History of ThoughtG751 Regulation, ch. 11 Eric Rasmusen, erasmuse@indiana.edu

February 26, 2014

*Adam Smith

Adam Smith, 1723-1790 Glasgow, Balliol-Oxford, Prof. at GlasgowFriend of David Hume, philosopher.

The Theory of Moral Sentiments(1759)

An Inquiry into the Nature and Causes of the Wealth of Nations(1776)

Big ideas: Division of labor, Invisible Hand. Sympathy. Equality of the profit rate across industries. Free trade as wealth-increasing. The Classical School of Economics.

Laissez faire et laissez passer, le monde va de lui mme!*

Adam Smith, 1723-1790 *

*Making Pins I

A workman not educated to this business... could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty. But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire; another straights it; a third cuts it; a fourth points it; a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on is a peculiar business; to whiten the pins is another; it is even a trade by itself to put them into the paper;

and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them. Why are they all in the same firm?

Making Pins II

The spinner is almost always a distinct person from the, weaver; but the ploughman, the harrower, the sower of the seed, and the reaper of the corn, are often the same. The occasions for those different sorts of labour returning with the different seasons of the year, it is impossible that one man should be constantly employed in any one of them. This impossibility of making so complete and entire a separation of all the different branches of labour employed in agriculture, is perhaps the reason why the improvement of the productive powers of labour, in this art, does not always keep pace with their improvement in manufactures. True or False?*

Economic GrowthTHE GREATEST IMPROVEMENTS in the productive powers oflabour, and the greater part of the skill, dexterity, andjudgment, with which it is anywhere directed, or applied,seem to have been the effects of the division of labour.

True or False?*

Product QualityBut though the poor country, notwithstanding the inferiority of its cultivation, can, in some measure, rival the rich in the cheapness and goodness of its corn, it can pretend to no such competition in its manufactures.

The hardware and the coarse woollens of England are beyond all comparison superior to those of France, and much cheaper, too, in the same degree of goodness. Why?*

Ricardo, David(1772-1823)A Jewish Unitarian convert.

He was a friend of Bentham, Malthus, and James Mill.Before the battle of Waterloo, Ricardoposted an observer, then deliberately created the impression the French had won by selling consols. A market panic ensued. He then bought consols. The Sunday Times obituary in 1823, said he made more than a million pounds sterling. He immediately retired from business, at age 41, and died 10 years later. On the Principles of Political Economy and Taxation(1817).Ideas: Comparative vs. Absolute advantage, rents, Ricardian equivalence, labor theory of value. *

Ricardo on RentRent is that portion of the produce of the earth, which is paid to the landlord for the use of the original and indestructible powers of the soil. It is often, however, confounded with the interest and profit of capital, and, in popular language, the term is applied to whatever is annually paid by a farmer to his landlord. If, of two adjoining farms of the same extent, and of the same natural fertility, one had all the conveniences of farming buildings, and, besides, were properly drained and manured, and advantageously divided by hedges, fences and walls, while the other had none of these advantages, more remuneration would naturally be paid for the use of one, than for the use of the other; yet in both cases this remuneration would be called rent. But it is evident, that a portion only of the money annually to be paid for the improved farm, would be given for the original and indestructible powers of the soil; the other portion would be paid for the use of the capital which had been employed in ameliorating the quality of the land, and in erecting such buildings as were necessary to secure and preserve the produce.*

Ricardo: ScarcityOn the common principles of supply and demand, no rent could be paid for such land, for the reason stated why nothing is given for the use of air and water, or for any other of the gifts of nature which exist in boundless quantity. With a given quantity of materials, and with the assistance of the pressure of the atmosphere, and the elasticity of steam, engines may perform work, and abridge human labour to a very great extent; but no charge is made for the use of these natural aids, because they are inexhaustible, and at every man's disposal. In the same manner the brewer, the distiller, the dyer, make incessant use of the air and water for the production of their commodities; but as the supply is boundless, they bear no price. If all land had the same properties, if it were unlimited in quantity, and uniform in quality, no charge could be made for its use, unless where it possessed peculiar advantages of situation. It is only, then, because land is not unlimited in quantity and uniform in quality, and because in the progress of population, land of an inferior quality, or less advantageously situated, is called into cultivation, that rent is ever paid for the use of it.*

Ricardo: Rent Rising* It is only, then, because land is not unlimited in quantity and uniform in quality, and because in the progress of population, land of an inferior quality, or less advantageously situated, is called into cultivation, that rent is ever paid for the use of it. When in the progress of society, land of the second degree of fertility is taken into cultivation, rent immediately commences on that of the first quality, and the amount of that rent will depend on the difference in the quality of these two portions of land. When land of the third quality is taken into cultivation, rent immediately commences on the second, and it is regulated as before, by the difference in their productive powers. At the same time, the rent of the first quality will rise, for that must always be above the rent of the second, by the difference between the produce which they yield with a given quantity of capital and labour.

Jevons,1835 1882A professor at Owens College, Manchester. Died of ocean drowning while swimming.

A General Mathematical Theory of Political Economy (1862)The Theory of Political Economy (1871)

Neoclassical Revolution: with Marshall, Menger, Walras, Gossen.

Ideas: Marginal utility. marginalism. Jevon's paradox: increases in energy efficiency can lead to more, not less, consumption.*

Jevons IJ. S. Mill, indeed, has given an opinion inconsistent with this. Political economy, he says, has nothing to do with the consumption of wealth, further than as the consideration of it is inseparable from that of production, or from that of distribution. We know not of any laws of the consumption of wealth, as the subject of a distinct science; they can be no other than the laws of human enjoyment.

But it is surely obvious that Economics does rest upon the laws of human enjoyment; and that, if those laws are developed by no other science, they must be developed by economists. *

Jevons IIEvery manufacturer knows and feels how closely he must anticipate the tastes and needs of his customers: his whole success depends upon it; and, in like manner, the theory of Economics must begin with a correct theory of consumption.

Sympathy is key. Greedy sellers must understand buyers in capitalism. *

Jevons: Intrinsic Value * In the first place, utility, though a quality of things, is no inherent quality. It is better described as circumstance of things arising out of their relation to man's requirements. As Senior most accurately says, Utility denotes no intrinsic quality in the things which we call useful; it merely expresses their relations to the pains and pleasures of mankind. We can never, therefore, say absolutely that some objects have utility and others have not.

The ore lying in the mine, the diamond escaping the eye of the searcher, the wheat lying unreaped, the fruit ungathered for want of consumers, have no utility at all.

Jevons: MarginalismA pound of bread per day supplied to a person saves him from starvation, and has the highest conceivable utility.

A second pound per day has also no slight utility: it keeps him in a state of comparative plenty, though it be not altogether indispensable.

A third pound would begin to be superfluous.

It is clear, then, that utility is not proportional to commodity: the very same articles vary in utility according as we already possess more or less of the same article. *

Jevons: Food and Marginal UtilityWe find these considerations fully illustrated by fig. 4, in which oa represents x, and ab is the degree of utility at the point a. Now, if we increase x by the small quantity aa', or x, the utility is increased by the small rectangle abb'a', or u; and, since a rectangle is the product of its sides, we find that the length of the line ab, the degree of utility, is represented by the fraction u/x.. *

Marginal Substitution:VarietyThis great principle of the ultimate decrease of the final degree of utility of any commodity is implied in the writings of many economists, though seldom distinctly stated. It is the real law which lies at the basis of Senior's so-called Law of Variety. Indeed, Senior incidentally states the law itself. He says

It is obvious that our desires do not aim so much at quantity as at diversity. Not only are there limits to the pleasure which commodities of any given class can afford,, but the pleasure diminishes in a rapidly increasing ratio long before those limits are reached. Two articles of the same kind will seldom afford twice the pleasure of one, and still less will ten give five times the pleasure of two. ...

*

Alfred Marshall (1842-1924)Cambridge University, first Prof. of Economics.

Principles of Economics(1890)

Ideas: Using diagrams. Supply and demand curves. Marginalism. Elasticities. Producerand consumer surplus. Quasi-rents.Economies of scale. Representative firm. Short run vs. long run. *

Marshalls System(1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life. (5) Burn the mathematics. (6) If you cant succeed in 4, burn 3. This I do often."[4*

Marshall IThus we assume that the forces of demand and supply have free play; that there is no close combination among dealers on either side, but each acts for himself, and there is much free competition; that is, buyers generally compete freely with buyers, and sellers compete freely with sellers. But though everyone acts for himself, his knowledge of what others are doing is supposed to be generally sufficient to prevent him from taking a lower or paying a higher price than others are doing.*

Marshall IIIn such a market there is a demand price for each amount of the commodity, that is, a price at which each particular amount of the commodity can find purchasers in a day or week or year. The circumstances which govern this price for any given amount of the commodity vary in character from one problem to another; but in every case the more of a thing is offered for sale in a market the lower is the price at which it will find purchasers; or in other words, the demand price for each bushel or yard diminishes with every increase in the amount offered. The unit of time may be chosen according to the circumstances of each particular problem: it may be a day, a month, a year, or even a generation: but in every case it must be short relatively to the period of the market under discussion.*

Marshall IIILet us call to mind the "representative firm," whose economies of production, internal and external, are dependent on the aggregate volume of production of the commodity that it makes*14; and, postponing all further study of the nature of this dependence, let us assume that the normal supply price of any amount of that commodity may be taken to be its normal expenses of production (includinggrossearnings of management*15) by that firm. That is, let us assume that this is the price the expectation of which will just suffice to maintain the existing aggregate amount of production; some firms meanwhile rising and increasing their output, and others falling and diminishing theirs; but the aggregate production remaining unchanged.*

Marshall IVThis is the real drift of that much quoted, and much-misunderstood doctrine of Adam Smith and other economists that the normal, or "natural," value of a commodity is that which economic forces tend to bring aboutin the long run.It is the average value which economic forces would bring about if the general conditions of life were stationary for a run of time long enough to enable them all to work out their full effect*

Arthur Pigou(1877 1959)* Cambridge Professorsuccessor of Marshall

The Economics of Welfare(1920), at least 4 editions.

Ideas: Externalities, price discrimination (1st, 2nd,3rd), the Pigou Effect, Pigovian taxes on externalities.

Joseph Schumpeter (1883-1950)Professor at Czernowitz, Graz, Bonn, Harvard.Finance Minister of Austria in 1919. Bank president 1920-24. Co-founder of the Econometric Society.

Theorie der wirtschaftlichen Entwicklung(transl. 1934,The Theory of Economic Development: An inquiry into profits, capital, credit, interest and the business cycle) 1911.Capitalism, Socialism and Democracy, 1942.Ideas: Innovation and entrepreneurs matter. Creative destruction. The interaction of politics and economics. The Schumpeterian Hypothesis (big firms innovate more).

*

*Schumpeter onThe Entrepreneur I When he swims with the stream in the circular flow which is familiar to him, he swims against the stream if he wishes to change the channel. What was formerly a help becomes a hindrance. What was a familiar datum becomes an unknown. Where the boundaries of routine stop, many people can go no further, and the rest can only do so in a highly variable manner.

...every man would have to be a giant of wisdom and will, if he had in every case to create anew all the rules by which he guides his everyday conduct.

*Schumpeter onThe Entrepreneur II

In the breast of one who wishes to do something new, the forces of habit rise up and bear witness against the embryonic project.

It is no part of his function to find or create new possibilities. They are always present, abundantly accumulated by all sorts of people. Often they are also generally known and being discussed by scientific or literary writers.

For its success, keenness and vigor are not more essential than a certain narrowness which seizes the immediate chance and nothing else.

*5 Types of Innovation

1. new goods (product innovation)2. new methods of production (process innovation)3. new markets4. new sources of inputs5. new organization

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