prefer present to future
consumption.
John Bates Clark (1847 1938) earned a worldwide reputation and represented
Americas great contribution to marginalist economics
Marginal Productivity Theory of Distribution:
Clark generalized the theory of diminishing marginal returns to all factors of
production. He stated that at some point the variable factor becomes so abundant
relative to the fixed factor that additional units of the variable factor cannot
contribute much to output. What about profits? In a perfectly competitive economy,
economic profits tend to disappear at both ends of the production process. His
theory says little about factor supply. Alfred Marshall emphasized supply as well as
demand for productive inputs. Clark was optimistic over the outcome of economic
dynamics. He said five trends are helping to promote industrial progress: (1)
population is increasing, (2) capital is accumulating, (3) technical process of industry
are improving, (4) modes of organizing labour and capital are becoming more
efficient and (5) human wants are being multiplied and refined. Clark favoured
government intervention in order to preserve competition from monopolies.
Ethical Implications of Clarks Distribution Theory:
Clarks overall conclusion from his marginal productivity theory was that the division
of labour of the social income, wages, interest and profit is, in principle, equitable.
He asked himself though whether the initial distribution is ethically derived...
The Adding-Up problem and the Returns to Scale:
From his mathematical calculations he concluded that the sum of the payments
based on marginal productivity would add-up to the total product only if there
were perfect competition and constant returns to scale. Today we call these
phenomena economies of scale.
30

Marginal versus Average Product

Francis Y. Edgeworth (1845 1926) was one of the second generation marginalists
who developed ideas that expanded and advanced the microeconomic theories. A
significant idea added by Edgeworth was his distinction between marginal and
average product. When total product is rising at an increasing rate , marginal
product is rising and is above the average product. Because MP>AP, average
product is also rising. Whenever a number that is greater than the average is added
to a total, the average must also rise. But once the total product rises at a
decreasing rate, marginal product falls; that is, diminishing marginal returns occur.
Eventually marginal product falls below the average product, thus pulling the
average down.

Tutorial 2
Age of Ricardo
1815-1848 Restoration period
- Aristocracy tried to restore traditional order against developments set in motion by the
Industrial Revolution.
- 18-15-1830: Age of Ricardo: conflict between landowners and industrialists + workers,
latter won, shared profits with landowners.
- Debate revolved around distribution of wealth; profit for capitalists vs. rent for
landowners.
Consequences of rent development
1. Ricardo argues that food production needs to be increased to feed the growing population.
Given the need to take land of inferior quality into cultivation, costs of production
increase and consequently food prices rise. As a consequence, the relative shares of
wages, profits, and rents in national income change, affecting further growth.
2. Rising costs and food prices push up both the relative share of rents and wages in the long
run (nominal wage at subsistence-level must rise in order to compensate for rising food
prices).
3. These relative shares of rents and wages increase at the expense of the share of profits,
which is squeezed between the two other shares. No profits, no capital accumulation, no
further growth.

1 Aim/problem
2 Level & time horizon
3 Focus, approach
4 Pricing theory

Classical School
Economic
growth
&
development
Macro, long run
Policy issues, supply side
Value = matter of production

Marginalist School
Allocation of means to maximize
utility
Individual consumer/firm, micro
Abstract/theoretical, demand side
Value = utility through competition
31

Lecture 5
Marginal productivity theory
Marginal productivity theory (MPT) applies the marginal utility theory to the supply side.
Applying more units of a factor of production will lead to a decrease in marginal product. If the
marginal product of a production factor decreases, the price of the production factor will also
decrease.
According to the MPT, choice decisions regarding factors of production depend on their marginal
products. John Bates Clark asked: how many units of the variable input factor should be used?
- As long as MPL*P0 > PL: add more units of labor.
- As soon as MPL*P0 < PL: reduce number of units of labor.
- Equilibrium: MPL*P0 = PL
The MPL-curve is the demand curve for labor.
Edgeworth explicitly distinguished between average and marginal products of a production
function.
Edgeworths table displayed the diminishing returns and the distinction between average and
marginal product.
According to Clark, the MPT is also a distribution theory. His theory of distribution was based on
the law of diminishing marginal returns. If capital, land and entrepreneurship are kept constant
and while units of labor are added, the MP and AP of labor will ultimately fall, although total
output rises. The reason is that eventually the variable factor becomes so abundant relative to the
fixed one, that additional units of the variable factor cant contribute much to output. He believed
that profit has no place in such conditions, it disappears.

Total wage bill:

ABCD
Total product:
AEBD
Reward for capital: CEB

Relationship between total, marginal and average product:

As labor is added to a fixed amount of capital, total
product first increases as an increasing rate, then at diminishing rate and finally declines. The
marginal and average products of labor rise for a time and then fall. When MP>AP, AP rises and
when MP<AP, AP falls.
When total product is rising at an increasing rate, marginal product is rising and is
above the average product. Because MP>AP, average product is also rising.
32

Whenever a number that is greater than the average is added to a total, the
average must also rise. But once the total product rises at a decreasing rate,
marginal product falls; that is, diminishing marginal returns occur. Eventually
marginal product falls below the average product, thus pulling the average down.

Debate following the MPT

1. The MPT is not a residual theory, since it doesnt matter which factor is held constant or
variable. If in the graph labor was fixed, and capital was variable, it would still yield the
same distribution of income.
2. Adding-up problem (product exhaustion). TP = MPL*L + MPK*K?
Wicksteed: sum of rewards of the production factors on the basis of their marginal
products = value of total product, under conditions of perfect competition and constant
returns to scale.
3. Profit-problem: reward for capital is interest. If profit reward for production factor, then
how is it explained? MPT: In perfectly competitive markets and long-run equilibrium: TR
= TC, there are no profits in the long run.
4. Ethical implication. Clark: if under perfect competition each production factor gets paid
according to their value of marginal product, the distribution of income is fair.
Objections: claims on fairness cannot be derived from a theory, which explains relations
between variables.
Supply became equally important as demand. There was a need to review old theories.

Mathematical Economics
Lon Walras
Had a different approach than Jevons and Menger (all 3 are considered originators of
marginalism). Walras emphasized the economy as a system of interdependence of variables.
Supply and demand are interdependent. This approach led to his general equilibrium model.
His theory presents a framework consisting of the basic price and output
interrelationships for the economy as a whole, including both commodities and
factors of production. Its purpose is to demonstrate mathematically that all prices
and quantities produced can adjust to mutually consistent levels.

Walras market model

Households

Supply of final goods

Demand for final goods

Demand for factors

Supply of factors

Firms

Prices are simultaneously determined by supply and demand.

Walras is considered as one of the founders of marginalism, the others being Menger
and Jevons. Walras developed and advocated general equilibrium analysis, which
considers the interrelationships among many variables in the economy. He said that
33

the function for the quantity demanded of a good depends on the price. That is,
price is the independent variable and the quantity demanded is the dependent
variable. (this was different than stated by Marshall) Because general equilibrium
concepts include many equations and unknowns, it has largely been a theoretical
tool helping us understand the blueprint of the economic systems.

Alfred Marshall (1842-1924)

Marshalls emphasis was on the interdependence of demand (wants) and supply (activities).
Marshall is considered to be the father of neoclassical economics.
Bridging differences:
- Abstract theory vs. empirics/induction
- Static vs. dynamic analysis
- Focus on money/wealth as an instrument.
Attempt at synthesis, in showing the complementarity of utility (marginalist) and cost (classical)
approaches.
According to Marshall, poverty is an obstacle in growth and development. Economics was an
instrument to improve well being and character of individuals, and thus of society.
Demand
- People aim to satisfy their wants.
- Law of diminishing marginal utility.
- Individuals take decisions at the margin: not whether he wants any but whether he wants a
bit more, comparing marginal utility with the price of an additional unit.
- Hence downward-sloping demand curve, since people insist on paying less for something
that yields less satisfaction (marginal utility). How much less people wanted to pay,
depends on the price elasticity of demand.
Consumer surplus
1. Downward-sloping demand curve, each next unit yields less marginal utility than the
previous unit.
2. If MUX decreases Price of good X also decreases.
3. This leads to the market price P.
4. Consumers were willing to pay more for the first units of consumption. They were willing
to pay above market price P.
5. The sum of these advantages of consumers = consumer surplus.
Maximization
Substitution at the margin. The assumption of rationality is important: resources are allocated
between commodities such that ratios of marginal utilities to prices of commodities are equal for
each commodity Equimarginal rule or Gossens second law.
Theory of demand

34

Time period is sufficiently short to allow for ceteris paribus assumption. This involves the
problem of aggregation. Again, the assumption of rationality is important. Preferences, persons
wealth, purchasing power of money, and prices of substitutes are all constant.
Supply
- Supply curves slope upwards to the right: additional efforts or costs to increase production
require extra incentives.
- Supply curve = marginal cost curve with nature of costs subjective: real costs. Marshall
spoke in terms of real costs when considering costs of production. By real he meant
ultimately the disutility of both the labor and the waiting involved in producing and
bringing a commodity to market. However, Marshall just assumed equality of real costs
and money costs.
- Supply price: sum of money to be paid for these extra efforts.
- Supply schedule: a locus of points linking in each case supply price to exertions necessary
for producing a given amount of a commodity.
- Distinction between prime (variable) and supplementary (fixed) costs.
- Time is the chief problem in economics: market period (very short run), short run, and
long run. The time periods are differentiated on the basis of the price elasticity of supply.
Market period: Price elasticity of supply = 0. Value is demand-driven, costs of production are
irrelevant.
Short run: Upward-sloping supply curve, supply can be adjusted, decisions depend on variable
costs.
Long run: Supply is perfectly elastic and all costs are variable. Supply price depends exclusively
of costs of production.
Distribution
- Four inputs: land, labor, capital and organization.
- One unified theory of inputs/outputs.
- Decisions are taken at the margin: comparing the marginal product of an input to its costs,
adding units of inputs until marginal costs equal marginal product.
- Prices of factors of production are determined at the margin, entrepreneurs compare the
relative efficiency of factors of production, substituting to produce at lowest costs.
- Next to these pecuniary motives:
- Custom (wage rigidities).
- Duty (moral imperatives).
- Environment (influence of climate, race, geographical location and national
character on motives/desires).
- Approbation (people not only do things for money but also for esteem and
admiration.
What did Marshall know and have we forgotten?
Dynamics of time
- Time key problem
- Consequences of decisions and actions become only apparent in the course of time.
- Method of isolation useful but also of limited use.
- Need for dynamic analysis
35

Consumption and progress

- Importance of growth of wealth but also of the composition of output.
- Rather than satisfaction of material wants: progress in terms of behavior and character.
Three classes of needs
- Biological needs: food, clothes, shelter.
- Wants which afford strength and increases efficiency.
- Artificial/superficial wants.
The point is to use increased opportunities for consumption productively.
Distinction between standards:
- Standard of comfort
- Standard of life. (= an increase in intelligence and energy and self-respect, leding to more
care and judgment in expenditures)
Increasing consumer expenditures Standard of life Health, physical and mental
strength, and moral Efficiency of labor Production Income Increasing
consumer expenditures etc.
According to Marshall wages depend on both demand and supply.
Marshallian economics dominated until 1930s, combining a formalist/deductive and
historical/institutional approach. This combination of approaches inspired criticism. From 1930s
economics focused on formal theory.

Lecture 6
Welfare Economics
Out of concern for the persistence of poverty, how to increase and better distribute health? ->
welfare economics
English variant/Pigou:
- In Marshalls footsteps
- Collecting knowledge to bring about social progress
- Self-interest does not necessarily result in maximum welfare
- Wealth and welfare 1912

Wealth and welfare

- Welfare cannot be defined
- Economics confined to economic welfare = part of social welfare which can be measures in
terms of money
- Assumption: increase in economic welfare = increase in social welfare
- Changes in economic welfare through national product
- Society is to ensure that:
1. Size of national product as large as possible
2. More equal distribution of the national product
36

3. Fluctuations in size of the national product to be tempered

- Distinction between private and social product: max private product is not equal as max social
product
- Justification of government intervention
- Intervention when private ends and social ends do not run parallel. Three kinds of disharmonies
1. Production or size of the national product: (Monopolies; external effects)
2. Distribution: desirability of redistribution
3. Fluctuations: uncertainty and irregularity of work and income
Continental variant/Pareto:
- General equilibrium model
- Conditions for maximum of welfare (Pareto-Optimum):
1. Optimal allocation of resources
2. Optimal level of output
3. Optimal distribution of goods

Austrian approach:
Model of explanation based on individual plans and motives in which disequilibria in the
economy are emphasized.
Objections against descriptions of market process in terms of a static equilibrium model
And against the mathematical formalization of economic phenomena.
Economic behaviour takes place in a world of imperfect knowledge and uncertainty:
disequilibrium is the rule.
And yet the market works better than regulation
Debate on socialism:
Von Mises: Common property of capital(goods) = no (factor)market = no pricing mechansim =
no efficient allocation and allocation of means
Oscar Lange: Prices are indeed essential, but why would a central planning board be unable to set
prices and assume the role of the market?
Friedrich Hayek: 1. Central planning board unable to solve the problem of information 2.
Socialism incompatible with liberty
Joseph Schumpeter (1883-1950)

Studied law/economics in Vienna

Theorie der wirtschaflichen Entwicklung 1912
Political career
President of a private bank
Professorship in Bonn
Harvard, US
Capitalism, Socialism and Democracy (1942)
History of Economic Analysis (1954)
37

Capitalism, Socialism and Democracy

Decline of capitalism:
1. Entrepreneurial function grows obsolete
2. Destruction of the political strata
3. Destruction of the institutional framework of capitalism

Institutionalism
- Originated in the USA around 1900
- Robber capitalism and labour conflicts
- Challenge to laissez-faire policy in the face of monopolies, depression, poverty etc.
- Debate on reorganization of society (socialism) and reforms
- Builds from ideas of the Historical school
- Criticism at (neo)classical thought:
Explanation of economic phenomena
From abstract individual
With given objectives and preferences
Within given institutions
Abstracts from what really matters in the economy
1. Preferences, behaviour etc. Are determined by social or institutional context
2. Institutions are starting-point of analysis
3. Rejection of notion of equilibrium
The economy is a process of continuous structural adjustments to changing societal and
technological circumstances
Thorstein Veblen (1857 1929)
- The theory of the leisure class (1899)
- The theory of the business enterprise (1904)
Veblens critique of (neo)classical thought:
1. Simplistic view of man: choice behaviour utility max.
But social process: institutions determine how people act and choose
Institutions: patterns of behaviour which we unconsciously adopt as we are socialized as
members of our society
2. Outdated concept of change is assuming some end-state
3. Assumption of harmony/equilibrium
4. Notion that capitalists produce socially desirable results.
Veblens alternative:
- Economics: the study of the evolving structure -> individual behaviour
- Structure = complex of habits of thought and behavioural patterns or instincts:
1) The paternal instinct
}
2) Workmanship
}
social orientation
3) Idle curiosity
}
38

4) Acquisitiveness

-> self-regarding

Industrial or technological activities and institutions

Socially-oriented instincts
Self-regarding instincts
Ceremonial activities and institutions

Theory of the leisure class

- Rejection of the view of consumption as a means to happiness; cultural theory
- Important purpose of consumption is to impress others. Spending money has not to do with
utility but with keeping up and outdoing others

Theory of the business enterprise

- Business activities
- Capitalist
- Making profits

- Machine process
- Engineer: making goods
- Technical procedures used to produce goods
- Productivity, serviceability and efficiency

Formalist revolution:
1. Growing use of mathematical techniques and tools
2. Emphasis on theory and development of theory
3. Institutional context disappears
4. Interest in Walras general equilibrium model and condition and stability equilibrium
Developments in micro-economics:
- Shift from Marshallian (partial equilibrium) economics to Walrasian (general equilibrium)
economics
- Less attention for historical and institutional factors and policy issues
- Mathematical formalization
- Market process in terms of equilibrium

The Institutionalist School (1900 Present)

Major Tenets
Holistic, broad perspective
The economy must be examined as a whole, rather than as small parts of separate
entities isolated from the whole. Institutional economics deals with social processes,
social relationships, and society in all its facets.
Focus on institutions
This school emphasized the role of institutions in economic life. An institution is not
merely an organization or establishment for the promotion of a particular objective,
39

but also an organized pattern of group behavior, well-established and accepted as a

fundamental part of the culture. Economic life, said the institutionalists, is regulated
by economic institutions, not by economic laws.
Darwinian, evolutionary approach
The evolutionary approach should be used in economic analysis, because society
and its institutions are constantly changing. They disagreed with the static viewpoint
that sought to discover eternal economic truths without regard for differences of
time and place, without concern for changes that were occurring instantly. The
evolution and functioning of economic institutions should be the central theme in
economics.
Rejection of the idea of normal equilibrium
Rather than the idea of equilibrium, institutionalists emphasized the principle of
circular causation, or cumulative changes that may be either salutary or harmful in
seeking economic and social goals. The institutionalists are convinced that collective
controls through government are necessary to continually correct and overcome
deficiencies and maladjustments in economic life.
Clashes of interest
Instead of the harmony of interests that most of their contemporaries and
predecessors deduced from their theories, the institutionalists recognized serious
differences of interest.
Liberal, democratic reform
The institutionalists espoused reforms in order to bring about the more equitable
distribution of wealth and income. They, invariably, condemned laissez-faire and
favored a larger role for government in economic and social affairs.
Rejection of the pleasure-pain psychology
They repudiated the Benthamite underpinnings of economic analysis. They reached
out instead for a better psychology, and some of them incorporated Freudian and
behaviorist ideas into their thinking.

Welfare economics
Several important contributors to economics have focused on either or both of the
following: (1) defining welfare optimality and analyzing how maximum welfare can
be achieved; (2) identifying factors that impede the achievement of maximum
wellbeing and suggesting ways that the impediments might be removed.
Vilfredo Pareto
Pareto Optimality:
Maximum welfare occurs where there are no longer any changes that will make
someone better off while making no one worse off.
Optimal Distribution of goods -> when two person have equal marginal rates of
substitution.
Optimal Technical allocation of Resources -> When the marginal rates of technical
substitution between labour and capital are the same
Optimal Quantities of Output -> MRS=MRT
Evaluation:
Paretos welfare theory is a significant contribution to economics. There are several
criticisms though: First, it fails to address the important issue of distribution. Second,
many public policies that increase national output, and overall welfare also
40

redistribute income. Third, it is based on a static view. Fourth, the moral judgements
that the Pareto criteria purposely exclude are often legitimate and dominant factors
in policy formulation.
Arthur Cecil Pigou
Income Redistribution:
Basing himself on Jevons and Marshalls principle that the marginal utility of money
diminishes as more is acquired, Pigou asserted that greater equality of incomes
under certain conditions could increase economic welfare.
Divergence between Private and Social Cost and Benefits:
Pigous most significant deviation from orthodox economic theory lay in his focus on
the divergence between social and private marginal costs and benefits. He derived
an important welfare implication from his analysis: not all competitive markets
produce a level of output that maximizes societys total welfare. The conclusion:
negative externalities result in an over allocation of resources (too much output) in
those markets in which they occur. According to Pigou, the governments task is to
equalize (1) private and social marginal cost and (2) private and social marginal
benefits.
Other Contributions:
He stressed the desirability of increasing savings in the economy. Pigou concluded
that economic welfare is diminished by government intervention that strengthens
the tendency of people to devote too much of their resources to present use and too
little to future use. Furthermore, it was him who classified price discrimination into
three steps: first degree, second degree and third degree.
Ludwig von Mises
Several ideas in welfare economics emerged from a debate emerged whether
welfare economics can be maximized under a system of socialism. An important
early figure in this debate was Ludwig von Mises. Economic Calculation under
Socialism:
Without private ownership of resources, free markets and entrepreneurs, such
calculations are impossible to make. Profit and losses perform two important
functions that cannot be duplicated under socialism: (1) they select out those who
can best fulfil wants, and (2) they provide the incentive to entrepreneurs to avoid
careless decisions.
Oscar Lange
Economic Theory of Socialism:
Lange set forth a model of market socialism. If administered according to a fixed
set of rules this form of socialism would result in economic efficiency and maximum
social welfare. Market socialism is characterised by (1) private ownership of
consumer goods and free choice of consumption from available good, (2) free choice
of occupation and (3) state ownership of the means of production. Price can take a
41

form other than a market one; it also can be a shadow or an index of the terms of
exchange between two items.
Counterattacks:
The counterattack was led by Friedrich von Hayek. First, it may be possible in theory
it wont be possible in reality. The data needed to solve such a big general
equilibrium problem is not available. Second, market socialism would give the
participants in the economy not enough incentive to allocate the resources
efficiently.

42