Fifty Major Economists A Reference Guide Sep 1999

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FIFTY MAJOR ECONOMISTS
Fifty Major Economists provides a comprehensive and clear exposition o
f the ideas of those
individuals responsible for shaping the discipline of economics. Numero
us examples help to
illustrate the key concepts and ideas of these economists. The book cov
ers a wide range of
thinkers, spanning several centuries, beginning with Thomas Mun and
Adam Smith, and
progressing to recent Nobel Prize winners such as Robert Lucas and Amart
ya Sen. Fifty Major
Economists contains brief biographical information about each economis
t, references to the
major works of each figure, guides to further reading and a glossary of eco
nomic terms used in
the book.
Steven Pressman is Professor of Economics and Finance at Monmouth Uni
versity, New Jersey.
He is the author of Interactions in Political Economy: Malvern after t
en years, also published
by Routledge, Quesnay’s Tableau Économique and Economics and its
Discontents (edited with
Richard Holt). He also serves as co-editor of the Review of Political Eco
nomy.
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KEY CONCEPTS
In this series:
Fifty Major Philosophers
Diane Collinson
Fifty Key Contemporary Thinkers
John Lechte
Fifty Key Jewish Thinkers
Dahn Cohn-Sherbok
Forthcoming:
Fifty Key Thinkers in International Relations
Martin Griffiths
Fifty Contemporary Choreographers
Edited by Martha Bremser
In memory of my mother, Phyllis Pressman (1926–95); a major figure
FIFTY MAJOR
ECONOMISTS
Steven Pressman
London and New York
First published 1999
by Routledge
11 New Fetter Lane, London EC4P 4EE
Simultaneously published in the USA and Canada
by Routledge
29 West 35th Street, New York, NY 10001
Routledge is an imprint of the Taylor & Francis Group
This edition published in the Taylor & Francis e-Library, 2002.
© 1999 Steven Pressman
All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or
by any
electronic, mechanical, or other means, now known or hereafter invented, including photocopy
ing and
recording, or in any information storage or retrieval system, without permission in writing from
the publishers.
British Library Cataloguing in Publication Data

A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Pressman, Steven
Fifty major economists: a reference guide/Steven Pressman.
p. cm.
Includes bibliographical references. 1. Economists—Biography. 2. Economics—History. I. T
itle.
HB76.P74 1999
330’.092’2–dc21
[b] 98–33133
CIP
ISBN 0-415-13480-3 (hbk)
ISBN 0-415-13481-1 (pbk)
SBN 0-203-02472-9 Master e-book ISBN
ISBN 0-203-20625-8 (Glassbook Format)
CONTENTS
INTRODUCTION
Thomas Mun (1571–1641)
William Petty (1623–1687)
John Locke (1632–1704)
Richard Cantillon (1687?–1734?)
François Quesnay (1694–1774)
David Hume (1711–76)
Adam Smith (1723–90)
Jeremy Bentham (1748–1832)
Thomas Robert Malthus (1766–1834)
Robert Owen (1771–1858)
David Ricardo (1772–1823)
Antoine Augustin Cournot (1801–77)
John Stuart Mill (1806–73)
Karl Marx (1818–83)
Léon Walras (1834–1910)
William Stanley Jevons (1835–82)
Carl Menger (1840–1921)
Alfred Marshall (1842–1924)
Francis Ysidro Edgeworth (1845–1926)
John Bates Clark (1847–1938)
Vilfredo Pareto (1848–1923)
Eugen von Böhm-Bawerk (1851–1914)
Knut Wicksell (1851–1926)
Thorstein Veblen (1857–1929)
Irving Fisher (1867–1947)
Arthur Cecil Pigou (1877–1959)
John Maynard Keynes (1883–1946)
Joseph Schumpeter (1883–1950) 1
Piero Sraffa (1898–1983) 1
v
ii
CONTENTS
Gunnar Myrdal (1898–1987) 1
Friedrich Hayek (1899–1992) 1
Simon Kuznets (1901–85) 1
John von Neumann (1903–57) 1
Joan Robinson (1903–83) 1
Jan Tinbergen (1903–) 1
John Hicks (1904–89) 1
Oskar Lange (1904–65) 1
Wassily Leontief (1906–) 1
Nicholas Kaldor (1908–86) 1
John Kenneth Galbraith (1908–) 1
Milton Friedman (1912–) 1
Paul Samuelson (1915–) 1
Franco Modigliani (1918–) 1
James M.Buchanan (1919–) 1
Douglass Cecil North (1920–) 1
Kenneth J.Arrow (1921–) 1
Barbara R.Bergmann (1927–) 1
Gary Becker (1930–) 1
Amartya Sen (1933–) 1
Robert E.Lucas, Jr. (1937–) 1
GLOSSARY 1
viii
INTRODUCTION
“The ideas of economists and political philosophers, both when they are ri
ght and when they
are wrong, are more powerful than is commonly understood. Indeed, the
world is ruled by
little else. Practical men, who believe themselves to be quite exempt fro
m any intellectual
influences, are usually the slaves of some defunct economist.” So wrote Jo
hn Maynard Keynes
at the end of The General Theory of Employment, Interest and Money
. Keynes was pointing
out that the key economic issues are generally argued within a context a
nd framework that
was developed over many centuries. Not knowing that history results in less infor
mal discussion
and also in worse economic policies. History counts not only because, as Santanya
na remarked,
those who lack a knowledge of history are bound to repeat its mistakes. Hist
ory also has value
for the perspective it bestows. Like other disciplines, economics was not developed
in a vacuum.
To the contrary, economic ideas were developed by real people who were
responding to the
important issues of their time. A sense of history is necessary to comprehend this n
oble function
of economics and to understand how great economists of the past respond
ed to the problems
of their time. Finally, history is important because, in a sense, history is the
arbitrator of what
has only fleeting importance and what has lasting interest and significance
.
Unfortunately, at the end of the twentieth century the majority of t
he economics
profession has come to reject historical pursuits and perspectives. Most e
conomists even
look down on those who study economics from an historical perspective. P
art of the reason
for this is that over the past several decades economists have come to
value technique
over ideas. Another reason economists ignore history is that they hold an
outmoded view
of what counts as truth in the social sciences. Believing that we can come t
o know timeless
and universal economic truths, many economists ignore history; past ideas
are thought to
be either imbedded in current economic knowledge or just plain wrong.
Historians of economic thought must also share some of the blame fo
r the demise of
their area of specialization. They tend to present their field as a history
of dead figures
whose ideas have little contemporary importance. Rarely do they explai
n how studying
the great figures from the past can help illuminate current issues, or how
it can help us
understand how economics might help mitigate important contemporary
problems. Even
less frequently do they study the ideas of economists who are still alive an
d who continue
to contribute to our knowledge of how economies work.
When Alan Jarvis of Routledge approached me about doing a book on t
he major figures
in economics I took his inquiry as an opportunity to remedy this situati
on, and also to
revitalize interest in the long and great history of economic ideas. All th
e key economic
figures from the past are contained in this volume. They are great figures f
or good reasons.
However, history does not end in the distant past; it continues up to the
present and it
permeates much recent economic thought. Thus, this volume explicitly
recognizes the
important contributions made by more recent economists.
i
x
INTRODUCTION
Nonetheless, choosing which fifty economists to include in this vo
lume quickly
became a daunting task. While the first forty or so were relatively ea
sy decisions,
things soon became difficult. And as time went on, and as the numbe
r of figures I
selected approached fifty, it became more and more difficult to ma
ke the final
choices. My general guidelines for these decisions were the power
of the ideas
developed by each economist, the breadth of their overall contributions,
and of course,
the judgment of history. In the latter case I was guided by how history
has viewed the
contributions of past and present figures and also by how I thought t
hat history will
likely view their ideas in the future.
Of course, there can be considerable dispute concerning who should
be included and
who should be excluded. In fact, “Who should be number fifty?” bec
ame an amusing
parlor game that I played with many colleagues over the past several
years. Alas, this
parlor game led to little or no consensus. On the bright side, there was
much heated and
enjoyable debate about the most important ideas and figures in the l
ong history of
economics. I thank my many colleagues who humored me by playing th
is game, and by
so doing, for helping me to think about what is really important in econ
omics and what
is really important about economic ideas. While I may not have gotten e
verything exactly
right, and while I am sure that people will point out many important fi
gures who were
ignored, as the failure to find consensus around number fifty shows, t
here is probably
no right answer here. However, I am confident that I have pretty muc
h gotten things
right. The fifty economists whose ideas I explain in this volume are al
l major figures
who have made important contributions. History is likely to view the
m as important
economic figures, worthy of continued study.
For each economist in this volume I have provided a short biography
and a summary
of the several key ideas that they promulgated. I have also attempted
to assess their
place in the history of the discipline. Towards this end, I have made so
me effort to let
the reader know where these figures rank according to the views of mo
st economists. I
have also gone out on a limb and provided my own assessments of the r
ankings of these
figures. I know that my colleagues will dispute many of these rankings;
and, of course,
these rankings will likely generate as much controversy as my decisio
ns about who to
include in this volume. Again, although my assessments may not be
perfectly right, I
think I have gotten things pretty much right in this regard.
Each entry ends with a bibliography containing the most important
writings of each
figure and a few references to the most accessible and most important se
condary literature.
These references should allow interested readers to pursue further the e
conomic ideas of
these major figures. The volume closes with a glossary of key terms, s
o that frequently
mentioned concepts do not have to be continually defined and explaine
d.
In all writing endeavors one incurs many obligations. This is especia
lly so in a work
covering so many ideas, so much history, and so many figures. Many
colleagues read
earlier drafts of this work and provided substantial comments in an att
empt to correct
my mistakes. For their hard work I thank Nahid Aslanbeigui, Peter
Boettke, Charley
Clark, Milton Friedman, John Henry, Sherry Kasper, Mary King, Roge
r Koppl, Franco
Modigliani, Laurence Moss, Douglass North, Susan Pashkoff, Alessa
ndro Roncaglia,
Ruth Sample, Mario Seccareccia, John Smithin, Gale Summerfield an
d Naomi Zack.
Any errors, of course, remain my responsibility.
Several of my students at Monmouth University and the University of
New Hampshire
read and commented on many individual chapters, thereby forcing me to
make the ideas
of all fifty economists clear to someone who is not cursed by havi
ng a Ph.D. in
x
I
NTRODUCTION
Economics. Special thanks here are due to Tad Langlois, Ivan Pabon, Ly
nn Van Buren,
Flavio Vilela Vieira and Sarah Youngclaus.
My editors at Routledge—Alan Jarvis and Alison Kirk—both pr
ovided
encouragement, ideas and suggestions at all stages of my writing this
book. For all
their assistance and support I am very grateful.
But perhaps my greatest debt and gratitude goes to those people w
ho typed the
numerous revisions to each chapter, as I tried to get the ideas of these fif
ty economists
exactly right and as I tried to make them intelligible to a broad audience.
For their hard
work, and for their patience in putting up with my endless revisions,
I thank Beth
Boyington, Nancy Palmer and Diana Prout.
xi
respected member of a group of seve
nteenth-
THOMAS MUN (1571–1641) century British merchant-
economists called
“the mercantilists.” This group prop
Thomas Mun is the best known a
osed that
nd most England run trade surpluses in order to pr
osper
economically. As set forth by Mun claimed that the firm was exporting g
([1664] old and
1954, p. 125), silver to the Orient (in exchange for
spices)
The ordinary means…to increase o and that this loss of precious metal
s was
ur wealth hurting the British economy. A Disc
and treasure is by Forraign Trad ourse of
e, wherein Trade was rather unmercantilist in
wee must ever observe this rule; to
its
sell more
to strangers yearly than wee consume o orientation. Rather than advocating
f theirs a trade
in value. …[T]hat part of our stock surplus and the accumulation of gol
which is d, Mun
not returned to us in wares must advanced any and all arguments he
necessarily could
be brought home in treasure. think up to support the East India Co
mpany.
Little is known about the life of
Mun. His
grandfather worked for the Royal
Mint; his
father was a textile trader. Mun himself b
ecame
a merchant early in life, lived in Italy for
many
years and quickly accumulated a gre
at deal of
wealth. He later became involved with th
e East
India Company, a large British joi
nt-stock
company that traded (primarily) in the F
ar East.
In 1615 Mun was elected to be a
Director of
the East India Company, and he re
mained a
Director of the firm for the remaind
er of his
life. After Mun achieved wealth a
nd social
status he was appointed to several
British
committees and commissions. Most
of these
commissions issued reports containi
ng Mun’s
name as part of a long list of co
mmittee
members; but Mun himself wrote
only two
economic tracts.
His first work (Mun 1621) defe
nded the
East India Company against critic
s who
THO luxury
MAS MUN imports were harmful; some imports
were
He claimed that nations become improved by British firms and re-
wealthy exported,
for the same reasons that families b thus leading to a net influx of precious
ecome metals
wealthy—by frugality and by makin into England. The goods imported by
g more the
than they spend. Likewise, nations East India Company, Mun claimed,
and were
families become poor by spending too generally goods needed by British exp
much orters.
money. Thus, Mun reasoned, as long While the Discourse made Mun
as the an
East Indian Company made money it apologist for the East Indian Compan
could y, his
not make Britain poorer. second book, published posthumously
Mun also pointed out that food, cl (1664),
othing, established Mun as an important ea
and munitions were necessities, so im rly
porting economic thinker. What is most note
these goods improved the welfare worthy
of about England’s Treasure by Forrai
England. On the other hand, impor gn Trade
ting is its much broader perspective. No longer d
luxury goods was harmful to the natio oes
n. Mun Mun try to defend the East India Co
then went on to argue that the East mpany;
India rather he adopts the viewpoint of the na
Company was importing only ite tion as
ms a whole. He looks at trade in general,
necessary for consumption. rather
Taking yet another line of defens than trade by the East India Company,
e, Mun and he
argued that trade with India provid makes the case that foreign trade enri
ed a ches a
market for English exports. In additio nation whenever it leads to a trade surplus. M
n, trade un
with India was good for Britain bec also examines the factors that cause a
ause it country
eliminated trade with Turkey; had th to run trade surpluses. Finally, Mun ad
e same vances
goods been imported from Turkey, a set of proposals that British leaders
Mun could
pointed out, the cost to Britain woul
d have
been much greater. 1
Finally, Mun argued that not all
THOMAS MUN between what a nation exports and
what it
implement if they wished to impr imports. When a nation runs a trade
ove the surplus,
national trade position. its exports exceed its imports. Sales
The trade balance is merely the abroad,
difference over and above what is bought from
foreign create more goods to be exported i
countries, must be paid for by forei n the
gners. In future. Here Mun recognized the
the seventeenth century these payme importance of capital investment, a
nts were nd he
made with precious metals—gold an viewed a positive trade balance as
d silver. a way
Trade surpluses thus enabled a na to accumulate productive capital.
tion to Besides explaining the benefits o
accumulate wealth and enrich a cou f trade
ntry. In surpluses, Mun also explained what
contrast, domestic trade could not could
make be done to encourage such surpluses.
England wealthier because the ga First,
in in there was price policy. Mun wanted
precious metals by one citizen wou exports
ld equal sold at the “best price”; that is, the
the loss of another citizen. To gener price
ate trade that brings in the most revenue and
surpluses, Mun noted, England must wealth.
become Where England had a monopoly in
more self-sufficient and reduce its world
need for
foreign-made goods. Britain must 2
also
become more frugal so that more go
ods were
available for export. Mun especiall
y looked
down on and discouraged the cons
umption
of luxury goods.
With the domestic money suppl
y rising
as a result of these trade surplus
es, a
danger lurks that people might t
ry to
purchase more goods. This would
cause
domestic prices to increase and
would
eventually lead to the loss of export
s, since
domestically produced goods wo
uld
become too expensive to sell abro
ad. But
these consequences, Mun noted,
could
easily be avoided. To make sure t
hat the
inflow of money from abroad actual
ly goes
to benefit a nation, all new money
must be
re-invested. Reinvestment would
also
manufacturers should be quite strict in
order
trade, or something close to a monopo to ensure that Britain produced high q
uality
ly, her goods.
goods should be sold at high prices Finally, Mun explained how nation
. But al tax
when foreign competition was great, policy could help generate trade surpl
British uses.
goods should be priced as low as po He recognized that (in opposition to
ssible. the
This would result in more sales for national interest) some firms might wa
Britain nt to
and help drive out foreign competi import luxury goods. In such a cas
tors. e,
When foreign competitors disappea government policies must bring privat
red, e and
Mun recommended that prices be rais national interests into harmony. Mun l
ed, but ooked
not to the point that competitors are e to taxation to achieve this end. Export
nticed duties
to come back into the market. were to be discouraged because they
Second, Mun explained that hig would
her cost Britain sales in foreign countri
quality goods would be in greater dees.
mand Import duties should be low on goods
throughout the world and would als that
o lead are subsequently exported and high
to greater exports for Britain. He t on
hen goods that tend to be consumed by B
explained how the British government ritish
could citizens. Excise or sales taxes, Mun ar
help improve product quality. Mun gued,
wanted did little harm. Although they raised
the government to regulate manufac the
turers price of food and clothing, Mun beli
and to establish a council of trade (s eved
imilar that these taxes would lead to higher
to the functions now performed by t wages
he US and thus be shifted to employers. Alth
Department of Commerce) which ough
would Mun did not offer any explanation for
advise the government in matters pert this,
aining one possibility is that he had in min
to the regulation of trade and indu d a
strial subsistence theory of wages (see also
activity. These regulations on Briti SMITH).
sh
and the
excise tax is paid by the wealthy. In
When higher prices for necessit order
to avoid paying this tax the rich ha
ies lead d only
to higher wages, the standard of liv two options—they could work long
ing for er and
British workers remains the same harder, or they could reduce luxu
ry mercantilists for recognizing that the
consumption. In either case, Mun demand
argued, generated by trade surpluses would i
the nation would benefit. ncrease
Mun, however, did not want the economic growth. Chapter 23 of The
state to General
collect tax revenues and then engage Theory (Keynes 1936), entitled “No
in lavish tes on
or wasteful spending. Tax collectio Mercantilism,” credits the mercantilis
ns had to ts with
be saved so that they were available for n understanding that countries could
ational create
emergencies, such as wars. At the s jobs and incomes for its own citiz
ame time, ens by
the state should not accumulate so generating a trade surplus, while the
much tax influx
revenue that the national supply of capit of money would increase business
al falls. investment.
As a compromise, Mun proposed that ea
ch year
the state accumulate a surplus of t
axes over
spending that was equal to the ann
ual trade
surplus.
Mun and mercantilism came i
n for
sharp criticism from other econo
mists
during the eighteenth and ninete
enth
centuries. David Hume explained
how
trade imbalances would
correct
t h e m s e l ve s a u t o m a t i c a l l
y. F r a n ç o i s
Quesnay and Adam Smith both s
harply
criticized the mercantilists, and ar
gued
that less government restrictions
on
bu s i n e s s e s wo u l d s p u r
d o m e s t i c
p r o d u c t i o n . F i n a l l y, D av
i d R i c a r d o
advanced a strong case for free tra
de. All
these anti-mercantilist views were
quickly
taken to heart by most economists.
Mercantilist thinking,
however,
experienced a revival of sorts in the
twentieth
century. John Maynard Keynes pra
ised the
THO economic growth is through the growt
MAS MUN h of
exports, constitute his two lasting
But perhaps the strongest suppo contributions.
rt for
mercantilist doctrines can be found in
Asia. Works by Mun
The success of the Japanese economy
in the A Discourse of Trade from England unto the
second half of the twentieth centur East-
y was Indies (1621) in Early English Tra
achieved with the aid of economic p cts on
olicies Commerce, ed. John R.McCull
that were mercantilist in spirit, even och,
if not Cambridge, Cambridge University Press,
by intent. The Japanese government s 1954
et high England’s Treasure by Forraign Trade
product quality standards, which he (1664) in
lped Early English Tracts on Commerce,
Japan become a producer of high q ed. John
uality R. McCulloch, Cambridge, Cambri
consumer goods. Economic success dge
was University Press, 1954
also achieved by using tariffs a
nd
protectionism to stem imports, whiWorks about Mun
le
encouraging domestic firms to export Buck, Philip W., The Politics of Merc
goods antilism,
(see Johnson 1982). New York, Octagon Books, 1964
Although Mun is not highly regar Johnson, E.A.J., Predecessors of
ded by Adam
economists today, and although Mun Smith: The Growth of British Econ
did not omic
make any path-breaking discoveries, Thought, New York, Augustus M.Kelley,
he did 1965
leave his mark on the history of econ Magnusson, Lars, Mercantilism: The S
omics. haping of
The idea that government economic an Economic Language, New York
policy and
should be used to generate a trade s London, Routledge, 1994
urplus,
and the idea that the way to achi 3
eve
WILLIAM PETTY 36), New
York, Harcourt Brace & World, 1964
Other references
Johnson, Chalmers, MITI and the
Japanese WILLIAM PETTY (1623–87)
Miracle: The Growth of Industr
ial Policy,
Stanford University Press, 1982 William Petty was one of the very fir
Keynes, John Maynard, The Genera st people
l Theory of to think and write systematically a
Employment, Interest and Money (19 bout
economics, and one of the first indi ointed
viduals to
apply economic principles to the re
al world. 4
His work provides insight into the
nature of
rent and taxation. But Petty is best
known for
his attempt to make economics a q
uantitative
and statistical science through what
he called
“political arithmetic.”
Petty was born in 1623 to a po
or cloth-
worker in the quiet market town of Ham
pshire,
on the river Test, in southern Engl
and. His
schooling consisted primarily of
rote
memorization; it was a typical edu
cation for
the children of the lower classes at
that time.
Nonetheless, Petty rose above his
formal
schooling because he possessed great c
uriosity
and read widely in the areas of liter
ature and
science.
At the age of 13 or 14 Petty left s
chool and
found a job as a cabin boy on a s
hip that
continually crossed the English C
hannel.
During his first year at work, Petty
broke his
leg. Since he was no longer usefu
l to his
employer, he was left on the French side
of the
Channel. Petty decided to stay in F
rance and
to attend the Jesuit College in Cae
n. He left
Caen in 1640, spent three years in
the navy,
and then went to Holland to study anatom
y and
medicine.
In 1646 Petty returned to Englan
d to study
medicine at Oxford. After receivi
ng his
doctorate in medicine, he was app
uffering
from neither economic decline nor a
Professor of Anatomy at Oxford. P decline
in trade. To the contrary, Petty claime
etty d that
established a name and reputation for England was richer than ever. He then set ab
himself out
by supposedly raising from the dead a to prove this thesis. Unfortunately,
woman in
who had been hanged (Strauss 1954, seventeenth-century England there we
Ch. 3). re no
But within weeks of giving his first le government agencies to report econom
cture, he ic data
decided that the academic life was n on a regular basis. Nor did newspapers prov
ot right ide
for him and he left Oxford to beco every economic and financial statistic t
me chief hat one
physician of the Irish army. At the sa might care to know (as well as many
me time, that no
Petty became chief surveyor of Ireland, a one cared about). Thus Petty assum
nd he ed
used the knowledge he acquired in thi responsibility for gathering the figur
s job to es
accumulate much land and great wealth. I necessary to make his case.
n the Essentially, the method of politi
1660s Petty helped establish the Royal So cal
ciety arithmetic was “to express myself in te
of London for the Improving of Na rms of
tural number, weight or measure; to use
Knowledge. Its agenda was to follo only
w the arguments of sense; and to consider onl
scientific method of Francis Bacon y such
—to use causes as have visible foundations in
observation and experimentation in onature;
rder to leaving those that depend upon the m
study the natural world and society. utable
Petty developed the method of p minds, opinions, appetites, and passio
olitical ns of
arithmetic as a result of applying the particular men, for the consideration of oth
Royal ers”
Society research program to econo (Hull 1899, p. 244). Political arithm
mic etic
phenomena. In the preface to his P employed quantitative methods to an
olitical alyze
Arithmetic, Petty ([1671] in Hull 18 economic and social phenomena. One
99) aspect
announced that his goal was to refute of this new method was to use numb
popular ers and
beliefs and show that England was s
about the way the world worked. For exa
mple,
measures to describe reality. Anoth by showing that A and B increased
together
er aspect Petty would draw the conclusion that
was to use these numbers to draw i in order
nferences to increase A it was necessary to in
crease B, ndon and
and in order to increase B it was ne in Paris over the prior three years (16
cessary to 83–5 for
increase A. The final thrust of the London and 1682–4 for Paris), and
political found a
arithmetic was an attempt to separate ec greater number of burials in London
onomic (22,337)
analysis from the morals or beliefs than in Paris (19,887). Assuming th
held by at death
individuals, thereby making any stu rates were the same in both cities,
dy of the Petty
economy more objective. concluded that the population of Lon
It is well known that the scien don was
tific or greater than Paris and that London
experimental method is difficult to was
employ in wealthier than Paris.
economics. A true controlled experime One key assumption in this analysis wa
nt would s that
require that we start with two ide national wealth depended on the populat
ntical ion of
economies, or two identical groups a nation. While this assumption ma
of people, y seem
placed in exactly the same situation. We bizarre in an era where poor countrie
would s tend to
then alter one condition for just one
of these
two groups. Then we would observe
how this
one change affected each group. Unfort
unately,
in the real world it is virtually imp
ossible to
create or find such an environment
. Political
arithmetic attempted to substitute
statistical
analysis for experimentation, believi
ng this is
the best we can do in economics. This stat
istical
method continues to be used in ec
onomics,
although there have been recent att
empts to
make economics more “scientific” b
y figuring
out how to run controlled experime
nts (Smith
1987, 1990; Burtless 1995).
To prove that London was wealth
y and that
it had been expanding economically,
Petty set
out to show that London had more p
eople and
more homes than Paris. Petty first
examined
the median number of burials in Lo
WILLIA to free
M PETTY international trade. Finally, unlike t
he
be the most populous and whose po mercantilists, Petty did not look tow
pulations ards
grow at the fastest rates, this was a re international trade to promote the ec
asonable onomic
assumption when Petty was writing growth of England. Rather, Petty thoug
. In ht that
seventeenth-century England there public finance, or government spending an
was no d tax
direct way to measure wealth; some policy, was a more important determi
indirect nant of
measurement was necessary. And Peeconomic well-being than trade polic
tty did y or
choose a reasonable indirect measure accumulating large trade surpluses.
. Before In fact, Petty became a harsh crit
modern birth control methods came ic of
into English public finance, arguing that the Eng
existence, population and population lish
growth tax system was a major force hindering natio
depended primarily on the ability of nal
children economic growth. In seventeenth-
to survive. This, in turn, required a century
greater England the cost of collecting taxes wa
standard of living or greater national s high,
wealth. there was great uncertainty about the taxes t
Greater wealth did actually lead to mohat
re rapid people owed, and the many injusti
population growth; thus Petty’s analy ces
sis was stemming from actual collection w
probably the best possible at the time. ere
Although Petty has been taken t legendary. This all reduced the incentiv
o be a es that
mercantilist (see also MUN) becauspeople had to work hard and better themsel
e he ves.
frequently called for England to run And when people lack such incentiv
trade es,
surpluses, Petty differed from the merca economies stagnate.
ntilists But Petty was not opposed to all fo
in many respects. Unlike the merca rms of
ntilists, taxation. Nor did he think that taxes
Petty advocated trade surpluses to i were
ncrease necessarily bad and hurt a nation. The probl
employment rather than to accumulate w em
ealth. was with the actual English tax policy
In addition, unlike the mercantilist . Petty
writers,
Petty recognized a number of benefits 5
WILLIAM PETTY means
of raising revenues, which he regard
(in Hull 1899, p. 64) condemned En ed as “a
glish poll tax upon unfortunate self-conceited
taxes because they were regressive fools”
in nature. (Hull 1899, p. 64). Instead, he fav
Petty also condemned state lotteries as a ored a
progressive tax where people pay acco expenditure, even on useless items, in
rding to order to
the “interest in the Public Peace; create jobs and eliminate idleness.
that is, Foreshadowing Keynes (see below),
according to their Estates or Riches.” he wrote
At times the following about government spendin
he also supported a proportional t g: “’tis
ax on no matter if it be employed to build
consumption (Hull 1899, p. 91). a useless
More important than how taxe pyramid upon Salisbury Plain, bring the
s were stones
collected, though, was how tax mo at Stonehenge to Tower Hill, or the lik
nies were e” (Hull
spent. According to Petty, taxation 1899, p. 31). All that really mattered
hurt the was that
economy only when tax revenues were r spending of some sort be undertaken.
emoved Despite his strong empirical and
from circulation. If tax revenues were spe practical
nt, they orientation, Petty did make key the
had few harmful effects. Governmen oretical
t spending contributions to economics. He was
would return money to circulation the first
and put
people back to work. This would c 6
ompensate
for the loss of money in circulation and th
e loss
of jobs that arose from taxation.
Moreover, Petty recognized the
possibility
that taxes could have positive ef
fects.
Anticipating Nicholas Kaldor (see
below),
Petty held that if taxation and sp
ending
encouraged the consumption and p
roduction
of high productivity goods, this would i
ncrease
national output. In addition, tax mo
nies spent
to assure that the economy functio
ned in an
orderly manner would promote na
tional
wealth. Petty thus considered i
t the
responsibility of government to spe
nd money
on things such as defense, justice, school
s, poor
relief and public works including
highways,
bridges and harbors (Hull 1899, p. 20). F
inally,
Petty noted the importance of gov
ernment
lose money. On the other hand, comp
etition
economist to define the notion of a surplu among renters would push rents up to the le
vel
s and of the surplus.
he was the first economist to explain land r Despite his contributions to the st
ents udy of
based upon this notion of a surplus (R public finance, and despite his work
oncaglia on
1985, Ch. 7). Although the view that rdefining and explaining the notion of a surpl
ent is a us,
surplus has come to be known a Petty was an important figure mainly
s the for his
Physiocratic theory of rent, the the emphasis on using numbers or data
ory was to
really due to Petty rather than to Ques understand and explain how real wo
nay. rld
To grasp the notion of a surplus, thieconomies work. Although he urged
nk of a the
primitive agricultural economy that grow development of better and more reg
s only ular
corn. During the year, corn will be both an i economic statistics to aid in this endeav
nput or (see
into the production process and an e Hull 1899, p. lxvi, note 4), it would
conomic take
output. As an input, corn will be used another 250 years before reliable data
as seed became
and to feed workers. At the end of t readily available (see also KUZNET
he year, S).
corn will be harvested, to be used next Hutchison (1988, p. 37f.) is surely corre
year as ct that
food and seed. Petty defined the ec Petty was overconfident that govern
onomic ments
surplus as the difference between th could collect reliable statistics in t
e total he
output of corn (at the annual harvest) seventeenth century; but Petty was als
and the o right
inputs of corn needed to produce that that without any statistics it is virtu
output. ally
Landowners, he thought, would tend to re impossible to understand how econo
ceive mies
rental payments equal to the surplus g change over time. Petty attempted to make s
enerated uch
on their land. No one would pay to r measurements and he used them to t
ent land ry to
for more than the surplus that can be understand the British economy. T
obtained his
from that land, since the renter would constitutes his most important econo
thereby mic
contribution and makes him the most im Works by Petty
portant The Economic Writings of Sir Willia

economic figure of the seventeenth m Petty, ed.
century. C.H.Hull, Cambridge, Cambridge
University a philosopher. He provided the first justifi
Press, 1899 cation
for private property and for limited
state
Works about Petty
Hutchison, Terence, Before Adam S
mith: The
Emergence of Political Economy, 1
662–1776,
Oxford, Basil Blackwell, 1988
Letwin, William, The Origins of S
cientific
Economics: English Economic Tho
ught 1660–
1776, London, Methuen & Co., 19
63
Roncaglia, Alessandro, Petty, Armonk,
NewYork,
M.E.Sharpe, 1985
Strauss, Erich, Sir William Petty:
Portrait of a
Genius, London, Bodley Head, 19
54
Other references
Burtless, Gary, “The Case for Rando
mized Field
Trials in Economic and Policy R
esearch,”
Journal of Economic Perspectives, 9,
2 (Spring
1995), pp. 63–84
Smith, Vernon L., “Experimental M
ethods in
Economics,” in The New Palgr
ave: A
Dictionary of Economics, ed. Jo
hn Eatwell,
Murray Milgate and Peter K.New
man, New
York, Stockton Press, 1987, 2, pp.
241–9
Smith, Vernon L. (ed.), Experimental Ec
onomics,
Aldershot, Edward Elgar 1990
JOHN LOCKE (1632–1704)
The contributions that John Locke
made to
economics were primarily the contri
butions of
JOHwas fascinated by William Harvey’s disco
N LOCKE very
that blood circulated throughout the bo
involvement in economic activity. Thi dy, and
s helped he began to study medicine in his spar
provide a philosophical foundation f e time.
or the He became personal physician to Lord Ash
capitalism developing in seventeenth ley,
-century who was Chancellor of the Excheque
England, and helped win its acceptan r, and
ce in an soon became his personal assistant. Fr
era dominated by religious concerns om his
. Locke relationship with Lord Ashley, Locke
also made several contributions to th learned
e theory about the important economic issues of the
of money and interest rates. day,
Locke was born in Somerset, En such as trade with the British colonie
gland in s and
1632 to a moderately well-off family. His f interest rates.
ather Because of the knowledge and expe
was a country lawyer with considera rtise he
ble land developed about colonial problems, in
holdings; one of his best clients and 1673
closest Locke was made Secretary to the Cou
friends was Alexander Popham. Po ncil for
pham Trade and Plantations. Two years lat
became a member of Parliament in 1 er he
647 and returned to private life and to another
helped Locke gain admittance to love—
the philosophy. Over the next few years
Westminster School, one of the most influ Locke
ential worked on An Essay Concerning H
and best English public schools. uman
Locke did so well at Westminster Understanding (1690a) and Two Tre
that he atises on
won a scholarship to Oxford UniversGovernment (1690b). These two wor
ity, and ks
entered Christ Church of Oxford in 1 established his reputation as a gre
652. He at
received a bachelor’s degree in 1656 philosopher. Nonetheless, Locke retai
and a ned an
master’s degree in 1659. He then we interest in economic issues, particula
nt on to rly
teach at Oxford—becoming a lecturer in monetary matters, and continued to
Greek exert
in 1660 and a lecturer in Rhetoric in political influence in England until his
1662. death.
Like many of his contemporaries,
Locke 7
JOHN LOCKE ture. He
set forth philosophical justification
Locke made five contributio s for
ns to private property and for the state, a
economics, three of a philosophical nat nd he
ure and developed a methodology that helpe
two that were more economic in na d make
economics “scientific.” k from
This the land did not spoil before it was c
latter onsumed
contribution involved assuming tha (Locke 1943, pp. 130ff.).
t people Locke then went from this limited
act rationally and respond to fina defense
ncial of property (based on what could be consu
incentives. Locke’s contribution med)
s to to a more extensive defense of private pro
economics concerned the theory of mo perty.
ney and Money or capital, Locke recognized, was
interest. He argued against gover really
nment the product of past labor. Thus, own
regulation of interest rates, and ag ership of
ainst a money could be justified because pe
government plan to devalue the ople had
British to work in order to acquire it. Mon
currency, because such actions wo ey also
uld have allowed man to accumulate more an
bad economic consequences. d more
Probably the most important phi property, since money did not spoil
losophical before it
contribution made by Locke w was consumed. The only constrain
as his t on
justification for an individual’s right
to private 8
property. In seventeenth-century E
ngland
commercial activity was growing ra
pidly and
came into conflict with the domina
nt feudal
and religious institutions. It was g
enerally
accepted that God gave the earth to
all men in
common. To own the resources of
the earth
meant that those resources were not
available
for someone else. This made it hard
to justify
private ownership.
Yet Locke provided such a justificat
ion. He
first set forth the rather uncontro
versial
proposition that men had a right to
their own
labor and the fruits of their labor. Men ac
quired
land as their lawful property by combinin
g their
labor with the land. This was acceptable a
s long
as there remained an ample supply o
f land for
others, and as long as what someone too
and presumably all citizens gave their
tacit
unlimited accumulation was the righ consent to the rule of government. Rul
ers, in
t of the turn, had to protect the interests of their citize
poor to enough income to be able to ns;
survive otherwise they would be removed from
whenever no land or jobs were availa office
ble, and and replaced with someone who would
whenever they were physically una uphold
ble to the social contract (Macpherson 1962).
support themselves (Locke 1690b). In ad Since
dition, the state arose as a result of individual decisi
Locke argued that private property had pra ons
ctical about laws and rules, the state could be justifi
value, because when men were allo ed
wed to by appeals to natural law.
accumulate property they were A final philosophical contribution
more made
productive. by Locke involved the methodology
A second philosophical contributi of
on made economics, or how economics shoul
by Locke provided a justification for t d be
he state done. Locke viewed people as rational
in economic society. In line with conte self-
mporary interested individuals, who responde
beliefs, Locke held that natural law dictate d to
d that economic incentives. This was quit
the ultimate source of political rule e
was the different from the prevailing religious
individual. The state could come into e view
xistence that people were altruistic, or that t
only when a group of individuals agreed to hey
turn primarily followed religious dictates.
over some of their rights to a comm Because people could be counted on
on ruler. to
Locke viewed the state like a compan behave in certain ways, economic laws
y whose and
shareholders were men of property. principles could be developed. For exa
Men put mple,
themselves under the rule of govern Locke recognized that when the pric
ment to e for
protect their life, liberty, and land. All some goods increased, people woul
citizens d
(or at least those owning land and substitute cheaper goods for the goods
wealth) they
therefore had an interest in joining civil soc usually consumed; similarly, sellers w
iety; ould
ic laws
could be developed analogous to B
respond to greater profit opportuni oyles’
Law in chemistry and Newton’s la
ties by ws of
producing and selling more (Lock motion in physics. Just as gases be
e 1968, haved
pp. 2–3, 46–68). As a result, econom according to the mathematical expre
ssions merchant and 40 percent go to the l
contained within the law of chemis ender.
try and There would be no additional inve
physics, so too humans would be stment
have and no net gain for the nation here. I
rationally when making economic d n fact,
ecisions there could be a net loss for the nat
(Vaughn 1980). ion if
In the area of economics prope some people were unwilling to lend
r, Locke money
made contributions to the theory of mon at a 4 percent rate. It would be better,
ey and Locke
the theory of interest. In the mid- concluded, if interest rates were allo
seventeenth wed to
century, Josiah Child held that the state s go to their natural level rather than
hould be set
limit interest rates to 4 percent (se by government decree.
e Letwin The natural rate of interest for Lo
1963, p. 157), arguing that lower int cke was
erest rates the free market interest rate, the
would benefit merchants and other rate
s wanting determined by the laws of supply and de
to borrow money for useful purposes, an mand.
d thus
benefit the nation as a whole. The on
ly people
who would be hurt by this policy, ac
cording to
Child, were lenders charging high intere
st rates.
Locke (1691) refuted this clai
m, and
made a case against government re
gulation
of interest rates. He argued that us
ury laws
merely redistribute the gains from
trade
between the merchant and the lend
er; they
do not benefit the nation as a whole
because
they do not increase borrowing
and
investing. For example, if a mercha
nt could
make 10 percent on borrowed mo
ney and
current interest rates were 5 perce
nt, the
lender and the merchant split the gai
ns from
trade 50–50. But if the govern
ment
prohibits loans at more than 4 perc
ent, 60
percent of the gains from trade go
to the
JOHformulate one of the first economi
N LOCKE c
principles. Gre-sham’s Law simply s
When money was in short supply, it tates
s price that “bad money drives out good money
(or the rate of interest) would rise b .” By
ecause this Gresham meant that rational peopl
lenders would know that they could e held
charge the best (least clipped) coins, and spent
more. Behaving rationally, lenders those
would coins that were clipped the most a
charge higher interest rates and mak nd
e more contained the least amount of silver.
money. Conversely, when there was As early as 1690 the English
more government proposed solving the prob
money to lend than borrowers wanti lem
ng this of clipped or depreciated coins by
money, the natural rate of interest wo reducing the weight of precious metal
uld fall. s in
Rational borrowers would shop for all coins, or essentially devaluing th
good e
deals, and only those lenders reducin national currency. Locke opposed th
g their is
rates would find someone who was wisolution, and he argued against devalu
lling to ing
borrow their money (Locke 1968, pp. a n d i n favo r o f r e c o i n i n g w i
9–11). t h t h e
Locke (1691) was also a prominen accustomed amount of precious met
t figure als.
in the recoinage question. In sevent Reducing the precious metal content in
eenth- all
century England, all coins were ma coins, he thought, would not help mat
de of ters
precious metals. Because these meta because the value or purchasing powe
ls had r of
value people began clipping or filing m o n ey wa s d e t e r m i n e d b y i
off the t s s i l ve r
edges of coins. These scraps would t content. This natural value of mone
hen be y
melted down and sold as gold or sicould not be set by public authorities
lver. or
Clippers thus accumulated wealth, by government laws (Letwin 1963,
while p.
clipped coins continued to circulat 171). Debasing the currency would
e in merely lead merchants to demand m
exchange for goods and services. ore
This
behavior led Sir Thomas Gresham 9
to
RICHARD CANTILLON stage,
Locke helped to convince govern
coins (and thus the same silver c ment
ontent) authorities not to devalue the Brit
in exchange for goods. Although ish
he currency and to recoin using the
entered this debate at a rather late accustomed silver content.
His argument that reducing the Possessive Individualism: Hobbes
silver to Locke,
content of each coin (and produ Oxford, Clarendon Press, 1962
cing Vaughn, K.I. John Locke: Economist
more coins) would lead to high and Social
er Scientist, London, Athlone, 1980
prices, makes Locke an importa
nt
forerunner of the quantity theory
10
of
money (see also FISHER). Howe
ver,
L o c ke h a s r e m a i n e d a key
fi g u r e i n
economics primarily for the impor
tant
philosophical contributions he mad
e to
economics. His justifications for
p r i v a t e p r o p e r t y, a n d f o r l e t t i n g
economic activity take place wit
hout
outside interference by governme
nt,
have been accepted by most econo
mists
throughout history—even up to to
day.
Works by Locke
An Essay Concerning Human Und

erstanding
(1690a), 2 vols., Dover, 1959
Two Treatises of Government (1690
b), 2nd ed.,
New York, Cambridge University Pre
ss, 1953
Some Considerations of the Conseq
uences of the
Lowering of Interest and Raising
the Value of
Money, 1691, in Locke 1696
Several Papers Relating to Money,
Interest and
Trade (1696), New York, Augustus
M.Kelley,
1968
Works about Locke
Letwin, W. The Origins of Scientifi

c Economics,
London, Methuen, 1963
MacPherson, C.B. The Political Th
eory of
took French nationality in 1708, and he
would
RICHARD CANTILLON have had to be 21 to do this.
(1687?–1734?) Little is known about Cantillo
n’s
upbringing or when he left Ireland. From 1
Richard Cantillon (pronounced KA 711
N-till- to 1713 he was a clerk for the British Assista
LON) is a mysterious and fascinatin nt
g figure. Paymaster General in Spain, who ha
Few details of his birth and youth are d the
known, responsibility for paying and outfitting
and his financial activities as well as British
his death troops fighting in Spain. In 1716, he
remain shrouded in controversy. De went to
spite France to take over his cousin’s bank.
devoting most of his life to making Cantillon made a small fortune in 1
money, 720 on
Cantillon wrote the first real economic tre John Law’s Mississippi scheme, whi
atise, ch
a study describing the interrelationsh involved selling shares of stock to all t
ips and he gold
workings of the economic system. and silver that were thought to be contai
He also ned in
contributed to monetary theory and was the the Mississippi River area. Having accumu
first lated
person to explain the important econo much wealth, he lent money to others who w
mic role ere
played by the entrepreneur. speculating on the value of Mississippi sha
Cantillon was born into a Catholi res.
c family In order to get around French usury
in Ballyronan, a small town in Nort laws,
hwest Cantillon disguised his loans as fore
Ireland, sometime between 1680 and 1690 ign
. The exchange transactions—he lent mone
exact date of his birth remains unc y to
ertain others in one currency and deman
because parishes did not keep birth re ded
cords in repayment in another currency. As a re
Ireland during the seventeenth century. B sult of
rewer all his wheeling and dealing, Cantillo
(1992, p. 2) makes a plausible case for n was
a birth constantly involved in legal battles. I
year of 1687 based on the fact that n an
Cantillon attempt to put an end to them, he deci
ded to
death of Cantillon is downright confu
sing. On
return to England and live a life of lu the night of 14 May 1734, shortly a
fter his
xury with return to England, a fire engulfed Ca
the vast wealth he had made from his inv ntillon’s
esting home on Albermarle Street in London
and lending activities. . At the
If some mystery surrounds his time it was thought the fire was an ac
birth, the cident or
that Cantillon had been murdered. But produced and people get hired to produce
Murphy those
(1986) argues that Cantillon was n goods. Book Two focuses on the m
ot in the onetary
house at the time of the fire. He thinks Ca system, and explains how money and
ntillon the real
fabricated his own death to end all the liti economy are related. Finally, intern
gation ational
arising from the fortune he amassed. In s trade and foreign exchange are brought int
upport o the
of this view, Murphy notes that C picture in Book Three.
antillon Book One of the Essay depicts the eco
withdrew £10,000 the day before the nomy
fire, that as an interconnected system, or a circ
a neighbor reported seeing what was su ular flow
pposed of money and goods. It also explains
to be Cantillon’s burnt corpse witho how the
ut a head,
and that Cantillon’s personal pape
rs were
found many years later in the Dutch
colony of
Surinam in South America. It is surel
y hard to
believe a thief would take valueless
personal
papers and hard to understand how these
papers
turned up in Surinam —unless, of
course,
Cantillon himself took them there.
Cantillon wrote only one surviving
work in
economics, his Essay on the Nat
ure of
Commerce (Cantillon 1755). This
book was
published more than twenty years after t
he fire
that engulfed his London home. A
statistical
supplement, which is referred to in
the text,
has never been found. There are reports o
f other
writings by Cantillon; but these too have
never
been found.
Divided into three books or parts, the
Essay
sets forth a simple set of overarching pri
nciples
that explain how economies work. The fi
rst part
describes how the real economy op
erates, or
the principles according to which
goods are
RICHARD CA 1964, p. 53) observed that productio
NTILLON n in
different occupations is determined b
different parts of this system interact y the
with one demand for different goods. If landowners
another. Cantillon breaks into the ci want
rcle of more manufactured goods and less food, pe
production and exchange by focusing ople
on the and resources will flow from the agri
money that gets spent by landowner cultural
s. This sector to the manufacturing sector;
spending supports manufacturers in ci more
ties and manufactured goods and fewer agric
towns. It also supports agricultural w ultural
orkers in goods will then be produced. In more
rural areas, by creating jobs and inc modern
omes for terms, if consumers want more runn
them. Manufacturing sector worker ing
s and sneakers and fewer shoes, shoe makers will
agricultural sector workers will need do
to buy less business. Some shoe makers wil
some manufactured goods, and they l go
will need bankrupt and new businesses will start
to purchase a lot of agricultural goo up that
ds. This produce running shoes. The same principle
creates more jobs and more incomes f also
or those applies to different geographic regions
working in both these economic se within
ctors. a nation. If more labor is wanted in citi
Because the need for food and agri es and
cultural less labor is needed in rural areas, workers
goods is greater then the need for manufactwill
ured move from rural areas to urban areas.
goods, money tends to flow from Cantillon also analyzed the economi
the c role
manufacturing sector to the agricultur of the entrepreneur within this circu
al sector lar
in exchange for food. At some p production process. The term “entrepr
oint eneur”
agricultural workers will have to goes back to ancient and medieval ti
pay mes,
landowners for the use of their land, when it referred to people who got t
and so hings
money will find its way back into the done. Early eighteenth-century entrepr
pockets eneurs
of the landowners, ready to start a ne were contractors; in particular, they
w cycle were
of spending and production.
Within this framework, Cantillon 1
([1755] 1
RICHARD CANTILLON occupation since governments genera
lly paid
people who had a contract wit their bills. Cantillon borrowed this
h the popular
government. This was a rather ri term and redefined it. He made
skless the
entrepreneur a risk taker, rather oney.
than Economists now describe this un
someone receiving a regular salary. certain
Cantillon impact of money as the Cantillon
recognized that the future was uncer Effect.
tain and The economic effect of new mone
that all economic activity was inh y is
erently uncertain because it depends on wh
risky. However, someone must take o gets
risks now the money and what they do with it.
in the hope of making a profit later If the
. If not, money goes primarily to merchant
no production would take place. T s and
he risk- exporters there will be more money
taking entrepreneur was thus essentia saved
l for the and more investment.
circular production process to oper With more
ate well production, rather than more spend
and for economies to prosper. ing,
Book Two of the Essay looked prices will not tend to rise. But if the
at how money
money affected this circular proce goes to landlords who revel in lu
ss. By xury
analyzing the economic impact of consumption, there will be a grea
money, ter
Cantillon can legitimately be rega
rded as
the founder of classical monetary 12
theory
(Bordo 1983). Money in the eigh
teenth
century meant gold and silver coins;
it could
be created in either of two ways—
by mining
gold and silver or by selling goods t
o other
nations. When miners or traders ha
d more
money their demand for goods and
services
increased, and so employment and
output
would expand in other industries or
sectors.
Greater demand would also raise pri
ces, but
not necessarily in proportion to
the
increased supply of money (Cantillo
n 1755,
Book II, Chs. 6, 7), since higher
prices
induce increases in output, and s
ince
sometimes there can be more money
but not
more spending of the additional m
protectionism, and supported running t
rade
increase in prices and luxury goods surpluses in manufacturing. However
, he
will advocated these policies more for mil
tend to go up in price the most. itary
At some point, Cantillon though purposes than for economic reasons
t, the .
greater prosperity due to more money Protectionist mercantilist policies, Can
would tillon
be likely to come to an end. It is pri thought, would increase the populatio
marily n of
through the effect of money on intern Britain. A trade surplus in manufact
ational uring
trade that this occurs. Rising prices would allow Britain to import food, an
will d this
make exports less competitive food could then support a larger popul
in ation
international markets at the same tim and make Britain a stronger nation.
e that Cantillon has been a much negle
imports become relatively cheap a cted
nd figure in economics. He is known pri
attractive to domestic consumers. A marily
trade for his influence on Quesnay and t
deficit will result, meaning that gol he
d will Physiocrats, and for developing the n
be shipped abroad in order to pay f otion
or all that money flows connect the differ
the imported goods flowing into t ent
he sectors of the economy. Yet the plac
country. With gold going abroad, t e of
he Cantillon in history is more important
domestic money supply is reduced than
and this. His Essay can legitimately be reg
domestic production stagnates. Cantarded
illon as the first real economic treatise. I
thus discovered the specie flow mec t
hanism envisioned the economy as an interrel
(see also HUME). ated
Book Three of the Essay discusse system, and explained how that syst
s trade em
policy, and pretty much follows t worked. For this reason, Cantillon pro
he bably
recommendations of the mercantilist deserves to be regarded as the first r
s (see eal
also MUN). Cantillon fav economist.
ored
Works by Cantillon Works about Cantillon
Essai sur la nature du commerce Bordo, Michael “Some Aspects of the

en général Monetary
(1755), translated by Henry Higgs, N Economics of Richard Cantillon,”
ewYork, Journal of
Augustus Kelley, 1964 Monetary Economics, 12 (1983), p
p. 235–58 Méré, around 15 miles west of Versai
Brewer, Anthony, Richard Cantillon: lles. His
Pioneer of father was a peasant fanner and sho
Economic Theory, London and N pkeeper,
ew York, and so Quesnay received little for
Routledge, 1992 mal
Murphy, Antoin, Richard Cantillon: E schooling. But Quesnay was enamor
ntrepreneur ed with
and Economist, Oxford, Clarend
on Press,
1986
Spengler, Joseph, “Richard Cantillon: Fir
st of the
Moderns I,” Journal of Political Eco
nomy, 62,
4 (August 1954), pp. 281–95
Spengler, Joseph, “Richard Cantillon: Fir
st of the
Moderns II,” Journal of Politic
al Economy,
62, 5 (November 1954), pp. 406–
24
Tarascio, Vincent, “Cantillon’s The
ory of
Population Size and Distribution,
” Atlantic
Economic Journal, 9, 2 (July 1981), p
p. 12–18
FRANÇOIS QUESNAY (1694–
1774)
François Quesnay (pronounced KE
N-nay) is
best known as the creator of the first eco
nomic
model ever developed, the Ta
bleau
Economique, and as leader of the P
hysiocrats,
the first school of economic thought. H
owever,
Quesnay has been admired for ma
ny other
things—his laissez-faire policy pro
posals, his
analysis of the generation and distri
bution of
an economic surplus, and his visio
n of the
economy as a closely integrated
set of
interdependent parts.
Quesnay was born in 1694 in the
village of
FRANÇOIS Q cles for
UESNAY Diderot’s Encyclopedia. The articles h
e wrote
books, and would often walk to Pa earned him great fame and a large foll
ris to owing.
purchase secondhand copies of Plat His disciples called themselves “Physi
o and ocrats,”
Aristotle (Beer 1939, p. 101). from the French term Physiocrate,
At age 17 Quesnay decided to bemeaning
come a rule of nature.
surgeon. Although dissatisfied with his m The Encyclopedia articles all anal
edical yzed
training, which included bleeding p economic processes as a circular flo
atients, w of
Quesnay continued with his studies. money, goods, and people from one se
In 1717 ctor of
he passed his medical examinations, the economy to another, akin to the fl
obtained ow of
a license, and opened a practice in th blood through the human body. “Cor
e village n” (in
of Mantes, just south of Paris. After publis Meek 1963) was the most import
hing ant
several books on medical subjects, Encyclopedia article because it first s
his et forth
reputation as a surgeon grew. In 1735 Que the doctrine that only the agricultural se
snay ctor of
was asked to serve as personal physician to the French economy was productive.
the That is,
Duke of Villeroy. In 1744 he recei only in agriculture could a surplus
ved a be
doctorate in medicine and became a generated, or only in agriculture does
member output
of the French Academy of Sciences. Five exceed the inputs needed to produce
years that
later he settled in Versailles to become persoutput. Quesnay thought that this surplus a
onal rose
physician to Madame de Pompadou from the natural, generative properties
r, the of the
powerful mistress of Louis XV, as w land. This idea was important becau
ell as a se it
medical consultant to the king. emphasized that wealth was generated
At this point in his life (age 55) in the
Quesnay process of production rather than thr
became interested in economics ough
and exchange or trade as the mercantilist
mathematics. His broad interests, ans had
d his
connections with those in high places, br 1
ought 3
him an invitation to write several arti
FRANÇOIS QUESNAY manufacturing activities were not pr
oductive
claimed. Another consequence of this vi because they did not create a surplus.
ew, one Cantillon, as we have seen, had
that resulted in much criticism, w already
as that described the workings of an economy
as a set
of circular flows or
economic become known as the Physiocratic t
interrelationships. Quesnay developed
this idea heory of
further, and quantified the various rent.
relations Following his position in “Corn,” Q
between parts of the economy in gre uesnay
ater detail assumed that only agricultural producti
in his Tableau Économique. The T on was
ableau was productive. Most Tableaux showed tha
thus the first attempt to mathematica t inputs
lly model employed in agriculture yield twice the am
an entire economy, and to actually ount
show the of output; however, Quesnay was awa
relationships between its various pa re that
rts. this assumption about the relationship bet
Quesnay began with the assumption ween
that the inputs and outputs depends upon t
economy could be best described in he
terms of techniques of production employed i
three different classes or sectors. Firs n the
t, there is agricultural sector. Some of his impo
an agricultural sector that produces rtant
food, raw policy proposals (see below) involve a
materials, and other agricultural goods. ttempts
Second, to increase productivity in the agricul
a manufacturing sector produces manu tural
factured sector.
goods like clothing and shelter as w Finally, Quesnay assumed that all
ell as the income
tools needed by both agricultura was spent, and that spending was di
l and vided
manufacturing workers. The manu equally between agricultural goods a
facturing nd
sector for Quesnay also includes what w manufactured goods. These assumptio
e today ns lead
call the service sector, since it is re Quesnay to his famous zig-zag model
sponsible of the
for facilitating domestic and internation economy, shown in Figure 1.
al trade. According to this model, landowne
Third, a class of landowners producers take
s nothing their $1,000 rental payments and spen
of economic value; but these landow d one-
ners have half of it on manufactured goods and th
claims on the surplus output prod e other
uced in half on agricultural goods. These two
agriculture. These rents represent pasectors
yment of now each have $500 in money income.
the surplus to landowners, and this Those
view has employed in these two sectors spend
half
their new income on goods produced b
y the
other sector. This spending leads to inc
omes
of $250 for each producing sector. A
gain,
half of this additional income gets sp the goods of the other producing class.
ent on This
Figure 1 The Tableau Économique
14
year they
produce nothing. They thus subsist
process continues until the amou on the
output of the two producing classe
nt of s or
additional spending gets to be ver sectors. In particular, they receive r
y, very ental
small. We can then add up all the payments from agricultural farmers e
spending qual to
on agricultural goods and all the s the agricultural surplus, and use th
pending ese
that takes place on manufactured g payments to buy and consume goods
oods. As .
Figure 1 shows, these both total $1, The other sectors take their initi
000. al $500
What happens within each sec income and use it to buy necessary in
tor is puts so
probably more important than what that more food and manufactured go
happens ods can
across the different sectors becaus be produced in the next year. The
e it is manufacturing sector buys $500
within each sector that production of
takes agricultural goods through the zig-
place, and it is within sectors th zags of
at an Figure 1 and has $500 in cash. It us
economic surplus gets generated. S es this
o let us $500 in cash to buy more inputs fr
look more closely at each sector (f om the
or more agricultural sector and then takes its
details see Pressman 1994). $1,000
Proprietors buy and consume of inputs to produce $1,000 wort
$1,000 h of
worth of goods—$500 food and $5 manufactured goods.
00 worth The agricultural sector has prod
of manufactured goods. During the uced
$2,000 worth of goods, but has so FRANÇOIS QU
ld only ESNAY
$1,000 to the proprietors and the
manufacturing class. In addition, iSince inputs yield double the amoun
t has t of
bought $500 worth of manufacture output, the agricultural sector will pro
d goods, duce
as depicted in the zig-zag diagram o another $2,000 worth of agricultural
f Figure goods
1, and it sold another $500 worth in the next production period. This pr
of goods ocess
to the manufacturing sector, as desc will continue from year to year, barring
ribed in some
the previous paragraph. These outside factor disturbing the reprodu
two ction
transactions balance each other o process.
ut, and Like the mercantilists, the Physio
leave the agricultural sector with crats
$1,000 viewed economic theory as a means
worth of inputs. It also has the $1,00 to
0 in cash appropriate economic policy rather th
needed to pay the proprietors their r an as
ents and an end unto itself. The purpose of t
start a new production distribution he
cycle. Tableau was not just to explain the prin
ciples
by which economies reproduce and gro
w, but
to set forth policies to help stimula
te
economic growth. Moreover, Quesna
y the
physician tended to look upon the eco
nomy
as if it were a sick patient in need of h
elp.
Towards these policy ends, Ques
nay
usually presented two Tableaux, a so
rt of
controlled experiment. One Tableau
would
be the control case, showing the present
state
of affairs in France. The other Tableau
would
show the effects of introducing vari
ous
policy changes into the French econo
my. A
good policy, Quesnay was able to sh
ow,
would lead to economic growth; the F
rench
economy would prosper. This would
be
demonstrated by increased output
of
agricultural and manufactured goods. produced no surplus to tax. Any atte
A poor mpt to
policy, in contrast, would cause the tax this sector would tax away the i
French nputs
economy to decline and stagnate. In li used in producing manufactured goo
ne with ds.
the name they adopted for themselv Since inputs exactly equals output i
es, the n
Physiocrats believed that all corr manufacturing, any reduction in inp
ect uts
economic policies were consistent w would lead to lower manufacturing o
ith the utput
rules of nature. and therefore would result in the decli
One important policy conclusion ne of
of the the manufacturing sector. To the exten
Tableau was that taxes should be plac t that
ed only the agricultural sector required good
on landlords. Taxes could not be pla s
ced on
the manufacturing sector because t 1
hey 5
FRANÇOIS QUESNAY decline.
A second important policy concl
produced by the manufacturing sect usion of
or, it too the Tableau was that the French agr
would experience economic decline icultural
. system had to be restructured. Two i
Similarly, any tax placed on t mportant
he changes were especially needed. F
agricultural sector would reduce th irst,
e inputs agriculture had to be modernized. Sm
available in this sector and lead to it all plots
s decline. of land, farmed with outdated techn
Since agricultural advances double ology,
during were terribly inefficient. By expand
production, each tax dollar impos ing the
ed on size of French land holdings, new cu
agriculture would lower national o ltivation
utput by methods could be employed that wou
two dollars. This outcome is even w ld only
orse than be feasible if done on a large scale. Invest
taxing the manufacturing sector. ment
If neither the manufacturing n in new technology, Quesnay recog
or the nized,
agriculture could be taxed without would only be profitable and would o
harming nly take
the economy, taxes had to fall o place if its costs were spread out ov
n the er many
landowners, the class that produced acres and many agricultural goods.
nothing. Second,
Since a tax on landowners does n agriculture had to become more capi
ot reduce talist in
the inputs available in either manu nature, following the example of E
facturing nglish
or agriculture, it would not lead to agriculture. Quesnay argued that t
economic hese
reforms would improve agricult
ural
productivity, or the surplus genera Quesnay was an important forerunner o
ted in
agriculture, by providing greater e f John
conomic Maynard Keynes.
incentives for successful farmers; Finally, in contrast to the mercantil
and he ists,
argued that with more food produc Quesnay supported free trade of goo
ed, all of ds
France would prosper. among nations. For the Physiocrats, w
A third policy prescription follo ealth
wing from depended upon the total output of g
Quesnay’s model was that saving, or hooods
arding produced rather than the precious m
money, was bad for the economy b etals
ecause it that a nation accumulated. More good
interrupted the circular flow of m s, in
oney and turn, required greater agricultural
goods. Any lack of demand would production. Quesnay thought that fr
lead to a ee
reduction in national output and c international trade would increase th
ause the e
French economy to stagnate. In this demand for French agricultural goods,
respect, and
shift economic resources or inputs fro
16
m the
unproductive manufacturing sector to
the
productive agricultural sector. As a re
sult
of more inputs and greater productio
n in
the agricultural sector, the economi
c
surplus generated within France wo
uld
increase and the country would pros
per
(see Pressman 1993).
In one sense, history has not been k
ind to
Quesnay. He has as much right as Sm
ith to
be regarded as the father of economics
. But
while “Adam Smith” has become
a
household name, Quesnay is virtuall
y
unknown outside the society of profes
sional
economists. Economists also parrot t
he
criticism, first made by Smith, that Qu
esnay
went wrong by assuming that manufac
turing
is unproductive. Finally, the Tablea p. 2)
u has claimed that the Tableau was an imp
been harshly criticized for being ext ortant
remely precursor of his input —output analy
difficult to follow and understand. sis.
Yet, in another respect, history ha Conservative economists value his lai
s been ssez-
good to Quesnay. Virtually all econo faire policy proposals and his oppositio
mists, n to
regardless of their orientation, think placing taxes on the productive sector
highly s of
of him (no small feat!). Mathemati the economy. More liberal economists
cally- have
minded economists look favorably been attracted by his Keynesian visio
upon n of
Quesnay for his role as a pioneer spending as an important determinan
in t of
economic modeling. Leontief (1941, economic growth and decline. Even
Marx
(1954) lavished praise on Quesna Beer, Max, An Inquiry Into Physiocracy,
y for London,
recognizing the importance of an e George Allen & Unwin, 1939
conomic Higgs, Henry, The Physiocrats, Lon
surplus arising in production, and don,
for Macmillan, 1897
showing how this surplus enables c Meek, Ronald, The Economics of P
apitalist hysiocracy:
economies to reproduce and grow. Essays and Translations, Cambridge,
Quesnay Harvard
is truly an economist for all season University Press, 1963
s. Pressman, Steven, “Quesnay’s Theor
y of
Economic Growth and Decline,” in Ec
Works by Quesnay onomics
as Worldly Philosophy, ed. Ron
L’Ami des Hommes, 5 vols., Avignon, Blackwell,
1762 with Jaspal Chatha and Edward J.Nell,
Victor de Riquetti, Marquis de Mir London,
abeau Macmillan, 1993, pp. 305–21
Philosophic Rurale 5 vols., Amerster Pressman, Steven, Quesnay’s Tab
dam, Chez leau
Les Libraries Associes, 1764 Économique: A Critique and Re
The Economical Table, New York, assessment,
Bergman Fairfield, New Jersey, Augustus Kell
Publishers, 1968 ey, 1994
Quesnay’s Tableau Économique, ed. Vaggi, Gianni, The Economics of Fr
Marguerita ançois
Kuczynski and Ronald L.Meek, Quesnay, Durham, North Carolina,
New York, Duke
Augustus M.Kelley, 1972 University Press, 1987
Works about Quesnay Other references
Leontief, Wassily, The Structure of the Marx, Karl Theories of Surplus Value,
American 3 vols.,
Economy, 1919–1929, Moscow, Foreign Language Publishing
Cambridge, House,
Massachusetts, Harvard University Pr 1954
ess, 1941
DAVID HUME (1711–76)
David Hume was a world famous philoso
pher
who argued that knowledge could aris
e only
from experience. But he also made s
everal
contributions to economics when t
he
discipline was just developing. These inv
olved
analyzing the impact of money on
an
economy, and on the trade that takes
place
between nations.
Hume was born in Edinburgh, Scotl
and in
1711. His father, a country gentleman,
died
when Hume was very young, so Hum
e was
raised by his mother. However, his fath
er left
plenty of money to the family. This al
lowed
Hume to receive an excellent educat
ion,
primarily by private tutors at home. H
e then
enrolled at the University of Edinbu
rgh
intending to study the classics. But
Hume
quickly became dissatisfied with t
he
education he was receiving, and he d
ecided
to drop out of school, go to France
and
become a great philosopher.
Despite having written several boo
ks that
are now regarded as philosophical cl
assics,
Hume could not support himself as
a
philosopher. Unable to get a teaching
job at the Advocates Library in Edinburgh.
any Scottish University, he agreed to t This
utor the provided him with additional income a
Marquis of Annandale in 1745. Severa s well
l years as ready access to a large number of b
later he accepted a position as secretar ooks.
y to an The result was a prodigious outpouri
army general. These jobs provided Hume ng of
with philosophical works as well as a six v
enough money that he soon achieved fina olume
ncial History of England (Hume 1757–
independence and could spend most 62). In
of his
time reading and writing. 1
In 1752 Hume was hired as a libr 7
arian at
1763 Hume became secretary of th government policies be enacted to
e British support
embassy in Paris, and in 1767 he the meritorious merchant (see MU
became N). But
undersecretary of the foreign offic they provided no justification for t
e. Two heir
years later he resettled in Edinburg program. Hume filled this void by ex
h, where plaining
he died in 1776. the economic function of the busine
As an economist, Hume made ssman.
several For Hume, the merchant was praise
contributions to the theory of money worthy
and the because he was frugal. Businessmen
theory of international trade. He anal tend to
yzed the save their income and accumulate
impact of money on interest rate capital.
s, on More capital lowers interest rates and
economic activity, and on prices. tempts
He also other businesses to borrow and expa
explained how and why countries w nd their
ould not operations, thereby increasing comp
be able to experience trade imbala etition
nces for and lowering profit rates. In contrast
long periods of time. Finally, H to the
ume merchant, wealthy landowners typi
addressed the important question: cally
“What borrow money in order to consume
happens when rich countries trade more
with poor goods. They, therefore, reduce the st
countries?”. His answer ock of
was that productive capital and push up intere
international trade would benefit b st rates
oth rich on loans.
countries and poor countries. This analysis not only explains
In mid eighteenth-century Engl the
and, the functions of the merchant or busine
mercantilists were ssman;
proposing it also provides a theory of interest
, now analysis of saving and investment pro
called the “loanable funds theor vides
y”. a justification for savings. Savings
According to Hume, interest rates are
are needed for new investment, and thus s
determined by the supply of savings avings
and the is needed for economic growth.
demand for savings. Greater saving Hume also analyzed the economic
s lowers effects
interest rates and also allows more of changes in the money supply. Hu
money to me
be borrowed. Less savings has the explained the positive effects of more
reverse money
effect—it increases interest rates on the economy and then explained ho
and w, in
discourages borrowing. Moreover, the long run, the entire effect of more
Hume’s money
would be to raise prices, leaving outp
18 ut and
employment unchanged. Finally, Hu
me
analyzed the economic effects of m
oney
leaving one country and going to an
other
country. This analysis of the internati
onal
flows of money has been called the
specie
flow mechanism. Although historicall
y this
transmission mechanism was first iden
tified
by Cantillon, Hume is the first person to
have
published something on this process a
nd is
usually given credit for its discovery.
With
his discovery of the specie flow mecha
nism,
Hume took one large step away fro
m
mercantilist thinking and one large s
tep
toward the classical macroeconomic t
heory
that was to develop in England durin
g the
late eighteenth and early nineteent
h
centuries.
The short-run effects of money w
ere a
consequence of the fact that prices di
d not
immediately change. In fact, Hume (
1875:
314) thought that prices would be stic if prices rise a bit, this inflation is a
ky over good
a rather long period, one lasting se thing because it increases business pr
veral ofits,
years. When gold and silver is mi which further stimulates eco
ned, nomic
according to Hume, it is put into circ expansion.
ulation At some point, however, the rise
by being spent. Money thus gets in
concentrated in the hands of a few me employment will lead to higher wages.
rchants. Also,
As these merchants spend the moneat some point in the process of money
y for being
investment purposes, industry begin spent and dispersed throughout the eco
s to nomy,
expand and employment begins to ris businesses will not be able to keep up
e. Even with
demand and their inventories will sta when gold is discovered and mined.
rt to fall. We saw
These two effects alter the mone above that this increase in the do
y mestic
transmission mechanism. Rather supply of money eventually causes a
than rise in
leading to greater output and empl prices. But this price increase has f
oyment, urther
the additional money creating now i economic consequences. Higher pric
ncreases es will
prices. As time goes on, the entire i make a country’s goods more expe
mpact of nsive
mining more money will be felt on t abroad, and so it will export less. Co
he price nversely,
side, and there will be no more pr with higher domestic prices, goods p
oduction roduced
or employment than we had origina abroad will be relatively less expensi
lly. ve. As
Hume next analyzed the impa a result, more goods will be purchas
ct of ed that
additional money on foreign trade. were made in other countries. Both d
This led eclining
Hume (1955:60–77) to develop th exports and rising imports will wors
e specie en the
flow mechanism, which explained national trade balance. More money
how will go
economic forces automatically lea abroad to buy foreign goods than com
d to a es back
position of balanced trade for all c through selling goods to other countri
ountries. es. This
It also explained how economic forc will lead to a loss of money from
es would the
establish a natural distribution of domestic economy. In the long run, w
money ith less
throughout the world economy. money and less spending, the domest
Consider again what happens to ic price
a nation level will tend to decline somewhat.
One important consequence of this analysis is that the amount of gold
this in a
analysis is that trade imbalances ca country will remain the same, or rea
nnot be ch an
maintained for long periods of ti equilibrium level, whenever its imports
me. equal
Countries running trade surpluses its exports.
will see Although many economists regard
their money supply rise and will ex Hume
perience as a mercantilist thinker, the specie f
inflation; this will tend to reduce th low
eir trade mechanism raises considerable doubt
surplus. Countries running trade de about
ficits, in this interpretation. One fundamental te
contrast, will see their money suppl net of
y decline mercantilism was that countries should
and their prices fall. This will tend t strive
o reduce for trade surpluses and that governm
their trade deficit. A further conseq ents
uence of should assist national businessmen in
this
endeavor. But the logic of the specie
flow
mechanism makes this goal an impo
ssible
dream. Any trade surplus will lead t
o an
influx of precious metals and high
er
domestic prices. This will tend to eli
minate
the surplus. What the mercantilists d
esired
could not be achieved according to the
logic
of the specie flow mechanism. And
Hume,
to his credit, did not push for merca
ntilist
economic policies that would generate
trade
surpluses.
Finally, Hume went on to examin
e the
question of what happens when po
or
countries and rich countries trade wit
h one
another. Many times since the eighte
enth
century this issue has been the subje
ct of
heated debate. It is an eternally impo
rtant
question because it is closely related t
o the
issue of what causes economies to gro
w. At
the end of the twentieth century the living
debate would converge with that of their wea
has focused on the economic conseq lthier
uences neighbors and trading partners. In con
of German unification, of bringing co trast,
untries Gunnar Myrdal (see below) would l
like Greece and Spain into the Eur ater
opean argue that cumulative causation leads t
Union, and of a North and South A o a
merican divergence of world living standards,
trading block. with
For Hume (1955:60–77), trade the rich getting richer at the expense
helped of
poor nations but did no harm to wea poor countries.
lthier
nations. Trade enabled poor countri
es to 1
grow and develop; their standard of 9
ADAM SMITH n each
other and on economic growth. But his pla
One mechanism that Hume ide ce in
ntified as the history of economics comes from more
leading to converging living standar than
ds is the his attempts at economic analysis. Hu
transfer of technology from more me is an
advanced important transitional figure betwee
to less advanced economies. As th n the
e recant mercantilists and the British classical econ
examples of South Korea, Malaysia omists
, Taiwan who would follow on his heels.
and Hong Kong show, advanced te
chnology
allows the living standard of less d Works by Hume
eveloped
countries to rapidly approach that History of England (1757–62), London: T
of more .Cadell
developed nations. Later, Hume (1 and W.Davies, 1802
955: 78– Essays, Moral, Political, and Litera
82) made the case that trade between un ry, ed. T.H.
equals Green and T.H.Grose, 2 vols, Lo
also benefits wealthy countries be ndon:
cause it Longmans, Green, 1875
provides them with export markets. Writings on Economics, ed. E.Rotwein, M
He then adison,
used these arguments to support free tra WI: University of Wisconsin Press,
de and 1955
oppose mercantilist restrictions on
exchange Works about Hume
between nations (see Elmslie 1995).
Starting with the questions rais
ed by the Cavendish, A.P., David Hume, New York:
mercantilists and the economic issues of t Dover,
he day, 1958 and Westport, CT: Greenwoo
Hume began to develop economic a d Press,
nalysis by 1979
showing the impact of money and trade o Elmslie, Bruce, “The Convergence D
ebate
Between David Hume and Josiah
Tucker”, Johnson, E.A.J., “Hume, the Synthetist
Journal of Economic Perspectiv
es 9 (Fall ” in
1995): 207–16 Predecessors of Adam Smith: The
Growth of
British Economic Thought, New Yor
k:
20 Augustus Kelley, 1965, pp. 161–81
ADAM SMITH (1723–90)
Although others wrote about economic
issues
and principles before him, Adam Sm
ith is
regarded by most people as the fath
er of
economics. This honor stems neither fr
om the
originality of his ideas nor from the techniq
ues
of economic analysis that he pioneered. Rat
her,
Smith is regarded as the father of eco
nomics
due to his vision of capitalism as an ec
onomic
system that makes everyone better off.
Smith
was the first person to see the bene
fits
stemming from greater competition a
nd to
argue for policies that promote grea
ter
competition. This required both redu
ced
government involvements in the economy,
and
also government actions to counter
monopolistic tendencies and practices.
Smith was born in 1723 in Kirkca
ldy, a
small town near Edinburgh, Scotland
. His
father, a lawyer and comptroller of cu
stomer
duties, died shortly before he was bo
rn; so
Smith was raised by his mother and
by
guardians appointed in his father’s will
(Ross
1995, p. 2). College for the next six years.
Although he was a sickly child, S Smith found Oxford to be intellec
mith had tually
a great passion for books and was a stultifying. Little teaching took place and e
n avid ven
reader. At age 14, he was sent by his parents less learning occurred. Since so few
to of the
the University of Glasgow, where he faculty actually lectured, Smith was a
studied ble to
moral philosophy, mathematics, and spend many hours in the library doing
political what he
economy. In 1740, he won a scholar liked best—reading, especially in the a
ship to reas of
Oxford University and studied at B literature, philosophy and history. S
alliol mith’s
Like the
conscience, this ability led people t
([1776] 1937, p. 717f.) suggestion that t o act in
ways that were morally right.
eachers When Charles Townshend read The
be paid based on the number of students in Theory
their of Moral Sentiments he decided that
classes probably stems more from he could
his bad do no better than to put his stepson, t
experience at Oxford than from a desire t he Duke
o spur of Buccleuch, under the tutorage of S
competition among faculty member mith. So
s. Townshend hired Smith, and Smith
In 1751 Smith was hired to fill th resigned
e Chair of from his professorship at Glasgo
Logic at the University of Glasgow. A yea w to
r later accompany the young Duke to Fran
he took over the Chair of Moral P ce. This
hilosophy. new job gave Smith lots of free time
His lectures on ethics were well att to read
ended and and reflect, and by traveling to Franc
became his first literary success— e, Smith
The Theory was able to meet the leading Physi
of Moral Sentiments (Smith 1759). ocrats,
The Theory of Moral Sentime including François Quesnay. In earl
nts tried to y 1764,
explain how people acquired the moral f Smith began writing a book “to pass a
eelings way the
that enabled them to distinguish ri time” (Rae 1895, p. 178), as he noted in a le
ght from tter
wrong. It found the answer in the ability to his friend David Hume.
people After traveling around France fo
had to put themselves in the positi r three
on of an years, Smith returned to Kirkcaldy
impartial spectator. This allowed p and then
eople to spent the next decade finishing his b
judge actions not only from the vie ook. The
wpoint of Wealth of Nations was published in
their own selfish interests, but also 1776, and
from the it brought Smith both fame and fort
perspective of an objective observer. une. In
contrast to The Theory of Moral ADA
Sentiments, M SMITH
The Wealth of Nations assumed that pe
ople act works, “he…intends only his own gain
according to their own self-interest. …[but]
Yet, The is…led by an invisible hand to promote an e
Wealth of Nations argues that indi nd
vidual acts which was no part of his intention.”
of selfishness contribute to the publi That
c good. In unintended end was economic growth
a famous passage, Smith ([1776] 1937, and
p. 423) improved living standards for the natio
describes this process: when each in as a
ndividual whole.
The Wealth of Nations set out to
analyze
what caused the national standard of li
ving to
rise, and to show how self-interest
and
competition contributed to economic
growth.
It also examined how governments a
ffect
economic performance. These studies
of the
principles of economics also led to an
attack
on the economic theories and policies
of the
mercantilists (see also MUN).
According to Smith it was the proc
ess of
mechanization and the division of lab
or that
enabled economic growth to take pl
ace.
Living at the onset of the industri
al
revolution in England, Smith saw first
-hand
the economic consequences of technol
ogical
innovation. In the 1730s the flying s
huttle
was invented, which was more efficien
t than
the handloom and thus made the we
aving
process go much faster. In 1769 the spi
nning
jenny was invented, which allowed
one
person to spin several threa
ds
simultaneously. These, and many other
new
technological innovations, allo
wed on…it is divided into a number of br
individual workers to be many times anches,
more of which the greater part are likewise pec
productive than they would have b uliar
trades. One man draws out the wire,
een
another
without the aid of machinery. straightens it, a third cuts it, a fourth points
The Wealth of Nations begins b it,
y pointing a fifth grinds it at the top for receiving the he
out how the division of labor enabl ad;
ed the to make the head requires two or three dist
productivity of workers to increase. inct
Smith operations…and the important busin
([1776] 1937, p. 4) describes the pr ess of
oduction making a pin is, in this manner, divid
ed into
process in a pin factory:
about eighteen distinct operations.
The way in which this business is now ca
rried 2
1
ADAM SMITH es that
allow them to produce more with less
Smith reports that he saw pin effort.
factories Smith felt that the natural tende
where ten people divided up all these tas ncy of
ks and people to buy and sell goods, and th
produced more than 48,000 pins per e natural
day. Yet, tendency of people to improve their
if these people had to work separa material
tely and condition (i.e. self-interest), were the
independently, Smith claimed, they driving
would not forces behind the division of labor
be able to produce much more tha and the
n 20 pins resulting improvements in producti
per day. The division of labor thus vity.
yielded a However, Smith did recognize one i
2000-fold increase in the number mportant
of pins limit to the division of labor. If firms could
produced. not
By dividing up the tasks, worker sell the additional pins they manufa
s become ctured,
more productive for a number of reasons there would be no incentive for them
. First, to divide
by concentrating on only one task, the ski up the many production tasks, empl
ll and oy more
dexterity of the individual worker machinery, and increase the number
improves, of pins
and workers can perform their tas produced. It was, therefore, critical t
k more o expand
quickly. Second, time is saved mov the market for British goods.
ing from Towards this end, Smith support
one task to another. Third, when fo ed free
cusing all international trade among nations. Fr
their attention on just one job, workers are ee trade
more would allow British firms to sell their goo
likely to come up with labor-saving devic ds in
an international arena rather than on
ly within
Britain. Moreover, Smith argued that fr also wrong about the gains accruing
ee trade
would benefit Britain because it wo from
uld allow English colonies in the New World, acc
firms to obtain goods more cheap ording
ly from to Smith. England did not gain because it co
abroad. This would lower the cost of pro uld
ducing sell goods to America and obtain gol
goods for exports. d in
The case for free trade naturally exchange. Rather, England gained bec
developed ause it
into a critique of mercantilism. Be could sell more goods, further divide
cause the up the
mercantilists wanted to limit trade tasks done by workers, and produce
in goods, more
their policies would limit the mar goods with the same work force.
ket for Smith, however, did not give his unquali
domestic producers and keep Briti fied
sh living support to free trade. Because national def
standards from rising. The mercanti ense
lists were was more important than national w
ealth,
22 Smith ([1776] 1937, p. 429) opposed
trade
whenever it increased the military mi
ght of
countries other than Britain or reduce
d the
military strength of Britain. Smith t
hus
supported the English Navigation Acts.
These
laws forced American ships to stop in Engl
and
and transfer their cargoes to British ships bef
ore
the goods moved on to their final Eu
ropean
destination. Smith reasoned that this
policy
would increase both the number of British sh
ips
and the number of trained British sea
men; in
times of war these two assets would
be
important for the defense of an island
nation
like Britain.
On the other hand, Smith oppo
sed
retaliatory tariffs on those countries
placing
restrictions on the sale of British goo
ds; he
claimed that one bad policy did not
warrant elimination, so that the transition process c
another bad policy. Smith thought th ould
at any take place slowly and smoothly.
British worker who lost a job due to fr Smith also rejected the popular i
ee trade nfant
would soon find another job at a bett industry argument for protective tariff
er wage s. This
as long as guild restraints and appre was that the claim protectionism was neces
nticeship sary
rules did not keep labor from moving for a country just beginning to devel
to new op a
areas and more productive uses. Realizin particular industry. Since new domesti
g that c firms
this would not occur quickly in the rea would be less experienced and knowle
l world, dgeable
Smith advocated a gradual lowerin in producing goods than already-
g of established
protective tariffs, rather than their imforeign firms, domestic firms would f
mediate ace a
together and devising schemes to raise the
price
competitive disadvantage compared of their goods and services. The fe
wer the
to their number of firms and the larger their
foreign rivals. If, the argument runs, size, the
a nation easier it would be for firms to conspir
is to develop production expertise i e against
n a new the public by raising prices.
industry, domestic firms must re Second, Smith ([1776] 1937, p. 1
ceive 47) held
protection until they obtain the re that monopolies were “a great enemy
quisite to good
experience. Smith ([1776] 1937, management.” Competition, he beli
p. 425) eved,
opposed the infant industry argumen forced managers to operate as effici
t because ently as
it created inefficient monopolies an possible and to seek out ways to imp
d diverted rove the
scarce capital resources to these mo efficiency of their operations.
nopolies. With
Monopoly was another enemy of fre competition, if your firm did not be
e trade, come as
of expanding the market for British goo efficient as possible, other firms surel
ds, and y would,
of rapid economic growth. Smith i or new firms would start up that operated
dentified more
four negative effects of monopolistic pr efficiently. Poorly run firms would t
actices. hen be
First, monopolies led to higher pri driven out of business by their
ces for more
consumers, and thus made consum competitive rivals.
ers worse Third, Smith held that monopoli
off. Smith ([1776] 1937, p. 128) n es were
oted that more likely than competitive firms to
businessmen had a penchant for pressure
getting government to support their mono
poly ADA
position, and were more likely to be suc M SMITH
cessful
in this endeavor. This would result i Finally, Smith noted that monopolies le
n bad and d to
oppressive laws being passed. One a misallocation of resources. Because
example of the
that Smith gives ([1776] 1937, p. high prices they could charge, mono
612f.) polists
involves prohibitions on the export would make huge profits. This would stim
of sheep. ulate
Draconian laws against selling Brit production. Resources would thus g
ish sheep o to
were passed by Parliament in order to m making goods not because people wan
aintain t those
the monopoly power of woolen goods most and not because there wer
cloth e many
manufacturers. Without British shee possibilities for improving the division of l
p exports, abor
other countries could not produce and reducing costs, but only becaus
woolen e a
goods for sale in England. monopoly existed.
This critique of monopolies also turned
into
a critique of mercantilism. Because mercan
tilist
policies kept out foreign competition
these
policies helped to promote national monop
olies
([1776] 1937, p. 595). They thus h
urt
consumers and severely hampered na
tional
economic growth.
While generally regarded as the patron s
aint
of laissez-faire economics and an oppo
nent of
government, Smith did not really opp
ose all
government intervention into economic af
fairs.
In fact, he recognized four important funct
ions
for government. The first, preventing mon
opoly
or guaranteeing a competitive environment
, has
just been discussed.
Second, Smith recognized that o
nly
governments could provide for the def
ense of
the entire nation against outside threat
s. It is
for this reason that Smith supported
the
Navigation Acts and large govern provision of public goods in cases wit
ment h large
expenditures on defense. Third, gov externalities.
ernment For most economic transactions, a
had to provide for internal order and ll the
defense; costs of production are paid for by the
that is, it had to protect all members of person
society who buys and consumes the good. Li
from every other member of soci kewise,
ety. all the benefits of production go to
Government was thus responsible for the
setting consumer of the good. However, in
up a police force and a judicial system. Fin some
ally, situations, many outsiders gain or l
Smith opened a door that Milton Fri ose
edman significantly from economic transacti
(1977) and other conservative thinke ons.
rs were
later to bemoan, by approving gove 2
rnment 3
ADAM SMITH other people’s efforts. But when ev
eryone
These gains and losses imposed o reasons in this manner we get too
n those little
outside the market transaction are r education and everyone loses. The moral i
eferred to n this
as “externalities.” One good exam case is that too little will be spent on educa
ple of a tion
negative externality is pollution. In unless education is provided by
this case, the
some production costs (a less government.
clean In addition to explaining how ec
environment) will fall on people living n onomies
ear the grow, Smith also attempted to expla
polluting plant who do not buy th in how
e good incomes were divided up from pro
produced in the plant. Education is ducing
a good goods and services. As the first economis
example of a positive externality. t who
Everyone attempted to explain the principles deter
benefits from a better-educated lab mining
or force, income distribution, Smith made s
since it leads to higher productivity everal
and more contributions. These centered aroun
goods. Here, those people who do d his
not spend analysis of what determined the price of g
more time in school gain from th oods
e greater and what determined the returns going to
education of others. Under such circum those
stances, who produce goods.
there is less incentive for me to spend tim Smith began by distinguishing th
e and e market
money on my own education, since price of a good from the natural price of a go
I receive od.
the benefits of a high living standa The market price was the price that people
rd due to paid
in their everyday economic transactions.
Market
prices were determined by the fixed qua capital to produce more of this good.
ntity of
goods brought to market as well a This
s by the would tend to reduce market price and
demand for those goods. In contrast, the move
natural the market price closer to the natural pri
price of a good was an equilibrium price, ce. On
or the the other hand, if market price were bel
price towards which market prices ow the
moved or natural price, landowners and employers w
gravitated (Smith [1776] 1937, p. 55 ould
). seek some other good to produce, or some ot
Smith thought that an automatic me her
chanism use for their land or capital. This would redu
would bring the natural price and t ce
he market the supply of this good, increase its
price into equality. If market price market
exceeded price, and move the market price tow
natural price for some good, then laards its
ndowners natural price.
and employers would shift their l Smith next tried to explain what determ
and and ines
the natural price of each good. He ad
24
opted a
cost of production theory of price,
where
natural price was the sum of the costs of payi
ng
land, labor and capital for their role
in
production. Each of these factors was to be p
aid
their natural rates, and so Smith need
ed to
explain what determined these natural
rates.
His remarks about natural rents wer
e quite
confusing. At times Smith ([1776] 1937, p.
145)
regarded rent as a monopoly price, which res
ults
from land being a very scarce resource. At o
ther
times he ([1776] 1937, p. 146) provi
ded a
Physiocratic theory of rent (see al
so
QUESNAY), regarding rent as a paym
ent for
the surplus output obtained from using
land to
grow things. And at yet other times
Smith
([1776] 1937, p. 147) hints of a diffe
rential
theory of rent (see also RICARDO), whe eveloped
re rent the subsistence theory of wages, a do
is a payment to the owners of more pr ctrine that
oductive was to dominate economic analysis f
land. or the
Smith’s theory of natural profits is eve century following publication of The W
n less ealth of
satisfactory than his theory of natur Nations. On this view, the natural wage was t
al rent. he
Smith says that natural profits are a r rate that just allowed workers to survi
eturn to ve and
capital, which results from savings. Bu reproduce. If wages fell below subsis
t this is tence
merely a definition of natural profits; levels, workers would die; and with
it does fewer
not explain what determines the level of na workers offering their services, wage rates w
tural ould
profits. have to go up. On the other hand, if wag
To explain natural wages, Smith d es rose
everyone should pay about the same perc
entage
above subsistence levels, higher living st of their income in taxes. While toda
y many
andards taxes (like the individual income ta
would mean that few workers died an x) are
d more of progressive in their incidence, takin
their children would survive. Here the in g larger
creased fractions of income from the rich than the
number of workers would eventua poor,
lly force when Smith was writing most taxe
wages down to subsistence levels. s were
Whether or not Smith was indeed the regressive, taking larger bites from th
father e income
of economics, he was no doubt fath of poor families than from wealthy fa
er of the milies. A
field within economics known as proportional tax therefore would have re
“public duced
finance.” As we saw earlier, The the tax burden on low-income famil
Wealth of ies and
Nations described the proper rol increased the tax burden on those wi
e for th large
government in a thriving economy incomes and wealth.
. It also Second, Smith held that taxpayers
discussed how governments could should
best raise not be kept in the dark about their tax
revenues. es. They
Given public expenditure decisi should know in advance how much th
ons, funds ey owe
had to be raised through taxation t and when their tax payments were
o pay for due.
this spending. Smith laid down four Moreover, tax laws should not be c
rules or hanged
maxims for taxing the public. First, he he radically from year to year, which
ld that would
taxes should be proportional, mea make tax payments each year arbitrar
ning that y rather
than certain. ADA
A third principle of taxation was M SMITH
that taxes
should be levied at a time, and in on their gains. Taxing gains only when
a manner, assets
that is most convenient for people to are sold makes it easier for people to pa
pay. The y their
current practice of taxing capital g taxes.
ains when Fourth, Smith maintained that the b
they are realized, rather than when they aest tax
ccrue, was the one that was least costly to c
provides a good example of this ollect.
maxim in Taxation should not require great num
practice. If capital gains taxes were bers of
imposed tax collectors; it should not damage ec
every year on the appreciation of a onomic
ssets that incentives or create excessive efforts to
each person owns, people might be evade
forced to taxes (for example, smuggling goods
sell their assets just to pay the taxes so that
they owe taxes don’t have to be paid on imports);
and it
should not impose penalties that are so
severe
that they will ruin tax evaders. All t
hese
principles were designed to generate
the
greatest growth, or to have taxes do th
e least
amount of damage to economic growt
h.
With Marx and Keynes, Smith ranks as
one
of the three most important figures in
all of
economics. His vision was of self-
interest and
the national interest in perfect harmony, lea
ding
to continued economic growth and pro
sperity.
The only potential problems were gove
rnment
intervention in the free market, mono
polistic
practices by businesses, or bad tax p
olicies.
Thus Smith argued against mercantil
ist
restraints on trade, and wanted the B
ritish
government to control monopolies and obs
erve
care in the manner by which it taxed its citize
ns.
The vision of Smith was an optimist
ic one
of competitive capitalism increasing ty of
living British workers, and the deterioration
standards and making everyone better of
off. In industrial British cities. These were
the time since The Wealth of Nati the
ons was problems that Smith’s successors were
published, this vision has, to a large forced
extent, to grapple with.
come to pass. But it was not a quick
passage.
Nor was it an easy one. What Smith Works by Smith
did not
live long enough to see was the set The Theory of Moral Sentiments (175
of the 9), New
serious and deep problems that wo York, Augustus M.Kelley, 1966
uld
accompany economic gro 2
wth— 5
unemployment, pollution, the pover
JEREMY BENTHAM
Lectures on Justice, Police, Reven
ue and Arms JEREMY BENTHAM (1748–
(notes taken by a student in 1763), Ne
w York, 1832)
Augustus M.Kelley, 1964
An Inquiry into the Nature and C
auses of the Jeremy Bentham is known primaril
Wealth of Nations (1776), New York
y as a
, Modern
Library, 1937 philosopher and social reformer, and it
is as a
philosopher that Bentham made his
Works about Smith main
contribution to economics. This inv
Friedman, Milton, “Adam Smith’s Relev olved
ance for introducing the notion of utility into eco
Today,” Challenge, 20, 2, (March- nomic
April 1977), analysis.
pp. 6–12 Bentham was born in London in 1
Hetzel, Robert, The Relevance of 748. His
Adam Smith, father was a prosperous attorney who was
Richmond, Virginia, Federal Reserve able
Bank of to provide an excellent education f
Richmond, 1977 or his
Hollander, Samuel, The Economics children. Like many of the major fi
of Adam gures in
Smith, Toronto, University of Toro economics, Bentham was somewhat o
nto Press, f a child
1973 prodigy. Everett (1931, p. 5) reports
Rae, John, The Life of Adam Smit that he
h, London, knew the alphabet even before he could s
Macmillan, 1895 peak.
Ross, Ian Simpson, The Life of Ad Bentham was educated at the We
am Smith, stminster
Oxford, Clarendon Press, 1995 School in London. He enrolled at
Queen’s
College, Oxford, aged 12. He rec
eived a Bentham never practiced law. In part th
bachelor’s degree in 1767 and then
went on to is was
study law, first at Lincoln’s Inn in Lo because he disliked the law. But a
ndon and more
then at Oxford. Admitted to the Bar important consideration was that Ben
in 1769, tham
wanted to change the world, or at least impro
ve
26
things in England. So instead of follo
wing in
his father’s footsteps, Bentham began t
o read
widely in philosophy and political theo
ry. He
also assumed the role of social refor
mer,
attempting to persuade political leaders an
d the
public to adopt his many schemes to i
mprove
life in England.
Some of the more noteworthy re
form
proposals advanced by Bentham were
birth
control, adult suffrage (including wom
en), the
legalization of unions, and the develop
ment of
a civil service. But his pet project was
always
prison and penal code reform. In the
1790s
Bentham launched a campaign to cons
truct a
model prison, the Panopticon Peniten
tiary,
which he envisioned as “a mill for gr
inding
rogues honest, and idle men industri
ous”
(quoted in Mitchell 1950, p. 194). Wh
ile this
plan was never implemented in Engl
and, a
Panopticon was built in St Petersburg
in the
early nineteenth century (Halevy 1949, p. 2
96).
These many reform proposals gai
ned
Bentham considerable fame and num
erous
followers, and he soon became the lead
er of a
group of British reformers known a was
s “the published in 1787 (in Stark 1952–4, Vol. 1,
philosophical radicals.” They earned pp.
this title 124–207). Since the Middle Ages, h
because their proposals were radical eated
by the disputes have raged over whether limits sh
standards of late eighteenth-century ould
England be placed on interest rates. In centuri
and were justified by the philosophical do es past
ctrine the issue was primarily whether it was
of utilitarianism, or the view that all moral
actions to charge any interest at all on loans.
should promote the greatest happiness In the
for the late twentieth century, the issue bec
greatest number of people. ame
The only significant contribution whether interest rate ceilings should be
Bentham placed
made to economics proper was his on credit cards and consumer loans. But
badly while
mistitled Defence of Usury, which
of goods”
(Stark 1952–4, Vol. 1, p. 125). Benth
the focus of the debate has shifted am also
argued that since one party had agree
somewhat, d to pay
the main positions have not. On on high interest rates it was hard to consider u
e side of sury
the debate is the argument that borr an offense that should be prohibite
owers are d by
poor people who desperately need mon legislation.
ey; thus But the main case against laws r
charging interest or charging high egulating
rates of interest rates was the negative econ
interest takes advantage of the we omic
ak and consequences that would follow. First
destitute. On the other side it is ar , people
gued that would not lend money if they could
lending money involves some ris not earn
k. interest on their loan. Anti-usury laws, de
Compensation is thus required for signed
the many to help people in need, would actually
times one lends money but does not get r hurt the
epaid. poor by making it more difficult for
Adam Smith (1776, p. 339) su them to
pported borrow the money they needed. Seco
public regulation of interest rates th nd, usury
rough the laws kept innovative businessmen, as
establishment of interest rate ceilings. B well as
entham the poor, from borrowing money. T
thought this was inconsistent with his hurt
Smith’s everyone’s standard of living, the poor
laissez-faire principles, and he pointed as well
out that as the affluent. Third, Bentham argue
there was “no more reason for fixing d that if
the price the poor could not borrow the mon
of the use of money than the price ey they
needed to survive they would find JEREMY BE
other, less NTHAM
socially desirable, ways to secure t
he funds. was persuaded that his support of usur
Fourth, Bentham held that making usury y laws
illegal was in error, and that there should b
led to the rise of a black market fo e no
r loans at government regulations on interest.
even higher rates of interest. Again, Bentham’s main contribution to econo
anti-usury mics
laws would only hurt those people was not his case against governm
the laws ent
were supposed to help. Finally, ant regulations on interest rates, but his w
icipating ork on
new institutional economics (see also N developing the notion of utility and b
ORTH) ringing
to some degree, Bentham held that a considerations of utility-maximization
ny law as into
bad as usury prohibition would cau economic analysis. Contemporaries
se people of
to disrespect all laws and thereby ha Bentham had been employing the term “util
rm social ity”
relationships as well as economic relati in legal, political, moral, and econo
onships. mic
After reading Bentham’s book, Ad discussions. But their use of this noti
am Smith on was
vague and imprecise. It was not clear what t
his
term actually meant, how utility coul
d be
measured, or how different utilities co
uld be
compared. Attempting to put the soci
al or
human sciences on a par with the na
tural
sciences, Bentham wrestled with these
issues.
His hope was that through these effor
ts he
would become the Isaac Newton of the
moral
world (Mitchell 1950, p. 180).
Bentham began his Introduction t
o the
Principles of Morals and Legislation (19
48, p.
1) with the following bold and often
quoted
statement regarding human behavior: “
Nature
has placed mankind under the governa
nce of
two sovereign masters, pain and pleasure.
” He
then went on to define the principle of
utility
as a moral principle— considerations
about 7) the
pleasure and pain determine “what w number of individuals to whom it ex
e ought tends.
to do,” and the right thing to do will al Bentham enumerated fourteen sim
ways be ple
whatever maximizes net pleasure, o pleasures, including wealth, skill, po
r total wer, a
pleasure minus total pain. good name, memory, imagina
This implies that individuals could m tion,
easure benevolence, and malevolence; and t
their pleasures and pains. Bentham h welve
eld that simple pains including disappointment, re
such measurements were made by gret,
each and desire. He also identified various
individual and involved considering factors
seven that influenced pleasure and pain suc
dimensions of pleasure: (1) its intensity, ( h as
2) its
duration, (3) its certainty, (4) its pro 2
pinquity, 7
(5) its fecundity, (6) its purity, and (
JEREMY BENTHAM A further implication of utilitari
anism
health, gender, age, education, and firm was that education and legislation
ness of were
mind. Thus, while his contemporar needed to promote the maximum a
ies talked mount
in general terms, Bentham spoke c of happiness within the nation. Edu
oncretely cation
and tried to be precise and specifi was important because it enables peo
c about ple to
measuring utility. do a better job of adding up and co
Bentham argued that all pleasure mparing
s were the pleasures and pains that result
equal, regardless of their source. from
The different actions. Legislation
pleasures from watching television was
counted necessary to penalize acts that did
as much as the pleasures receive not
d from maximize happiness and also to pr
reading a book on economics or ovide
philosophy; and the pleasures recei incentives for people to act morally,
ved by or in
the poor counted as much as the pl ways that contribute to the maxi
easures mum
enjoyed by the very rich. Since the happiness of the population. Govern
pleasure ment,
of one person counts no more than for Bentham, became a mechanis
anyone m for
else’s pleasure, economic and so helping to increase the net happiness
cial of its
policies should not favor the rich, a citizens.
s most The doctrine of utilitarianism
policies did at the time Bentham also
was provides a means for
writing. evaluating
government policies and legislati
on.
Government acts were good that in comparing the benefits from that
creased expenditure with the costs produced b
net utility in the nation, while gove y the
rnment “most vexations and burthensome ta
action that decreased net utility i x”
n the (Stark 1952–4, Vol. 2, p. 202). He ar
nation was bad. As such, the util gued
itarian that if the benefits from governmen
calculation is an important forerunt
ner of spending exceed the costs produced f
contemporary cost-benefit analysis. rom
In fact, having to tax citizens, the spending sh
Bentham’s Manual of Political E ould
conomy take place. On the other hand, if the c
contains the first use of cost- osts
benefit arising from additional taxation wer
considerations to justify e
public greater than the benefits of the publ
expenditure. Bentham proposes that ic
public expenditure, the spending should not
spending should be take
evaluated by place and taxes should not be imposed
for
28 this purpose.
Despite its usefulness as a moral g
uide
and a policy tool, utilitarianism also g
ave
rise to numerous problems that wou
ld
greatly perplex later economists. Fir
st,
although Bentham struggled to make
the
notion of utility concrete, it is not cl
ear
how someone could, in practice, mea
sure
this elusive notion. It is also not clear
how
we could go about comparing, let al
one
adding up, the pleasures and pains
experienced by different people. Sec
ond,
many people have criticized utilitarian
ism
for being an immoral doctrine, since
it
ignored the notion of justice or fairnes
s as
a means of judging government and
individual actions. For example, und
er
utilitarianism, discrimination would
be
justified if it led to maximum happ circumstances, it is hard to talk about
iness right
in the nation. Finally, there is a curand wrong actions, or to hold peop
ious le
conflict between Bentham’s view of responsible for their actions.
human To be fair, Bentham was aware of
nature and his view of morality. If p these
eople problems with his theory. His respo
by nature are always under the domi nse
nation was that, despite such problems, hi
of pleasure and pain, and if they al s
ways system was the best one available f
act to maximize their net pleasure, or
then organizing society and for running
people cannot behave any differently a
than government. The only alternative wo
they actually behave. Under such uld
THOM
AS ROBERT MALTHUS
b e t o h ave eve r y o n e p i c k t Legislation, Riverside, New Jersey,
h e i r own Hafner,
standard for how government and 1948
society
s h o u l d b e r u n ; a n d t h i s a
l t e r n a t ive , Works about Bentham
according to Bentham, could only l
ead to Everett, C.W. The Education of Jere
chaos and anarchy. my
By providing a detailed explanat Bentham, New York, Columbia Un
ion of iversity
the principle of utility, as well a Press, 1931
s a Halevy, Elie, The Growth of Philos
concerted argument for using this ophical
notion Radicalism, New York, Augustus
in economic analysis, Bentham earn Kelley,
ed the 1949
title “father of utilitarianism.” He Mitchell, Wesley C., “Bentham’s Feli
also cific
became a philosophical guiding spi Calculus,” Political Science Quar
rit for terly, 33
the many generations of economis (June 1918), pp. 161–83. Reprinted
ts that in The
were to follow him. Backward Art of Spending Money
and Other
Essays, New York, Augustus M.K
Works by Bentham elley,
1950, pp.177–202
Economic Writings, ed. W.Stark, 3 vols.,
London,
Allen & Unwin, 1952–4 Other references
Manual of Political Economy, in Bentha
m 1952– Smith, Adam, The Wealth of Nations (1776
4, Vol. 2 ), New
Introduction to the Principles of M York, Modern Library, 1937
orals and
THOMAS ROBERT MALTHUS received a good education. At first,
(1766–1834) Malthus
was instructed by his father and private
tutors
Thomas Robert Malthus (pronounce in his home. Then he was sent off to ex
d Mal- cellent
THISS) is one of the most controversial figprivate schools. At the age of 18 he enro
ures lled at
in the history of economics. He achiev Jesus College, Cambridge where he s
ed fame tudied
chiefly from the population doctrine that is mathematics and natural philosophy.
now Although his father wanted him to
closely linked with his name. Contrary become
to late- a surveyor, Malthus decided to enter the chur
eighteenth-century views that it was ch.
possible He was ordained in 1788, thus beco
to improve people’s living standards, ming
Malthus Reverend Malthus. In 1793 he became a fel
held that any such improvements wou low
ld cause of Jesus College and curate of Okewood, a lit
the population to grow and thereby tle
reverse chapel in Wotton.
these gains. Malthus also sparked con While he was working at Wotton,
troversy Malthus
with his contemporaries on issues got into a heated argument with his father ab
of out
methodology (by arguing that econ the ability to improve the economic well-
omics being
should be an empirical rather than a d of the average person. His father thoug
eductive ht this
science), over questions of theory (by was possible; Malthus remained skeptical.
holding The
that economies can experience prolonged dispute prompted Malthus to do some read
bouts ing,
of high unemployment), and on policand then some writing, on the topic.
y issues The
(by arguing against free trade and a outcome was his Essay on Populatio
gainst n, which
government assistance to the poor). was first published in 1798.
Malthus was born in 1766 in the
town of
Wotton, in Surrey. His father was a w
ell-to-do 2
country squire, who made sure that 9
Malthus
THOMAS ROBERT MALTHUS
The population essay brought a training
Malthus school for employees of the East I
instant fame, and then (in 1805) a ndia
job as Company who were about to take
Professor of History, Politics, Com administrative posts in India. The t
merce, and eaching
Finance at the New East India Col position made Malthus one of the
lege near first
London. The college was primarily academic economists. And, as is true
of many best known were the Marquis de C
teaching jobs, it required little time ondorcet,
and effort. Robert Owen and William Godwin. Con
This left Malthus much free time to dorcet
socialize, (1795) argued that greater economic
to correspond with his many friends (es equality
pecially and more security for workers would
David Ricardo), and to stir up con improve
troversies their material well-being. Towards thi
regarding economic principles and poli s end he
cies. In advocated two reforms —a welfare s
addition to the controversies surrou ystem to
nding his provide security for the working po
principle of population, Malthus or, and
became government regulation of credit to ke
embroiled in important debates wit ep down
h Ricardo interest rates so that needy families
over the British Poor Laws and Corn La could
ws, the
benefits of free trade, and the poss 30
ibility of
gluts or insufficient demand for goo
ds.
In mid-eighteenth-century Engl
and the
industrial revolution was in full s
wing.
However, workers lived near the l
evel of
physical subsistence, and their co
ndition
worsened in the latter half of the e
ighteenth
century. Monotony and repetition chara
cterized
factory work; the tyranny of the fact
ory clock
and the pace of the assembly line were b
eyond
the control of all workers. The division of
labor,
praised by Adam Smith in The W
ealth of
Nations as the means to productivi
ty growth
and rising living standards, made
work so
routine that women and children could p
erform
jobs just as easily as men. Busines
s owners
logically preferred such workers bec
ause they
could be hired for less.
These circumstances gave rise to nu
merous
champions of the working class. A
mong the
borrow money at lower cost. Owen (see be economics “the dismal science,” an appell
low) ation
attempted to develop utopian commu that has stuck for more than two centur
nities in ies.
industrial towns that would improve Malthus held that the human con
both the dition
economic and social conditions of could not be improved for two reasons
working . First,
class families. Godwin (1793) was ev he believed that people were driven b
en more y an
radical in his analysis and his policy propo insatiable desire for sexual pleasure. T
sals. his led
He blamed the capitalist system for the po to population increases which, if l
verty eft
of workers. He then demanded that unchecked, would grow geometrically
property —1, 2,
be taken from its owners and given 4, 8, 16, etc. Second, Malthus believe
to those d that
whom it would benefit the most. This, Go diminishing returns operated in agric
dwin ulture;
claimed, would end all poverty, injust that is, as more and more land was brought in
ice, and to
human suffering in the world. cultivation, each new plot of land would be a
The Essay on Population (Malt ble
hus 1798) to grow less food than the previous pl
was inspired by these men; yet it was ot. For
written this reason, food production could at
to refute their arguments about the p best
ossibility increase in arithmetical proportions—
of improving economic conditions. 1, 2, 3,
Malthus 4, 5 etc. Since population was growin
thought that human betterment was impo g more
ssible rapidly than the food supply, at some po
because poverty and misery were the inevi int the
table population would exceed the food that
lot of the majority of people in every could
society. be grown to feed everyone. Starvation
Moreover, he argued that all attemp would
ts to ensue if there were no other checks
alleviate poverty and suffering, no mat on
ter how population growth.
well-intentioned and no matter how In the first edition of the Essay
well on
thought out, would only worsen thin Population Malthus allowed only “po
gs. It is sitive
this position that led Thomas Carlisl checks” on a growing population. Thes
e to call e were
THOM
AS ROBERT MALTHUS
factors that raised death rates—famine, added a set of “preventive checks”
natural —sexual
catastrophe, plague, and war. But in the s abstinence, birth control, and delayed ma
econd rriage.
and subsequent editions of the Ess These had the effect of lowering birth rates
ay Malthus and
population growth. Allowing preventiv High Price of Provisions (in Malth
e checks us 1970),
on population growth also toned d Malthus went even further in arguin
own the g against
pessimistic nature of the economic relief for the poor. This work argued t
forecast. hat poor
But Malthus still held that because of the relief would also lead to increases in
strong the price
human desire for sexual pleasure, of corn in England. Thus, not only wo
population uld poor
growth could not be reduced very relief hurt the poor, but by raising the
much by price of
preventive checks; the conclusion there necessities, poor relief would also
fore still hurt all
followed that it was impossible to British citizens.
improve Although best known for his po
overall economic well-being. pulation
The case against Condorcet, O doctrine, Malthus also made several theo
wen, and retical
Godwin followed simply from this and policy contributions to economic
analysis. s.
If wealth and income were distribut
ed more
equally, as Godwin advocated, or if
the poor
were made better off through vario
us social
reforms, as Condorcet and Owen su
ggested,
working families would respond b
y having
so many children that they would sh
ortly find
themselves impoverished again. It
is for
these reasons that Malthus oppose
d every
attempt to legislate relief for the p
oor, and
was opposed to granting charity to t
he poor.
This, he thought, would only lead
to more
poor people. Contemporary Malthus
ians (for
example, Murray 1984) make si
milar
arguments, maintaining that govern
ment aid
merely causes welfare recipients t
o have
more children, thus worsening t
heir
economic plight.
Several years later, in a pamphl
et entitled
An Investigation of the Cause of
the Present
At the theoretical level, Malthus ere the
provided result of economic prosperity and a
a justification for profits (see the Essay on measure
Rents of prosperity.
in Malthus 1970). As we saw earlier At the policy level, Malthus (18
, Adam 20)
Smith really had no theory of profits and c attempted to explain why economies
ould were
not explain what determined the level of pr subject to periodic depressions or gluts— ti
ofits. mes
Malthus filled in this gap left by Sm when businesses could not sell goods and w
ith. For hen
Malthus, profits were a return to the cunemployment remained very high.
apitalist The
for his part in producing goods. Work answer Malthus gave was that gluts w
ers who ere due
had tools and machinery were more prod to insufficient demand or too little sp
uctive ending.
than workers lacking this capital eq Conversely, Malthus’ explanation for
uipment. rising
By allowing such capital to be employed i prices was too much spending taking p
n the lace in
production process, capitalists contri the economy. It is for this reason that
buted to Keynes
production and deserved to be remu (1964, pp. 362ff.) has cited Malthus
nerated as an
based on this contribution. important precursor of his theory of
The Essay on Rents, also devel the
oped the business cycles.
differential theory of rent (see also RICA Just as Malthus (1820) was writin
RDO). g his
According to this doctrine, rents exPrinciples of Political Economy, Gre
isted at Britain
because of differences in soil fertilit suffered a major Depression. The cause
y and of this
because landlords made improvements o problem, according to Malthus, was t
n their hat as
land. Economic progress meant tha capitalism developed there was a tende
t the ncy for
demand for agricultural goods would capitalists to receive too much income. In f
increase act,
and less fertile lands would have to be he argued that capitalists got more income t
used to han
feed people. Differences in land fertility they could profitably invest. There we
would re two
therefore rise and so would rents. In
contrast 3
to Ricardo, for Malthus high rents w 1
THOMAS ROBERT MALTHUS
reasons for this. First, new machiner workers requires 15 years or more. Durin
y requires g this
new workers. While it is easy to b time there will be a shortage of labo
uild new r; wages
machinery in a short period of time, to get will rise, profits will fall, and capital
more ists will
prefer to hold their income as cash r Malthus
ather than believed that wages would rise in pr
investing. Second, Malthus held t oportion
hat new to the increased price of corn due to
machinery increases the productivit trade
y of labor restrictions. The losers would be capi
and reduces the need for workers. talists,
Because whose savings would fall as their i
capitalist received more income than the ncome
y could declined.
profitably invest they wound up sa Despite his many
ving too theoretical
much. Private virtue thus became public contributions, and despite being
vice— an
too little spending leads to a surplus important forerunner of Keynesi
of goods an
and reduces the need for workers. economics, Malthus remains an imp
The solution that Malthus prop ortant
osed for figure in economics primarily becaus
the problem of gluts followed direct e of his
ly from population doctrine. The term “Malth
his analysis; he wanted the state to a usian”
lter the will always connote pessimism abo
distribution of income so that cap ut the
italists
received less income and landow 32
ners
received more income. Malthus b
elieved
that landowners spent almost all
their
income; if they received more inco
me they
would consume it by hiring more
servants
and engaging in luxury consumpti
on. For
this reason Malthus supported the
British
Corn Laws (which were passed in 1
815 and
then repealed in 1846). This legis
lation
prohibited the import of grain into
Britain
until certain price levels were reach
ed. With
fewer grain imports, Malthus reas
oned,
more land would be used in Brit
ain for
growing food. This would incre
ase
(differential) rents due to diminish
ing
returns in agriculture and provide
more
money to landowners. In addition,
ability of mankind to improve its eco Economy, 6, 3 (1974), pp. 278–304
nomic James, Patricia, Population Malthus: His Li
well-being. fe and
Times, London, Routledge & Kegan Paul,
1979
Works by Malthus
Keynes, John Maynard, “Malthus,” in
Essays
An Essay on the Principle of Popul in Biography, New York, Norton, 195
ation as it 1, pp.
Affects the Future Improvement of Soc 81–124
iety, with
Remarks on the Speculations of
Mr. Godwin, Other references
M.Condorcet, and other Writers, fir
st edition de Cariat, Jean-Antoine-Nicholas, Marq
1798. A paperback edition of the uis de
Essay is Condorcet, Outlines of an Historic
published by Penguin. al View of
The Principles of Political Economy the Progress of the Human Mind,
Considered London, J.
with a View to their Practical Johnson, 1795
Application, Godwin, William, An Enquiry Concer
London, Murray, 1820 ning
The Pamphlets of Thomas Robert M Political Justice (1793), NewYork, Woo
althus, New dstock
York, Augustus M.Kelley, 1970 Books, 1992
Keynes, John Maynard, The General
Theory of
Works about Malthus Employment, Interest and Money (1936
), New
Bonar, J.R., Malthus and His Work, York, Harcourt Brace, 1964
New York, Murray, Charles, Losing Ground: Ame
Augustus M.Kelley, 1966 rican
Grampp, William D., “Malthus and Social Policy, 1950–1980, New York
His , Basic
Contemporaries,” History of Poli Books, 1984
tical
conditions in nineteenth-century Eng
land and
ROBERT OWEN (1771–1858) improve the living standard of those
working
there. As an economic and social thinker,
Robert Owen was a pioneer of
Owen
British argued for economic policy changes that
socialism and a leading figure of th would
e utopian improve the performance of the Br
socialist movement during the early ni itish
neteenth economy and the lives of British wor
century. Owen was also a practical s kers.
ocial and Owen was born in Newtown, a remote
economic reformer. As manager and part little
owner town in central Wales, in 1771. His fat
of a number of manufacturing pla her was
nts and a common tradesman, and so Owen
communities, he tried to humanize received
factory an ordinary education in the village
school. ROBER
This meant he could read, write legT OWEN
ibly, and
understand basic arithmetic. Since When Owen took over New Lanar
he was k, the
poorly taught at school, Owen fell ba town contained around 1,500 family mem
ck on his bers.
own resources—he read widely an In addition, around 500 pauper childre
d thought n were
carefully about everything that he re brought from the closest large town to live a
ad. nd
At the age of 10 Owen left W work there (Johnson 1929, p. 61). Fa
ales for milies
London to live with his brother a were housed in small one-room shack
nd seek s, with
fame and fortune in the world. He no sanitary arrangements, that were ow
worked ned by
as a draper’s apprentice, a retail c the firm. Drunkenness and thievery we
lerk, a re both
manufacturer of “mules” for spi common. The working conditions in th
nning e mills
cotton, and manager of a large cott were as bad as the living conditions
on mill. outside
Then Owen and a number of rich the mills. Hours were long and hard,
business wages
partners bought New Lanark, primit were low, and benefits such as health care w
ive mills ere
in the Scottish lowlands, from his unknown (Owen 1813–14).
wife’s Owen began by building a second
father for £60,000. Like many mill storey
s at the on every house so that each family coul
time, New Lanark was located far f d have
rom any two rooms. He built streets, started r
town. Mill owners therefore had t egular
o offer garbage pick-ups, and set up wor
their workers food, lodging and ker
other committees to improve cleanliness in
benefits. This system gave the o side
wners homes. Then he bought up all the shops in to
control over not just the work of wn
their that were privately owned. By purchasing f
employees, but their entire lives. ood,
While his partners desired the fuel, and other goods in large quantity,
greatest and by
possible profit, as manager of Ne forgoing any profit, Owen was able to
w Lanark, charge
Owen looked upon the mills as a l workers low prices for all necessities.
aboratory This
for social experiments in educatio action alone increased the standard of
nal and living
industrial reform. The changes that Owe of his employees by 25 percent. Owe
n made n also
at New Lanark developed his reputaestablished a general community fun
tion as a d. All
social reformer. workers contributed one-sixth of their
wages
to the fund, and the fund provided free medi
cal
care to all residents of New Lanark. were working full-time in England’s fa
But his main efforts were directe ctories.
d at the Owen also built parks and playgrounds
children of Lanark. This was becaus so that
e Owen children could have places to play.
believed that it was necessary to provide the Most important of all was educatio
right n. All
environment for people early in life, when children at New Lanark between the
their ages
character and personality were most m of 1 and 10 were provided with fr
alleable. ee
He totally opposed employing young schooling. Today, when universal educ
children. ation
His first decision as manager of New is taken for granted, it is hard to realize
Lanark how
was to stop importing paupers as ap radical Owen’s proposal was. In ear
prentices ly
and to stop employing children under
10 years 3
old. At this time, children as young as 3
6 or 7
ROBERT OWEN quality of the output was high, profits were
good,
nineteenth-century England, most and the workers were content and i
people dolized
believed that education was only Owen. But Owen wanted to do even
for the more for
upper class and was not necessary the residents of New Lanark. However
for the , he was
children of the working poor. Tho constrained by the demands of his c
se few o-owners
reformers who advocated educat for greater profits and by pressure f
ing rom his
children of the working class limit competitors who insisted on sque
ed their ezing
proposals to simple computations, everything possible out of their wo
writing, rkers to
and reading the Bible. Owen, ho reduce production costs. Owen came t
wever, o realize
wanted all children to learn, to th that his reforms had to be made univ
ink, to ersal, so
dance and sing, and to understand that no employer could gain a com
how the petitive
world works. He believed that ed advantage by using cheap child l
ucation abor,
was the basis for character format mistreating their workers, or not educ
ion and ating the
that it had the power to reconcile children of their employees. Owen (18
class 15) thus
differences and unite the world. began reporting on the deplorable con
Over the course of several yea dition of
rs Owen manufacturing plants in Britain, and argue
managed to turn New Lanark into d that
a model the factory system should be judged by its ef
community. Working conditions were g fects
ood, the on character and health as well as on the w
ealth
it creates. He also pressed for legisl
ation that regulated the way factory owners d
would prohibit child labor and m
andate id
education for young children. business and the state assumed respons
The first Factory Act was passed ibility
in 1819. for protecting those too weak to pro
It limited child labor slightly, but tect
only in themselves.
certain types of manufacturing pla The failure of a political solution
nts. This to the
watered down and ineffective law d problem of child labor, as well as deteriorat
issuaded ing
Owen from further pursuing a politi economic circumstances, led Owen to
cal route change
to the reforms he thought neces the focus of his efforts. With the end
sary. of the
Although the Factory Act fell far Napoleonic War in 1815, the Briti
short of sh
what Owen wanted and what he government no longer needed goods t
was o fight
advocating, an important principle hFrance. Reduced demand led to an oversu
ad been pply
established—for the first time gov of farms and an oversupply of goods that pil
ernment ed
up in warehouses. Farm servants a
34
nd
manufacturing labor were discharged
at the
same time that the army was dischar
ging a
large number of men In addition, mac
hinery
was increasing production and reduci
ng the
demand for labor. As more people los
t their
jobs, sales fell and economic problems
grew
even worse—agricultural wages fell
by 50
percent and close to 50 percent of t
he
population were paupers.
Owen (1821) saw only three pos
sible
outcomes to the problem of unemplo
yment
and poverty: (1) to stop using machiner
y, (2)
to let the millions of people who coul
d not
find work starve, or (3) to find jobs
and
income for the poor and unemployed
. He
argued that instead of unemployme
nt community.
insurance, the government should set Owen held that the poor in Englan
aside d could
capital to develop small villages of produce wealth for the nation and could
around escape
1,200 people. People in these comm poverty if they were given a chance to work a
unities nd
or “villages of Co-operation” would a decent environment in which to live. Howe
provide ver,
goods for their own subsistence, buyhis plan was greeted with ridicule on t
ing as he one
little as possible from the outside. hand and outright rejection on the other
Any hand.
surplus they produced would be used t And like his attempt at getting factory legisla
o trade tion
with the outside world for any nece passed, his call for co-operatives failed to sp
ssities ark
that could not be produced within any significant legislation in England.
the
policy
issues, and it is here that Owen was a
Hoping that the New World woul pioneer.
All contemporary labor legislation
d be more —such as
receptive to his ideas, Owen came to the limiting the use of child labor, and est
United ablishing
States in 1824. He set up a coop minimum wages and decent wor
erative king
community in New Harmony, Indiana ac conditions—goes back to Owen. The v
cording iew that
to the principles he had been advo eradicating poverty requires educati
cating for on and
years. But life in New Harmony wa developing human capital (see also
s not the BECKER)
socialist utopia Owen envisioned also goes back to Owen. But perhaps
. The the most
community could not produce enoug important contribution of Owen was his ut
h to meet opian
its material needs; there was consta vision. It is the vision of a capitalist
nt shirking system
of work by community members; a producing horrible problems in addition t
nd people o great
could not get along with each other. A wealth, and the possibility of fixing
s a result these
of this experience Owen became e problems with intelligent policies.
ven more
disillusioned and pessimistic; and i
n the last Works by Owen
years of his life he even lost the optimistic
spirit A New View of Society (1813–14), N
that he had as a young man. ew York,
Owen discovered no economic relati Cassell, 1991
onships; Observations on the Effect of the M
no theories, modes of analysis, or t anufacturing
echniques System, London, 1815
bear his name. His focus was primarily on Report to the County of Lanark of
a Plan for DAVID RI
relieving Public Distress and Re CARDO
moving
Discontent by Giving Permanen The Marriage System of the New World, Lee
t Productive ds, J.
Employment to the Poor and Workin Hobson, 1838
g Classes The Life of Robert Owen, 2 vols . (1857
(1821), New York, AMS Press, n.d. –8), New
The Book of the New Moral Worl York, Gordon Press, 1973
d in Selected
Works of Robert Owen, ed. Gre Works about Owen
gory Claeys
(1836–44), London, Pickering, 19
Cole, G.D.H., The Life of Robert Owen, Lo
93
ndon,
Frank Cass & Co., 1925
Cole, Margaret, Robert Owen of New
Lanark,
London, Batchworth Press, 1953
Johnson, D.C., Pioneers of Reform, N
ew York,
Burt Franklin, 1929
DAVID RICARDO (1772–1823)
David Ricardo was interested first and fore
most
in issues concerning income distributi
on and
economic growth. He sought to unde
rstand
how the economic pie was divided up
among
rent, wages, and profits; and he soug
ht to
understand the principles causing eco
nomies
to grow and decline. Ricardo saw f
ree
international trade as one important f
orce
leading to greater economic growth. But he
saw
diminishing returns in agriculture as
a
counterforce, one which tended to sq
ueeze
profits and slow down economic growt
h.
Ricardo was born in London, in 177
2, to a
prosperous Jewish family. His educa
tion
prepared him to follow his father into the wo
rld
of trade and finance. True to plan, at 14 Rica is father
rdo when he married a Quaker and conve
entered his father’s brokerage firm. rted to
Rather Christianity. Penniless, and having to
quickly he took to the business. He support
was a family, Ricardo borrowed all the mo
regarded as an extremely able negotianey he
tor, and could and began his own brokerage firm. W
rather adept at difficult and arcane o hile
perations the first years were difficult, he quickl
such as currency arbitrage (see y made
also
COURNOT). 3
Ricardo became estranged from h
5
DAVID RICARDO Parliament. As might be expected,
Ricardo
a great fortune and became indep quickly became a recognized expe
endently rt in
wealthy by the age of 26. This allo Parliament on financial matters, and
wed him he spoke
the leisure time to pursue his intelle up frequently on critical economic iss
ctual and ues such
scientific interests. These included s as currency and banking, tariffs, taxat
tarting up ion, and
a laboratory, beginning a mineral c the agricultural depression.
ollection, Economists remember Ricardo p
and joining the Geological Society rimarily
of Britain. for his theory of comparative advanta
Ricardo came across a copy of ge. This
The Wealth theory provides the justification vir
of Nations in 1799 while on vacatio tually
n with his every economist uses to support fre
wife. According to legend, after reading e trade.
Smith But Ricardo made several other la
he decided to spend his spare time sting
studying contributions to economics. He explaine
economics. Ricardo also joined a d how
group of national income got distributed among
distinguished economists who met reg wages,
ularly to profits, and rents; how income distr
discuss economic issues. This group ibution
included changed over time; and
James Mill (the father of John Stu what the
art Mill), consequences of changing income distri
Bentham, and Malthus. bution
In 1819, Ricardo bought a seat in the were for Britain. He also developed t
House he labor
of Commons. The seat was in the Irish bo theory of value.
rough In The Wealth of Nations, Adam Smit
of Portarlington, an area that Ricar h held
do never that a country would export goods t
visited. To be fair, at the time it o other
was not countries if it were more efficient at prod
uncommon for wealthy people to bu ucing
y seats in these goods. Smith called this “ab
solute
advantage.” According to this view
, if Japan For Ricardo, there was no problem
produced cars, computers, food, and
clothing if one
more efficiently than the US, Japa country was less efficient at produci
n would ng
export all these goods to the US. The US everything. Trade, he contended, depen
would ded on
run a large trade deficit with Japan, comparative advantage, or relative eff
giving it iciency,
money in exchange for these Japane rather than on absolute efficiencies. R
se goods. icardo
then demonstrated that countries woul
36
d tend
to sell those goods it was relatively
more
efficient at producing, or that it was rel
atively
less inefficient at producing. Throu
gh
specialization each country would ga
in from
foreign trade.
A simple numerical example helps to
make
this point. Suppose both Japan and the US ea
ch
produce two goods—automobiles and
rice. In
the US, one worker can produce either
one car
or one ton of rice in any given year. In
Japan,
one agricultural worker can produce t
wo tons
of rice in a year, and one manufacturing wor
ker
can produce three cars in one year. Fo
r both
rice production and automobile manufact
uring
Japanese workers are absolutely m
ore
productive than American workers. Ho
wever,
Japanese workers are relatively more e
fficient
at producing cars and US workers are relativ
ely
less inefficient at producing rice. Jap
anese
workers are three times more efficie
nt in
manufacturing cars, and US workers a
re only
half as efficient as the Japanese when it
comes
to growing rice. Japan produces 150 cars and 100 tons
What Ricardo demonstrated is that bo of rice
th the for the year. Combined output for b
US and Japan will gain from special oth
izing in countries is 250 cars and 200 tons of ri
what it does relatively better at produc ce.
ing, and Now consider what happens when
then trading with each other. The argument Japan
runs specializes in car production and the
as follows. Suppose the US has 200 US
workers specializes in rice production. In Japa
and Japan has 100 workers, and that n 100
workers workers make 300 cars; in the US 200 work
are divided equally between car productio ers
n and produce 200 tons of rice. World outp
rice production in each country. The ut has
US then gone up by 50 automobile due to
produces 100 cars and 100 tons of ric specialization.
e, while
Moreover, because both countries ca
n benefit
The next important question tha from economic specialization and tr
ade only
t must be if the rate of exchange falls within
answered is who gets this extra output. R these
icardo boundaries, both countries have str
noted that this depends on the rate of exc ong
hange incentives to make sure that the exch
between the two goods. If Japan trades 10 ange rate
0 cars between cars and rice will fall within this r
to the US for 100 tons of rice, Japan ange
winds up (or that the exchange rate between t
with 200 cars (the initial 300 produced le he US
ss the dollar and the Japanese yen will pu
100 traded to the US) and 100 ton t trade
s of rice, within this range). Ricardo, unfortuna
while the US winds up with 100 cars tely, did
and 100 not explain where actual exchange rates
tons of rice (the 200 produced domestical would
ly less fall within this range, or how gains fr
the 100 traded for cars). Here all the gains om trade
from would actually get divided up betw
specialization and trade go to Japa een two
n. On the countries. That job was left for John Stuart
other hand, if Japan trades 150 cars t Mill.
o the US A second theoretical contributio
for 100 tons of rice, all the gains n of
from Ricardo was the first concerted the
specialization (the 50 cars) go to the ory of
US. income distribution. Ricardo also dre
Within these boundaries (1 ton w out the
of rice important practical consequences of his t
trading for 1 car and 1 ton of rice t heory.
rading for Ricardo’s theory of distribution h
1.5 cars) both countries will benefit from ad three
trade. elements—a theory of rent, a theory to ex
plain DAVID RI
wages and a theory of profits. His CARDO
theory
showed how national income was d But usually there is a limited supply of go
ivided up od
into these three categories, and what ha land. When the most fertile land is us
ppened ed up,
to rents, wages, and profits over t the next most fertile plot of land has
ime as to be
economies grew. In analyzing rent, cultivated. Gains immediately accrue t
Ricardo o those
followed Malthus (1970) in advanwho own the most fertile land. If the
cing a most
differential theory of rent. Accord fertile land yields ten bushels of corn p
ing to the er acre
differential theory, rents stem from the di and the second best land yields eight
fferent bushels
fertility of various plots of land. Wheneve per acre, some farmer should be willing
r there to pay
is an ample supply of rich and fert close to two bushels of corn for using t
ile land, he best
people will not pay for the use of this land rather than the second best land.
land and As worse and worse quality land
there will be no rent on the land. gets
brought into use, differential rents wil
l rise.
“When land of the third quality is tak
en into
cultivation, rent immediately rises on
the
second, and is regulated…by the differ
ence in
their productive powers. At the same ti
me, the
rent of the first quality will rise” (Ri
cardo
1951–5, Vol. 1, p. 70). If the third be
st land
yields seven bushels per acre, rent on t
he best
land will rise to around three bushels pe
r acre,
while the second best plot of land n
ow
commands a rent of one bushel per acr
e.
Worker wages, Ricardo held, depen
d upon
subsistence requirements—the minim
um that
workers would need to survive. Unlike
Smith,
Ricardo interpreted this minimum
in
conventional terms rather than in phy
sical
terms; it “essentially depends on the habits
and
customs of the people” (Ricardo 1951 ry must
–5, Vol. therefore take account of the higher l
1, p. 97). As the general standard of iving
living standards to which people have gro
improves, so too does the minimum wwn
age that accustomed.
can be paid to workers. The minimum Finally, Ricardo held that profits
income were a
needed to survive in late twentieth- residual, or what was left over for the capita
century list
America was not the same as the m after paying workers their wages a
inimum nd
income needed in nineteenth-century A landowners their rents. Ricardo also he
merica. ld that
Indoor plumbing and private baths, profit rates would be the same in every indust
while ry,
uncommon in the nineteenth centurysince if one industry received higher
, were profits,
essential at the close of the twentieth
century. 3
Wage levels in the late twentieth centu 7
DAVID RICARDO crease in
wages. Only with such a pay increa
more capital would enter that industry an se can
d push workers buy higher-priced food and
down prices and profits. Similarly, maintain
capital their standard of living.
would leave industries earning low profi With both wages and rents rising, the p
ts. This rofits
would tend to raise prices and profit of the capitalist must get squeezed. Lando
s. wners
These theories of rent, wages, a receive higher rents, wages rise to keep up
nd profit with
led Ricardo to a rather unhappy co rising food costs, and so profits m
nclusion. ust fall.
Over time, as a country grows, its p Moreover, as profits fall, the motiva
opulation tion for
will likewise grow. More people m accumulating capital disappears. At th
ean more is point,
mouths to feed and more food that economic progress comes to an end
has to be and the
produced. Consequently, less fertile la economy stagnates.
nd must Ricardo made several suggestio
be brought into use. This will raise ns for
the rent dealing with this looming crisis. Fi
on all land and increase the rents that rst, he
must be argued for a repeal of the British Cor
paid to well-off landowners. As th n Laws.
e cost of First passed in 1660, the initial goal
producing food rises (due to high of the
er rent Corn Laws was to stabilize the price
payments), so too must the price of f of grain
ood. The in England. High duties on imports a
subsistence theory of wages maint nd low
ains that export duties were imposed when
higher food prices must lead to an in the
domestic supply was great. When th
e harvest
was bad, import fees were removed Ricardo saw that a repeal of the
, thereby
allowing more grain to come into Corn
England, Laws would increase imports of foreign
and export duties were imposed. This grain
initially into Britain. This would have two ben
helped exert a downward pressure eficial
on grain effects on profits. By keeping down the
prices in times of shortages. But over price
time the of food, grain imports would keep d
legislation did not work as intended own
. By the wages and stop the squeeze of wage
early 1800s, the Corn Laws wer s on
e not profits. Greater grain imports would
stabilizing prices. Rather, they were also
keeping mean that Britain itself would need
up grain prices and protecting the in to
comes of produce less grain. This would reduc
landowners who gained from the hi e the
gh prices amount of land used domestically to
of corn grown on their land. grow
food. Since the least fertile land woul
d be
38
taken out of cultivation, and since rents
were
a differential, rents in Britain would fal
l and
reduce the squeeze on profits.
A second policy reform advocate
d by
Ricardo was greater capital accumula
tion.
More capital equipment would improv
e the
productivity of land. If all land we
re
improved equally, there would be no c
hange
in differential rents. And with wage
s
determined by habitual subsistenc
e
requirements, wages would not be aff
ected
by greater productivity. Thus the gains
from
capital accumulation would go primari
ly to
business profits. Moreover, this increa
se in
profits would generate greater investm
ent in
the future, the hiring of more workers
, and
even greater productivity growth.
Ricardo eventually came to enter
tain with Adam Smith that machinery assi
considerable doubt that capit sted
al the division of labor and thus contrib
accumulation could improve British l uted
iving to economic growth. In addition, follo
standards. The third edition of h wing
is Smith, most economists thought that
Principles of Political Economy (Ri the
cardo introduction of machinery would not
1951–5, Vol. 1) added a chapter en lead
titled businesses to lay off workers. Earl
“On Machinery.” This chapter disc y
usses editions of the Principles concurred in
the possibility that new machinery this
would view, and claimed that greater use
harm workers by displacing labor. B of
efore machinery would lower the price of g
Ricardo, virtually all economists ag oods
reed
ther
consequence was that it made Ric
rather than displacing labor. Thu ardian
economics even more pessimistic.
s all With
society would benefit. technological unemployment loomi
But after reading a pamphlet b ng on
y John the horizon, not even capital accumu
Barton (1817) entitled Observations lation
on the could be counted on to improve the
Condition of the Labouring Classes welfare
, of society (see Hicks 1969).
Ricardo changed his mind. With the Finally, no summary of
aid of the
numerical examples, Barton show contributions made by Ricardo wou
ed how ld be
capitalists might make more mon complete without mentioning his the
ey by ory of
hiring fewer workers and employin value. Ricardo’s theory of value b
g more egan
machines. Based on these examp with observation that “commodities
les, derive
Ricardo concluded that workers wer their exchange value from two sou
e right rces:
to fear and oppose the introduction from their scarcity and from the qu
of new antity
machinery on the grounds that it of labor required to obtain them” (Ri
would cardo
likely lead to what we now call 1951–5, Vol. 1, p. 12). Scarcity was
“technological unemployment.” only
One consequence of the new m important in determining the value of
achinery those
chapter was that Ricardo came to goods that cannot be reproduced—
agree things
with Malthus that continued hi like rare paintings, books, coins, and
gh wine.
unemployment was possible. Ano These goods were not important
in DAVID RI
Ricardo’s opinion. The vast major CARDO
ity of
goods were reproducible, and wh its value gets determined by the direct
at was and
important in determining their val indirect labor needed to produce it.
ue was By
the amount of labor needed to pr going all the way back, the value of e
oduce very
them. Two sorts of labor were nece good could reduce to the amount of l
ssary— abor
direct labor and indirect labor. Direcneeded to produce it directly and t
t labor he
is the amount of work time or the amount of labor needed to produce
number the
of workers needed. Indirect labor machinery required in the productio
is the n
machinery used in the production p process.
rocess. Ricardo held that reproducible go
Since machinery is a reproducible ods
good, would exchange at rates that mainl
y
depended on the amount of labor (di
rect
plus indirect) needed to produce them
. If
it took twice as much labor to produ
ce a
boat as it took to produce a car, a
boat
would be twice as expensive as the car.
But
if it took three times as much labor
to
produce a boat, a boat would cost t
hree
times what it cost to buy a car. O
ne
important implication of this theory
of
value is that (relative) prices depen
d
exclusively on production and technol
ogy.
Demand for cars and boats is irrelevant
. All
that matters is the way that cars and
boats
each get produced, in particular how
much
labor is required to make each good.
Ricardo did not hold a total labor t
heory
of value. He recognized that different
capital
structures might be required to prod
uce
different goods. Thus if two goods b
oth get taken into account when using past
require 1,000 hours of labor, but one labor,
good or machines. Ricardo (1951–5, Vol. 1, p.
uses all direct labor and the other req 36)
uires a thought that the amount of capital and
good deal of machinery, the two goo labor
ds may employed in producing every good
not cost about the same amount. The was
reason roughly the same. Hence, the quantit
for the cost differences in this cas y of
e is labor needed to produce a good wa
essentially the interest cost on the s a
earlier reasonably good approximation of the
labor used to produce machinery. Svalue
uch of every good, but it was not a per
interest does not need to be paid fect
when measure of relative prices (see Stigler
producing some good by using only 1958).
direct
(i.e. current) labor. But interest does n 3
eed to 9
ANTOINE AUGUSTIN COURNOT
With Smith and Marx, Ricardo became
was one the basis of the neo-Ricardian or S
of three giant figures in classical ec raffian
onomics, school of economic thought.
the period stretching from the
late
eighteenth century to the late nine Works by Ricardo
teenth
century. He made several lasting Works of David Ricardo, ed. Piero Sraffa, 1
and 0 vols.,
important contributions to economi Cambridge University Press for th
cs—the e Royal
labor theory of value and the the Economic Society, 1951–5
ory of
comparative advantage being the
Works about Ricardo
most
prominent. Ricardo also developed t
he first Blaug, Mark, Ricardian Economics, New
rigorous economic theory of distri Haven,
bution, Connecticut, Yale University Press,
and drew out its consequences. F 1958
inally, Hicks, John, “Ricardo on Machinery,” in A
Ricardo had a vision of an economi Theory
c system of Economic History, New York,
where relative prices were deter Oxford
mined University Press, 1969, pp. 168–71
mainly by the costs of production Hollander, Samuel, The Economics
, and of David
where demand and utility played littl Ricardo, Toronto, University of T
e or no oronto
role. This vision was subsequently Press, 1979
adopted Stigler, George J., “The Ricardian Th
and formalized by Piero Sraffa, and eory of
Value and Distribution,” Journal of Chicago, University of Chicago Press, 1
Political 965,
Economy, Vol. 60 (June 1952). Rep pp. 326–42
rinted in
Essays in the History of Econo
Other references
mics,
Chicago, University of Chicago Pres
s, 1965, Barton, John, Observations on the Circums
pp. 156–97 tances
Stigler, George J., “Ricardo and the 93 which Influence the Condition of
Per Cent the
Labor Theory of Value,” Amer Labouring Classes of Society, Lond
ican on, John
Economic Review, 48 (June 1958). R & Arthur Arch, 1817
eprinted Malthus, Thomas Robert, The Pamphl
in Essays in the History of Ec ets of
onomics, Thomas Robert Malthus, NewYork, Au
gustus
M.Kelley, 1970
40
ANTOINE AUGUSTIN COURNO
T
(1801–77)
Antoine Augustin Cournot (pronoun
ced
CORE-KNOW) developed much
of
contemporary microeconomics. He w
as the
first economist to draw a demand cur
ve, he
explained how market structure affected pr
ices,
and he provided the first analysis of
how
markets reach equilibrium. But Cournot is
best
known for his analysis of the proces
s of
arbitrage and for his analysis of pri
cing
behavior in industries with only two
firms
(duopolies).
Cournot was born in Gray, a small
French
town east of Dijon, in 1801. He atten
ded the
local high school until he was 15 and then sp
ent
four years studying on his own. Duri
ng this
time he primarily studied law and mathema
tics. memoirs. This job provided ample fre
In 1821 Cournot was admitted to th e time,
e École and Cournot used his time well. He
Normale Supérieure in Paris, but w wrote a
hen the thesis in astronomy, a doctoral disserta
school was closed for political reas tion in
ons he mechanics, and he obtained a law de
transferred to the Sorbonne. gree.
After graduating in 1823, Cournot spe Cournot also began writing articles
nt ten on
years helping a French marshal wri mathematics. These articles earned h
te his im
ANTOINE A
UGUSTIN COURNOT
substantial notoriety among distin and wrote about the philosophy of his
guished tory and
French mathematicians, and event the theory of knowledge. Only later in
ually a life did
position as professor of analysis and me Cournot become interested in econo
chanics mics. His
at the University of Lyons. major economic treatise, Researches
Cournot turned out to be an e into the
xcellent Mathematical Principles of the The
administrator as well as an exc ory of
ellent Wealth (Cournot 1838), was the first
mathematician. He soon became Rec work in
tor of the economics to bring the differential calculu
Academy of Grenoble, and over t s into
he next economic analysis, and the first appli
several decades he held many cation of
other calculus to the pricing behavior of th
administrative posts. Cournot was e firm.
Inspector Surprisingly, Cournot’s contemp
General of Education in Paris, ser oraries
ved as showed no interest in this pioneerin
Commander of the Legion of Honor, g and
and was revolutionary approach to microeco
Rector of the University of Dijon. nomic
In 1862 Cournot retired from admin analysis. Many historians of econo
istration mic
and returned to Paris in order to devote th thought have speculated that Courn
e last ot was
years of his life to scholarly resea ignored because other French econ
rch and omists
publishing. Unfortunately, with his failed to understand the mathematic
eyesight s of the
deteriorating, Cournot was able to produ calculus or what light the calculus could t
ce little hrow
during his retirement. on economic principles. However,
Early in his professional career, Ekelund
Cournot and Hébert (1990) put some of the
published mainly in the field of ma blame
thematics. directly on Cournot. They contend
He then developed an interest in p that
hilosophy, Cournot was ignored because he fa
iled to he removed all the mathematics fro
apply his mathematical economics to thm his
e main treatise. But this book (Cournot 1863
issues of the day. ) also
A quarter century after publicati made no impression on his contempo
on of his raries.
Researches, Cournot took another Cournot (1877) then made a third an
stab at d final
economics. Hoping to reach a larger attempt to simplify his theories. This work
audience also
was ignored.
Although his contemporaries may
have
failed to appreciate him, subseque
nt
economists have recognized the ma
ny
analytical advances due to Cournot.
These
advances involve developing microeco
nomic
concepts and modes of analysis. The
most
important microeconomic ideas due
to
Cournot are his analysis of demand,
his
analysis of firm costs and producti
on
decisions, and his explanation of ho
w an
arbitrage guaranteed that prices of g
oods
would be equal throughout the world.
Cournot (1960, Ch. 4) was the f
irst
economist to describe and define the down
ward
sloping demand curve, noting that the qua
ntity
demanded for any good, such as a bo
ttle of
French wine, depended on the price
of that
good. He noted that rising prices would red
uce
the quantity of wine that people woul
d buy,
while falling prices would increase the qua
ntity
of wine demanded. Cournot then drew the f
irst
demand curve relating prices and the
amount
of wine consumers would purchase. Unlike
the
demand diagrams of today, where price
is put
on the vertical axis and quantity o where demand and supply were equa
n the l. If
horizontal axis (see also MARSHA demand exceeded supply for some goo
LL), d, the
Cournot recognized that the quantity price of that good would rise. With de
of goods mand
demanded by consumers was the de greater than supply, businesses woul
pendent d see
variable in the relationship and that p their inventories decline; this would
rice was be a
the independent variable; so Cournot cor signal to the firm that it could charge
rectly higher
put quantities on the vertical axis an prices for each bottle of wine. At this h
d prices igher
on the horizontal axis. price, demand would be lower; thus de
Cournot (1960, p. 81) next show mand
ed that
an equilibrium price existed at the 4
point 1
ANTOINE AUGUSTIN COURNOT
would come to equal supply more firms require more grapes, more bott
closely. les and
Conversely, if supply exceeded d corks, and more workers.
emand, Cournot recognized the practi
sales would be sluggish and bus cal
iness importance to the firm of knowing
inventories would not get bought up whether
. In this costs and revenues will rise or fal
case, firms would know that if they l as
wanted production changes. He defined m
to sell their stock of wine they wo arginal
uld have cost as the cost of producing one mo
to lower prices. This would increase re unit
demand, of output (one more case of wine) an
thereby bringing it closer to supply. d noted
Cournot also introduced several that the marginal cost of producing on
economic e more
concepts concerning business costs. unit could be increasing, decreasin
He was g, or
the first to distinguish variable co constant as more goods were prod
sts from uced.
fixed costs. Fixed or overhead costs, Similarly, he defined marginal reven
such as ue as the
insurance and the rent payments o additional revenue going to the fir
n a wine m as a
bottling plant, stay constant as th result of producing and selling one m
e firm ore unit
produces more and more wine. Varia of output or case of wine.
ble costs Using these two notions, Cou
include expenses on raw materials, p rnot
arts, and explained how a monopolist should
labor. Expenditures on these items behave
must rise in order to maximize its profits. He
as output increases. To produce mo proved
re wine, that profits are at their maximum w
hen the that wine, profits will rise and the firm
firm produces at the level where margin should
al cost produce that case of wine.
equals marginal revenue, and then se Once the firm compares marginal
ts a price cost
based upon the demand for that qu and marginal revenue to determine
antity of how
goods. If the last case of wine a m much to produce, it must decide how
onopolist much
is considering producing has marg to charge for what it produces. Here
inal cost the
greater than its marginal revenue, demand curve plays an important ro
the firm le.
should not produce that case for i Wanting to receive as much money
t loses as
money by doing so. On the other ha possible, the firm looks to demand,
nd, if the which
marginal revenue from producing shows the price that people are willin
one more g to
case of wine exceeds the cost of p pay for that level of output, and it ch
roducing arges
the price indicated by that curve.
At the opposite end of the spectrum
42 from
monopoly lies the market structure “p
erfect
competition.” Cournot defined t
he
characteristics of this type of industr
y.
Perfect competition requires large num
ber of
small firms. It also requires no restric
tions
on new firms entering the industry.
Such
restrictions could be in the form
of
government regulations or they could
be the
high start-up costs for any new firm. C
ournot
(1960, p. 90) noted that only with p
erfect
competition are sellers unable to alter
market
price by varying the amount that they s
upply.
Cournot also analyzed the prici
ng
principles for duopoly, market which ha
s two
sellers and two sellers only. For his an
alysis,
Cournot assumed that neither seller co
uld set
prices. He also assumed that each seller
knew
the demand for the product it produc require the second firm to also lower its
ed, and price
that costs were similar for both firms. if it is to remain competitive. Moreove
From these assumptions Cournot r, the
was able second firm faces similar decisions reg
to show how the decisions of each arding
firm how much to produce. It too can atte
affected the price in the market and t mpt to
hus the increase production and profits. Any de
output decisions of the other firm. If o cision
ne firm made by the second firm will affect the
increased production in an attempt t price
o raise that the first firm could charge and the
profits, that firm would have to lower iprofit
ts price it could make. When the second firm ch
to sell the additional output. This anges
would production and prices, the first firm has
new
ANTOINE A
UGUSTIN COURNOT
information, and might to make of foreign currencies. Here he explain
a new ed how
decision about how much to prod arbitrage guarantees an equilibrium
uce and set of
what it can charge. This decision, in t exchange rates among a number of d
urn, will ifferent
affect the situation facing the second currencies that will be totally consist
firm. It ent.
too will have new information and Arbitrage is merely the process of
will have buying
to make a new decision about pro and selling in different places and
duction. making
One might think that the process of money on any price differences.
each firm For
altering its price and output decisi example, if a bushel of corn goes fo
ons in r $1 in
response to the decisions of its riv Mexico and $1.10 in Canada, one ca
al might n earn
go on forever. But Cournot showed profits buying corn in Mexico and
that this then
would not be the case. Eventually a reselling the corn in Canada. Moreov
situation er, this
would result where neither firm activity will increase the demand for
could corn in
improve their position (make more Mexico and thus push up its price. In
profit) by Canada,
increasing or decreasing the amoun the greater supply of corn will tend t
t of the o lower
good that they produced. This was a prices. Thus, arbitrage pushes prices
duopoly to the
equilibrium (see Machlup 1962). same level all over the world.
Finally, Cournot (1960, Ch. 3) tu What is true of buying and selling
rned his corn is
attention to international prices or t likewise true of trading foreign exch
he price ange—
arbitrage will equalize the price of Japan, but in England 100 yen costs
foreign only
currency throughout the world. In 1 75 cents, since 75 cents will buy ha
996, 100 lf a
yen cost around $1 in Japan, and th British pound and half a pound buys
e British 100
pound cost around $1.50 in Engla yen. Arbitrage works here just like it d
nd. For id in
exchange rates between the yen, th the corn example. Americans would
e dollar make
and the pound to be consistent, one money buying yen in England and se
British lling
pound had to equal 150 Japanese yen in Japan. These trades would pus
yen. h up
Arbitrage assures that this will be t the price of yen in England (due to gr
he case. eater
Consider what would happen if t demand) and reduce the price of ye
his were n in
not so—for example, suppose th Japan (due to the greater supply). T
at in his
England £1 traded for 200 yen. F process of arbitrage will continue unti
rom an l the
American perspective 100 yen cost price of all three currencies were eq
s $1 in ual
throughout the world.
Cournot is surely one of the m
ore
underrated figures in the history
of
economics. Given the many importa
nt
conceptual and analytical advances he
made,
and given the mathematical nature of
these
advances, it is surprising that his repu
tation
has not been much greater. In part, t
his is
probably due to the fact that Cournot f
ocused
too much on technique. Another lik
ely
reason is that he had few disciples
to
promulgate his ideas and his approac
h to
economics. Nonetheless, his ma
ny
contributions to microeconomic theory
have
held up over time and they remain the
heart
of microeconomic analysis.
Works by Cournot
Researches into the Mathematical Pri
nciples
Works about Cournot
of the Theory of Wealth (1838), t
rans. Ekelund, Jr., Robert B. and Hébert, Ro
Nathaniel T. Bacon , New York, Au bert F,
gustus “Cournot and His Contemporaries:
M.Kelley, 1960 Is an
Principes de la thèorie des richesse Obituary the Only Bad Review?,”
s, Paris, Southern
Hachette, 1863
Revue sommaire des doctrines écono
miques, 4
Paris, Hachette, 1877
3
JOHN STUART MILL rtant
forerunner of the marginalist schoo
Economic Journal, 57, 1 (July 1990), p l that
p. 139– began to arise in the late nineteenth c
49 entury.
Machlup, Fritz, The Economics of Mill was born in London in 18
Sellers’ 06. His
Competition, Baltimore, Marylan father, James Mill, was a promin
d, Johns ent
Hopkins Press, 1962 historian. James Mill devoted consi
Moore, Henry Ludwell, “The Perso derable
nality of time each day to teaching his childr
Antoine Augustin Cournot,” Quarte en, and
rly Journal he attempted to give them the best p
of Economics, 19, 3 (1905), pp. 3 ossible
70–99 education. The story of these efforts i
Plantz, Don V., “Cournot’s Recherc s quite
hes: Some remarkable. Mill ([1873] 1957, p. 5)
Insights on Its Influence Upon t reports:
he “I have no remembrance of the time
Development of Economic Thought, when I
” Western began to learn Greek. I have been told
Economic Journal, 2 (1964), pp. that it
195–208 was when I was three years old.” At
7 years
of age, Mill was reading the philos
ophical
JOHN STUART MILL (1806– dialogues of Plato. At 8 he began t
o learn
73) Latin. Over the next four years math
ematics
was added to his studies. Mill lea
John Stuart Mill was an impo rned
rtant elementary geometry and
algebra
transitional figure in economics. I
thoroughly, as well as the differen
n some
tial
ways he was part of the classical sc
calculus and higher mathematics.
hool that
On
included Smith, Malthus and Ricard
reaching age 12, the advanced stage
o; but in
of his
other respects Mill was an impo
education began with the study of lo
gic and
philosophy. One year later Mill ([
1873] attending many discussions between
1957, p. 19) went through “a comple
te course his
in political economy,” which incl father and David Ricardo.
uded But it was the constant presence
of
Bentham in the Mill household that ha
d the
44
greatest impact on the young Mill
.
Conversations with Bentham, and re
ading
his works, convinced Mill to follow
in
Bentham’s footsteps and become a s
ocial
reformer. On reaching adulthood, M
ill
sought to spread the gospel of Bent
ham
throughout the world. From 1834 to
1840
he edited the Westminster Review, a
major
intellectual periodical in Britain and
the
vehicle of communication for the
Philosophical Radicals (see al
so
BENTHAM). He then began publish
ing
books on economics, philosophy, poli
tics,
and social theory. These works made
Mill
one of the best known and most resp
ected
figures in nineteenth-century England
.
In his many books and articles Mill
made
several important contributions
to
economics. Some of these extended
and
completed classical economic analysi
s;
others broke new ground by analyzi
ng
economic phenomena as relationships
and
trade-offs. Mill also made several
contributions to the broad area wher
e
economics and philosophy overlap. T
hese
explained the philosophical foundati editions, and dominated economic tea
ons of ching
economics, and set forth justificatio in England for half a century (until
ns for the
individual freedom and limits on gov publication of Marshall’s Principles).
ernment One important contribution of th
intervention in economic and social e
affairs. Principles was its analysis of future
The Principles of Political Econ economic growth. Here Mill attempt
omy (Mill ed to
1848) was essentially a text find a middle path between Smith a
book nd
summarizing the economic wisd Malthus. As we have seen, Smith s
om aw
prevailing in mid-nineteenth- societies becoming wealthier as a resu
century lt of
England. The book went through nu greater freedom to trade, technologic
merous al
In this
case, as in Malthus, the result wou
innovation, and the division of la ld be
lower wages and higher profits. The
bor and living
capital investment. Malthus, on th standard of the ordinary worker ha
e other d to
hand, saw economic progress limite decline.
d by the A second scenario closely follow
press of people against fixed resour ed the
ces. Mill analysis of Smith—capital accumul
saw both sets of forces operating ation
at once. increased faster than the population
Rather than predicting the ultimate grew.
outcome Here real wages rose, thus making
of these conflicting forces, he (Mil the
l 1848, average worker better off.
Book 4) set forth several possibili In a third scenario, the supply capi
ties or tal and
scenarios for the future. As a resu the population increased at the sam
lt, Mill e rate,
deserves credit for being the first ec but technology was relatively stab
onomist le.
to recognize that long-run trends Because the supply of labor and the
or demand
outcomes cannot be forecast with c for labor increased at the same rate
ertainty, there
but depend on how various opposin would be no change in real wages. B
g forces ut since
work themselves out over an extend technology did not improve, inferio
ed time r land
period. A first scenario followed had to be used to feed the grow
pretty ing
much along Malthusian lines— population because the most fertile
population land
grew more quickly than capital would be used first (see also RICA
and RDO).
technology could increase output. This increased the cost of producing
food. JOHN STUAR
With food prices and rents increa T MILL
sing,
profits had to fall. This is essentia Mill thought that the third scenari
lly the o was
Ricardian outcome. the most likely of all the possible fu
Fourth, Mill noted that technol ture
ogical outcomes. Living in the middle of t
advances might improve more rapi he
dly than Industrial Revolution, and having n
capital and population grew. This o
would experience with concerted, long-
make it easier to grow food, and wo term
uld lower technological advance, it was some
both wages and rents. As a result what
profits natural for Mill to believe technolog
would rise, and the economy would ical
prosper. progress must come to an end. Whe
n this
happened, Mill argued, capital accumu
lation
and economic growth also would come
to an
end, as Ricardo predicted.
Most classical economists feared th
e end
of economic growth. Mill, in contra
st,
thought that the stationary state would
have
many benefits. The most important b
enefit
of all was that the end of growth woul
d end
the perpetual rat race of industrial life.
I am not charmed with the ideal of li
fe held
out by those who think that the norm
al state
of human beings is that of struggling
to get
on; that the trampling, crushing, elbowing
, and
treading on each other’s heels.
(Mill 1848,
p. 334)
Mill helped bring classical theory
to
completion in other ways. One proble
m left
unanswered by the theory of compar
ative
advantage (see also RICARDO) was
how
the gains from international trade g
et need for Japanese automobiles and co
divided up between countries. Mi uld
ll easily do without Japanese automobi
explained that most of the gains from les
trade (i.e., if our demand for Japanese
would go to that country with the l automobiles was relatively elastic), w
ower hile
demand and the greater elasticity Japan could not do without American
of food
demand. If demand is elastic, a chan and had a great appetite for Americ
ge in an
price will yield a large change in qua food, most of the gains fro
ntities m
bought by consumers. On the other h specialization and trade would go to
and, if the
demand is inelastic, consumers will
not be
4
swayed much by price changes.
Mill explained that if the US had 5
less
JOHN STUART MILL y and
demand as schedules or relationsh
US. The US would sell food to Jap ips
an at a (Stigler 1965). In the work of S
high price and get their automob mith,
iles Ricardo, and other classical econo
cheaply. On the other hand, if Am mists,
ericans supply and demand were treated
are hooked on Japanese automobil as
es and quantities of goods brought to marke
cannot get these goods elsewhere, t and
while as quantities of goods bought by
Japan finds alternate sources of f consumers. Mill recognized that qua
ood, ntities
most of the gains from trade will responded to changes in price. As
go to prices
Japan. In this case, the high and in increased businesses would bring f
elastic orth
demand for cars in the US mean greater quantities of goods to the m
s that arket,
Americans pay high prices for Ja and as prices fell consumers wou
panese ld
cars, while the low and inelastic d purchase greater quantities of the
emand goods
in Japan means that the Japanes provided by businesses.
e get Mill was also the first to formula
American food cheaply. te the
Mill made his most lasting contr notion of opportunity cost. Any hu
ibutions man
to economics not when he exten action involves giving up the opport
ded unity
classical economic analysis, but w or ability to do something else. T
hen he he
began to think in new ways. He opportunity cost of any action incl
was the udes
first economist to speak of suppl financial costs as well as non-
financial
costs. Deciding to pursue a colle
ge have been earned by not going to sch
education requires spending mone
y on ool.
tuition, books, and other things. Th The total opportunity cost of a colle
ere are ge
opportunity costs involved since education includes both the money sp
other ent
goods cannot be purchased beca for schooling and the lost wages fr
use a om
college education was bought. Thes attending school.
e other Mill’s most important contributio
g o o d s a r e g ive n u p , o r a r en to
l o s t economics may be his rejection of t
consumption opportunities. But the he
re are classical wage fund doctrine. This do
further costs of a college degree. ctrine
When holds that worker wages were a for
going to school one is not earning m of
money. capital and paid out of a fund th
Thus one gives up the income that at
could businesses accumulated before produ
cing
46 goods. On this view, the only way
to
increase both wages and employment
would
be for the entrepreneur to accumulate
more
profits. Mill (1869b) argued that there
was
no fixed amount that businesses had t
o pay
labor. The amount of money that fir
ms
could pay as wages was flexible, and it
was
determined by the willingness of empl
oyers
to pay workers more. Mill also noted
that
business owners could always reduce
their
own consumption of goods, for exa
mple
buying $5 million homes rather than
$20
million homes. This would make m
ore
money available for workers. Consequ
ently,
there was no fixed wage fund. More
money
was always available to increase wag
es or
to hire more workers; and business o
wners
and workers can always negotiate inition
over of Political Economy” (in Mill 1844)
wages. was
Mill achieved fame not only fo the first attempt by an economist to ex
r his amine
economics, but also for his philosop the issue of economic method. Mill w
hical anted
and political writings, both of which to know if the social, behavioral, and
dove- moral
tailed with his economic work. Mill (sciences (such as economics) were lik
1863) e the
defended the utilitarian philosoph natural sciences. His answer was “n
y o”
developed by his father and Benthambecause controlled experiments were
, and not
that had come to form the foundatio possible outside the natural sciences.
n for It is
much of economics. impossible to set up two economies
More important, his “On the Def ,
angles.
Finally, On Liberty (Mill 1859
identical in all respects except for )
discussed the limits of government
the one and
factor we wish to alter, in order to s societal restrictions on individual fre
tudy its edom.
overall impact. Since economic kn Mill argued that the state and societ
owledge y had
could not come from experience, a right to restrict individual freedom
Mill only
reasoned that it must come from to keep one individual from harm
introspection. We know from exa ing
mining another individual. On Liberty was
ourselves that people behave in w thus a
ays that ringing endorsement of laissez-
attempt to maximize the pleasure faire. In
they contrast to Smith, who argued for la
received. And we know that all atte issez-
mpts to faire because it maximized material
maximize pleasure are constraine well-
d by being, for Mill laissez-faire was desi
nature—we can only work so hard rable
and so primarily because it resulted in the g
long, and we can only produce so reatest
much in individual self-development.
any given year. Economics, for Mill, The
is thus Subjection of Women (Mill 1869a)
the science that deduces the conse also
quences advocated equality for women on
of these assumptions, just like geo the
metry is grounds of self-development. Mill a
a science that proves theorems a rgued
bout that the greatest obstacle to the libe
triangles and circles after starting ration
with of women was received opinion a
assumptions about points, lines, and nd
custom that relegated women to JOHN STUAR
a T MILL
subordinate position in society.
This counted among the very best and m
limited the development of half t ost
he important economists. Part of the rea
population. It also limited the abil son
ity of for this is that while he added bits
society to progress. By allowing wo and
men to pieces to economic analysis, Mill mad
compete with men for jobs and for ae no
ll other major advances. Moreover, as a transit
positions, society would gain by ha ional
ving the figure, Mill left no school of follower
best and most qualified person in s to
every further and continue his work. Yet ano
position. ther
During his lifetime, Mill was r factor is that there was no single are
egarded a of
as one of the two or three most pr economics in which Mill specialized
ominent and
economists. However, today Mill made major contributions. Rather, the
is not work
of Mill encompassed numerous an
d
disparate areas —methodology, theo
ry,
policy, labor economics, internationa
l
trade, and political theory.
Works by Mill
Essays on Some Unsettled Questions o

f Political
Economy (1844), New York, Kelley, 1
968
Principles of Political Economy, 2 vols
. (1848),
New York, Oxford University Press, 1
994
On Liberty (1859), Indianapolis, Indian
a,
Hackett, 1978
Utilitarianism (1863), Indianapolis, Indi
ana,
Bobbs Merrill, 1957
The Subjection of Women (1869a), Ca
mbridge,
Massachusetts, MIT Press, 1970
“Thornton on Labour and It’s Claims,” Fortn
ightly
Review, 5, May 1869b, pp. 505–18. Repri
nted
in Collected Works of John Stuart
Mill,Vol. 5,
Essays on Economic and Society,
London, my of J.
Routledge & Kegan Paul, 1967, pp. S.Mill, Durham, Duke University Press,
631–68 1972
Autobiography (1873), Indianapolis, InStigler, George J., “The Nature and Ro
diana, le of
Bobbs-Merrill, 1957 Originality in Scientific Progress,” in
Essays
in the History of Economics, Chicago, Ill
Works about Mill inois,
University of Chicago Press, 1965, pp
Hollander, Samuel, The Economics o . 1–15
f John
Stuart Mill, Toronto, University of
Toronto 4
Press, 1985 7
Schwartz, Pedro, The New Political Econo
KARL MARX to go to
the University of Bonn to study law, but sh
KARL MARX (1818–83) ortly
after beginning his studies he beca
me bored
Although the name Karl Marx is m
with legal issues and developed an i
ost closely nterest in
associated with socialist economic philosophy. In order to pursue this i
systems, nterest
Marx actually wrote very little about soc Marx transferred to the University of
ialism. Berlin,
Rather, he studied the operation of which at the time was the hub of H
capitalist egelian
economies and analyzed the problems th philosophy.
at arise According to Hegel, human life
under capitalism. He then argued t was
hat these constantly in flux; every idea and ev
problems could not be remedied by ery force
economic generated an opposite force, and the
policies, or by other actions to make the s tension
ystem generated by these two opposing forc
work better, because they were es es would
sential inevitably lead to change. Marx embr
characteristics of capitalism. These aced the
problems, Hegelian notion of change; and his id
Marx thought, would continue to f ea of all
ester and economic systems generating opposin
eventually destroy capitalist econo g forces
mies. and then undergoing radical transfo
Marx was born into a middle- rmation
class Jewish derives from the philosophy of Hegel. It s
family in Trier, Germany in 1818. He hould
was first go without saying that this vision th
educated at home by his parents and Baro reatened
n von political leaders, who preferred the st
Westphalen, a close friend and neigh atus quo,
bor of his and business leaders, who saw Marx
father. Marx then went on to attend high s and his
chool followers as attempting to ruin their good t
in Trier. Upon graduating, he decided hing.
In 1841 Marx received a Ph
.D. in
Philosophy, and in 1843 he marri was banned by Prussian censors. Seei
ed the
daughter of the Baron von Westphalen. ng no
Unable future in Germany, Marx moved to Paris, wh
to get an academic job teaching ph ere
ilosophy, he began to associate with numerous socia
and without many marketable skills, he lists
worked and communists. In Paris, Marx also
as editor of the liberal-left news met
paper Frederick Engels. Engels was the son
Rheinische Zeitung. Within a year of a
the paper wealthy textile manufacturer and a well-
known
economist in his own right. His classi
48
c, The
Condition of the Working Class in
England
(Engels 1844), described the sad stat
e of
working class families in the industrial
towns
of northern England. Engels and Marx qui
ckly
became friends and collaborators. Per
haps as
important, Engels provided financial s
upport
to Marx during the rest of his life.
Because of his radicalism, Marx
was
expelled from Paris after a short period of ti
me.
He tried living in Brussels, but was
soon
expelled from there as well. Finally, he
moved
to London, where he was accepted by polit
ical
authorities, although not necessarily with
open
arms. Marx lived the last 33 years of his
life in
London, spending most of his time a
t the
British Museum, reading and writi
ng
economics.
The economic writings of Marx atte
mpt to
understand how capitalist economies
work,
and where capitalism fits into the eco
nomic
history of mankind. Marx saw capitalis
m just
as one phase of an historic process th
at all capitalism due to the rise of businessme
economies move through. Human ec n who
onomic engaged in small-scale manufacturing
activity, Marx noted, began in hunti and
ng and who traded goods both domestically
gathering societies. Then people settle and
d down internationally.
and formed agricultural communities, As was true of each economic epoch
which , Marx
shortly developed into feudal econo recognized that capitalism possessed
mies. both
Under feudalism, landowners provi positive and negative aspects. Amon
ded g its
protection for peasant fanners, and p positive attributes was the ability to i
easants ncrease
provided part of their output to the lando average living standards through the
wner. use of
Feudalism, in turn, was transformed more advanced technology and machinery
into (see
communications and transportation n
etworks,
also SMITH), and the ability to attract w and the establishment of a national b
ank. But
orkers Marx saw these policies as band-aids
to towns and cities, and away from “ to make
the idiocy life more tolerable under capitalism; he di
of rural life.” d not
But the negative attributes of c think they could fundamentally change th
apitalism e way
dominated the positive ones, acco capitalism operated or keep it from
rding to self-
Marx. Moreover, Marx saw these pr destructing. No matter what policies
oblems as were put
being essential parts of the capitalis into effect the capitalist system was
t system. destined
Reform efforts, which attempted to miti to collapse at some point under the
gate the weight of
negative aspects of capitalism, could no the many problems that it created. Mo
t really st of the
solve the deep-seated problems, o economic writings of Marx attempt
r save ed to
capitalism from its ultimate fate. Indeed, identify and explain these problems.
in The One crucial characteristic of cap
Communist Manifesto, Marx and Engel italism,
s (1948, according to Marx, is that it expl
Ch. 2) advocated a number of suc oits
h reform individual workers. To understand the
measures including free public libr notion
aries, free of exploitation, it is necessary to und
education, the abolition of child fact erstand
ory labor, Marx’s analysis of the value of any
a graduated income tax, the end good.
to all Following Ricardo, Marx adopted a
inheritances, government labor
control theory of value. This theory held t
of hat the
value of any good depended upon th KAR
e amount L MARX
of labor spent producing it. This lab
or could depreciation that is familiar to all acc
either be direct labor, which is curr ounting
ent work students. Variable capital refers to the
effort, or indirect labor, which is the current
amount wage bill, or what workers are paid t
of labor that went into making the o help
machinery produce goods. Marx defined surplus
that was used in producing the goo value as
d. the value of a product over and abov
Marx then divided the value of e wage
all goods and depreciation costs. It is similar to the m
into three categories—constant capital, ore
variable familiar notion of profit. Marx provi
capital, and surplus value. Constan ded a
t capital second, and similar, perspective on s
referred to the machinery, plants, urplus
and value. He noted that the essence of cap
equipment used up in the production of a italism
good; was to take money (M), use this money
this notion is similar to the noti to buy
on of things (labor and machines) that could pro
duce
some commodity, and then sell that commo
dity
for a greater amount of money (M’).
Surplus
value could thus also be defined as
the
difference between M’ and M.Marx he
ld that
the appropriation of surplus value by
the
owners of capital constitutes exploitati
on.
Exploitation was made possible by t
he fact
that workers had to offer their services or w
ork
effort because they owned no capital and co
uld
not support themselves in any other
way.
Through their daily efforts, workers
created
something of value. They produced goods,
and
they produced machinery that could
help
produce even more goods in the futur
e. But
workers did not receive the full valu
e of
everything they produced. Some of th
e value
they created was taken by their empl
oyer in workday, so that during each day m
the form of surplus value. At the begin ore
ning of surplus value was created. Second, t
the workday, workers produced enoug hey
h goods could increase the intensity of work
so that the sale of these items would effort,
pay for so that workers produced more goods
their wages plus wear and tear on in a
the given time period. One means of incr
machinery used in production. For the easing
rest of work intensity was to increase the spe
the day, however, laborers worked to ed of
enrich the assembly line. Another was to inc
their employer. rease
Marx noted that capitalists had the monitoring and control of worker
three s, so
means at their disposal to increase s that workers were less able to slack of
urplus f.
value and thus the exploitation of w
orkers. 4
First, they could increase the length 9
of the
KARL MARX ere limits
to the exploitation of workers by t
In these cases, workers produc hese
ed more methods—workers could physically
during the day; and with variable an endure
d constant working just a certain number of ho
capital fixed, more output would tra urs each
nslate into day, technology and physical capab
greater surplus value. Finally, capitalis ilities
ts could limited the extent to which an employ
increase surplus value by reducing er might
the wage speed up the assembly line, and fami
bill. One obvious way to do this wo lies had
uld be to to be paid enough to buy the necessi
lower the wages of current empl ties that
oyees. would enable them to survive and wo
Alternatively, women and children rk in the
could be future. Competition, however, forced
hired to replace men and paid less. I firms to
n the late maximize their exploitation of work
twentieth century we could look a ers. In a
t firms competitive environment, not every f
moving to less developed countrie irm will
s (where be profitable and thrive. Firms unable
labor costs are much lower than in to do as
developed well as their many competitors will i
countries) as another way to reduce nvariably
the wage go out of business. Competition amo
bill. These three strategies all have ng firms
the same thus forces each firm to exploit its
effect—they lower wages and in workers
crease more in order to lower costs, increas
exploitation or surplus value. e profits,
Marx did recognize that there w and remain in business. Only those
firms
exploiting their workers to the full
est extent But, contra Adam Smith, the division of
possible will survive; other firms wil
l cease to labor
exist because their costs of produci did not promote dexterity and skills; r
ng goods ather it
will be too high. Competitive capita transformed the production process i
lism thus nto
guarantees that workers live on the simple, monotonous tasks. Work bec
edge of ame
subsistence and that they get exploitboring and had no meaning except as a
ed to the source
maximum extent. of income; it destroyed the creative, emoti
A second major problem with conal,
apitalism aesthetic, and intellectual potential of
that Marx noted is that it creates a the
lienated worker (see Braverman 1974). Thus,
workers. Alienation had four aspe rather
cts. First, than work being an integral part of human li
under capitalism workers become fe,
alienated this aspect of alienation leads to the f
from how they produce. Marx tho amiliar
ught that aphorism “life beginning when work e
human beings were naturally creat nds.”
ive and A second reason for alienation u
wanted to control and shape their environder
nment. capitalism is that workers lose control over
the
50
goods that they produce. The indivi
dual
craftsman, Marx noted, could take pr
ide in
what he produced. For the assembly
line
worker, however, this is not the case.
These
workers are not responsible for produc
ing the
final product and can take little pride
for the
small part they play in producing it. In additi
on,
the capitalist system leads inexorably
to the
production of cheap and shoddy merch
andise.
Capitalists always seek to produce at the lo
west
possible costs. Again, survival is at stak
e. One
way to cut costs is to cut corners. Thus
quality
tends to suffer, and workers tend to t
urn out
cheap junk that they can take no pride in havi
ng
made. By losing control over the me
ans of wages. This means that the relative posit
production workers become alienate ion of
d from the worker worsens as a result of working ha
what they produce. rd.
A third reason for alienation is th The standard of living for workers rem
at under ains at
capitalism the surplus value created by wo the bare minimum necessary for survival, w
rkers hile
goes to enrich their employer. People work capitalists increasingly become richer
hard and
all day long. But these efforts only i richer. Marx believed that this characteristi
mprove c of
the absolute position of the capitalist; capitalism stemmed from the fact t
they do hat
not improve the absolute standard of l capitalists monopolized the means
iving of of
the individual worker who puts in all the ef production. Workers had to work in o
fort. rder to
Workers always and only receive sub earn enough money to eat and survi
sistence ve.
capitalist system when the pressure
s on
Capitalists, in contrast, owned enough workers became too great. And co
mpetition
property among capitalists guaranteed that s
so that they could live well without uch
working pressures would continue to rise and
or producing. Thus workers were a build.
t a great Marx always placed his analysis of the
disadvantage relative to capitalists class
and were struggle in an historical context, not
forced to accept subsistence wages. ing over
Finally, Marx contended that and over that capitalism arose out
under of a
capitalism the labor power of the predominantly agricultural and feudal
worker society.
becomes the property of the cap Capitalism destroyed feudal ties. It
italist would
employer. The worker is thus aliena therefore not be surprising if capitali
ted from sm were
himself or herself. There is a loss of indi replaced with another socio-economic s
vidual ystem,
freedom and self-respect; employ socialism, where workers owned the
ment means of
becomes a form of slavery for the w production and made decisions reg
orker. arding
Alienation and exploitation of work working conditions, quality of output
ers lead , prices,
inevitably to a class struggle bet wages, etc. Moreover the forces tha
ween t would
capitalists, who own the means of p eventually cause capitalism to self-
roduction, destruct
and workers, who do not. This strug were all integral parts of the capitalis
gle, Marx t system.
thought, would lead to the destructi First, capitalism was about taking
on of the fortunes
and using them to create larger fortunes. KAR
Large L MARX
fortunes are needed because they br
ing power profits away. All firms, therefore, des
and prestige. Also, each capitalist w ire to
as always become large and all desire to be mono
under pressure from other capitalists polies.
. Anyone The process of competition crushes th
trying to stand still would quickly e weak
be forced and the small, or they become absorbed
out of business by competitors, los by the
e prestige big and the strong. Furthermore, to r
and power, and have to seek employ emain
ment as a competitive a firm had to constantly i
worker (i.e., be exploited and aliena mprove
ted). worker productivity; but technolog
Second, capitalism was characteri ical
zed by an improvements required increasing amo
unending drive towards monopol unts of
y and capital. Thus larger and larger firms were nee
economic concentration. Monopoli ded
sts made to supply this rising capital requirement.
huge profits. In contrast, the firm These
s in a tendencies towards monopoly meant tha
competitive environment tend to co t small
mpete their businesses would be bankrupted by large fir
ms,
small businessmen and women would
soon
become workers for these large monopolies,
and
more and more people would come to
resent
monopolies.
A final force leading to the demi
se of
capitalism was the tendency for profit r
ates to
fall. Capitalism is all about trying
to
accumulate more and more wealth. To
win at
the game, more and more efficient ma
chinery
must be bought and used. As such,
the
production process comes to rely on rel
atively
more capital and relatively less labor. The pr
ofit
rate though equals total profits divided
by the
initial monies put out to produce goo
ds. In
Marx’s terminology, the rate of profit
equals
the ratio of surplus value to constant
plus
variable capital. Since surplus value han
comes anything else, that will help bring abo
from exploiting workers, using m ut the
ore end of capitalism.
machinery and fewer workers can onl These many pressures on the cap
y reduce italist
surplus value and the rate of profit. system, Marx thought, would continue to b
The tendency to replace labor uild
with until the system is finally destroyed. As
machinery also increases unemploymen Marx
t. This (1957–62, Vol. 1, p. 929) writes:
“reserve army” of the unemployed h
elps to the mass of misery, oppression, sla
keep wages down and counters the t
endency very,
of the rate of profit to fall. But at the same ti degradation and exploitation grows; b
me, ut with
higher unemployment and lower wa
ges lead 5
to greater social unrest. And it is this, more t 1
KARL MARX ore equal
distribution of income and wealth
this there also grows the revolt of the w under
orking socialism than existed under capitali
class, a class constantly increasing in n sm. But
umbers, beyond this, there is nothing in the
and trained, united and organized b
y the very
work of
mechanism of the capitalist proc Marx. Yet, even without a clear visio
ess of n of the
production…. The centralization of th future, Marx continued to inspire ni
e means neteenth-
of production and the socializatio century workers to organize and to rebel a
n of labor gainst
reach a point at which they b capital oppression.
ecome With Adam Smith and John Ma
incompatible with their capitalist inte ynard
gument.
Keynes, Marx must be regarded as on
The integument is burst asunder. Th
e knell of e of the
capitalist property sounds; the ex three greatest figures in the histor
propriators y of
are expropriated. economics. Unlike Smith, who prima
rily saw
Marx had little to say about eco the benefits that would accrue from
a free
nomic life market capitalist economy, Marx saw the
or the economic world after capitalism. dark
He was side of capitalism and saw this as le
clear that workers rather than capitalists ading to
would its ultimate demise. And unlike Keyn
own the plants and factories used t es, who
o produce looked towards rational government p
goods and services. This is the tra olicy to
ditional save capitalism, Marx thought capit
definition of a socialist economic sy alists
stem. It is would buy out government offici
also clear that Marx envisioned a m als.
Politicians, therefore, would not put int
o place
any policies such as unemployment ins the twentieth century, governments did
urance,
welfare systems, maximum hourassist
s or labor unions, and labor —
minimum wages, that might impr management
ove the conflicts were reduced to manageab
condition of workers and keep class le
conflicts proportions.
from becoming violent and revolu In the end it seems that Marx
tionary. underestimated the flexibility of the c
Likewise, Marx did not think gov apitalist
ernment system and its ability to change in order to sa
policy would be employed to keeve
p itself. He also seems to have underest
unemployment down, imated
provide legal the ability of democratic governments
recognition for labor, or help labor unio to rise
ns gain above the capital-labor conflict, and
bargaining power. Yet many social to
policies implement policies that soften the har
were put into effect throughout the sh, and
world in sometimes brutal, aspects of capitalis
m. But
52 despite these flaws in his predictions, prob
ably
no one has understood the dynamics
of the
capitalist system and the tensions it c
reates
among its various participants better than M
arx.
Works by Marx
The Communist Manifesto, New Yor

k,
International Publishers, 1948, (with Fre
derick
Engels) Capital, 3 vols., Moscow,
Foreign
Languages Publishing House, 1957–62
Theories of Surplus Value, 3 vols., Mo
scow,
Foreign Language Press, 1963
Value, Price and Profits, New York, Intern
ational
Publishers, 1976
Wage-Labor and Capital, NewYork, Intern
ational
Publishers, 1976
Works about Marx
Heilbroner, Robert, Marxism: For and

Against,
New York, Norton, 1980 Political
McLellan, David, Karl Marx: His L Economy, New York, Monthly Review
ife and Press,
Thought, New York, Harper & Row, 1970
1973 Wolff, Robert Paul, Understanding Ma
Robinson, Joan, An Essay on Marxian Eco rx: A
nomics, Reconstruction and Critique of ‘C
London, Macmillan, 1960 apital’,
Sweezy, Paul, The Theory of Capit Princeton, New Jersey, Princeton Un
alist iversity
Development: Principles of Marxian Press, 1984
mathematics would come to be
used
Other references increasingly in the social sciences.
Walras
Braverman, Harry, Labor and Monopol revered his father and wanted to live
y Capital, up to the
New York, Monthly Review Press, high expectations that his father set
1974 for him.
Engels, Frederick, The Condition of So after graduating from high school
the Working , Walras
Class in England (1844), Mosco applied to the prestigious École Polytec
w, Progress hnique.
Publishers, 1973 Ironically, he was turned down beca
use he
lacked the necessary backgroun
d in
LÉON WALRAS (1834–1910) mathematics and twice flunked the
entrance
examination. As a result, Walras wou
Léon Walras (pronounced VOL- nd up at
the École des Mines studying engi
wras, with a
neering
German W and the S enunciated) i
rather than social science. Not really inte
s known
rested
primarily for developing general e
in engineering, he spent his time r
quilibrium
eading
analysis. He took a very abstract and theo
literature, philosophy, art, history, a
retical
nd the
problem about how all markets in an
social sciences. Eventually he droppe
economy
d out of
are related, applied sophisticated m
school. Walras then started writing no
athematics
vels, but
to the problem, and arrived at a sol
he was not successful at this endeavo
ution. His
r either.
solution showed that all the marke
In 1858, during an evening walk, h
ts in the
is father
economy could simultaneously ac
suggested that making the social science
hieve
s akin
equilibrium.
to the natural sciences was one of t
Walras was born in Evreux, France (
he major
around
jobs remaining to be accomplished
90 kilometers west of Paris) in 1834. His
in the
father,
a teacher and an economist, stress
ed that
LÉON persevered and continued to write. He s
WALRAS ent his
articles, free of charge, to others usin
nineteenth century. Walras promised his g the
father inheritance he received following the d
he would give up writing novels and eath of
devote his mother. These articles helped Wa
his life to developing a scientific ec lras
onomics. achieve international recognition and num
Inspired by his reading of Cournot, as erous
well as awards for his contribution to econo
by his father, he decided to make this scien mic
tific science. Towards the end of his life h
economics a mathematical economics e was
. made an honorary member of the A
Progress towards this end, howev merican
er, was Economic Association.
slow and hard. Walras wrote article Walras made several impo
s for rtant
economics journals, but all he had to s contributions to economics. Along with Je
how for vons
his efforts was a pile of rejection leand Menger, he was one of several independ
tters. ent
Nonetheless, Walras learned more mathe discoverers of the notion of marginal
matics utility.
and he continued to praise the virtuHe was one of the first and strongest advoca
es of tes
making economics more quantitative. of methodological individualism, the belie
During f that
the 1860s, while working on his mathall explanations of economic pheno
ematical mena
economics, Walras supported himsel should be based upon individual acts of ch
f as a oice
newspaper columnist and as an admi (Hicks 1934, pp. 347f.). But Walras i
nistrator s best
for a railway company. Finally, his known for constructing a general equi
efforts librium
began to pay off. In 1870 he received a teach economic model, which views the ec
ing onomic
position with the law faculty of the L system as a set of interrelated mathe
ausanne matical
Academy. equations. Walras then explained how to
Walras was not happy teaching at Laus solve
anne. this set of equations for all prices a
Neither his few students nor his law nd
faculty quantities.
colleagues were especially intereste
d in 5
mathematical economics. However, 3
Walras
LÉON WALRAS history in economics; the idea goes
back at
The notion that different sectors least as far as Cantillon and Quesnay.
of any Walras
economy are related to each other ha added two important things to this v
s a long ision—
a mathematical representation of h goods
ow all (those using little labor and much
markets were interrelated, and an a energy)
rgument and reduce the price of other goods
that economies would move to (those
wards using little energy and much lab
equilibrium in all markets. or).
Walras recognized that whenev Consumers will tend to cut back t
er one heir
market moved towards equilibriu spending on those goods whose pric
m, or es rise,
whenever one market was affected b and will buy more of those goods
y outside whose
forces, these changes would upse prices fall or remain stable. But t
t the hese
markets for other goods. For exampl changes in consumer spending will
e, in the change
1970s when OPEC raised oil pri the quantities of inputs (such as work
ces, ers and
consumers wound up paying mor energy) that businesses want to hir
e for e. This
gasoline and heating oil. With changed demand for inputs will, in
more turn,
consumer dollars going to energy- change input prices. Again, when i
related nput
products, less could be spent on othe prices change, the cost of productio
r goods. n will
As a result, the producers of thes
e other 54
goods had to cut back production an
d lay off
workers. These lay-offs, in turn,
would
further reduce consumer spending,
leading
to further production cutbacks and l
ay-offs.
In addition, the energy shock aff
ected the
costs of producing goods. Even tho
se goods
using little energy in production still
require
energy when transported from where
they get
produced to where consumers buy
them.
Similarly, the parts required for pr
oduction
have to be transported from elsew
here. On
the other hand, the lay-offs due to
reduced
spending will push down
wages.
Consequently, the rising cost of e
nergy
should increase the price of some
price of every good.
A second set of equations described
change and so too will the final price what
determines the price of every good b
of each ought
good. by households. Walras assumed that
The question raised by the noti all
on of markets were competitive and that f
general equilibrium is whether all t irms
hese could not charge high prices based upo
changes tend to slow down and stabi n their
lize at monopoly power. This enabled him to s
some point, so that all markets reach et the
a point price of each good equal to its cost
where there are no more forces of of
change production (the price of inputs times
affecting any good or input. Walras an the
swered quantity of each input used).
this question with an unqualified “ye These first two sets of equations
s.” To dealt
support this answer he set up a seri only with product markets, or goods s
es of old to
mathematical equations representing consumers. But another set of mark
the ets
market for every good and for every i operates in all economies. These are f
nput in actor
the economy. or input markets. They are where
There were four sets of equations remuneration is determined for the fa
in his ctors
economic model. The first set show of production—the wages received
ed the by
quantity of each good that consum workers, the rental payments receive
ers d by
demanded. Consumer demand was landlords, and the profits received by
based owners
upon individual preferences and the of capital. Factor markets contribute
price two
of every good that consumers co more sets of equations. One set show
uld s the
purchase. Each good sold to consu quantity of inputs or factors (land, labo
mers r, and
could be represented by a mathem capital) offered to help produce goo
atical ds.
equation relating the amount of the Owners of factor inputs (workers,
good landowners, and capitalists) determin
consumers wanted to their income a e the
nd the
and also
on how much can be bought with the
quantity of factors they wish to sup income
received from helping to produce goo
ply. This ds. The
decision will be based upon how reward for working, in turn, depends
disagreeable it is to work or suppl on the
y their price of goods and the income receiv
input into the production process, ed from
working. ved by
A final set of equations show the various factors of production must b
quantity e used
of inputs or factors that businesses to buy something. This can be done
want to either
buy. This depends on the final de directly by each household spending
mand for all their
goods (how much consumers want t income, or indirectly by some hous
o buy at eholds
different prices), on production tec saving money and then lending this
hnology, money
and on the cost of all inputs (en to other households.
abling This extra equation created a di
businesses to figure out the least co fficult
stly way problem for Walras. As all student
to produce things). For exampl s of
e, if algebra learn, to solve a set of mathe
consumers decide to spend more m matical
oney on
clothing, clothing manufacturers w
ill need
to hire more workers and buy
more
machinery. Alternatively, higher wa
ge costs
or new labor-saving technology wil
l reduce
the demand for labor and increas
e the
demand for machines.
So far we have four sets of equ
ations—
one showing the quantity of g
oods
demanded, one relating price to c
osts of
production, one showing the quan
tity of
inputs supplied, and one showin
g the
quantity of inputs demanded. We al
so have
four sets of unknowns that we need
to solve
for: (1) the price of each good, (
2) the
quantity of each final good bought a
nd sold,
(3) the price of each factor of produc
tion, and
(4) the quantity of each factor supp
lied and
bought by business firms.
But Walras adds one more equatio
n to his
mathematical system. This equa
tion
stipulates that all the money recei
LÉON existence of general equilibrium is “w
WALRAS hat, if
anything, does this have to do with th
equations it is necessary that the nu e real
mber of world?” After all, in the real world t
equations equals the number of unk hings
nowns. change all the time; and in the real
Walras now had one more equation t world
han the there is no master economist who sol
number of unknowns. To deal with ves a
this large set of equations in order to dete
problem Walras selected one good, rmine
G1, prices of each good and wages receiv
arbitrarily; the prices of all other g ed by
oods each worker. Walras believed that h
would be determined relative to G1 is
. The mathematical solution to the system
price of G1 thus would be a standaof
rd of equations would be the same soluti
comparison, or numéraire. Mathem on
atically reached by markets in the real world
the number of unknowns would no . But
w equal how could the real world achieve equili
the number of equations in the gen brium
eral without a master economist to solve
equilibrium representation of the eco the
nomy. many mathematical equations?
The system could thus be solved for th Walras devised an answer which h
e price e felt
of all goods relative to G1. The so showed that his abstract model and
lution his
could not explain the absolute level of mathematical equations were
prices, good
or why a gallon of milk cost $2 rath depictions of actual reality. His answe
er than r was
$1 or $4. But it could explain why a two-fold. First, Walras held that all tr
gallon aders
of milk costs twice as much as a doze wanted to maximize utility and that u
n eggs tility
and four times as much as the d maximization and competition moved
aily the
newspaper. whole economy to the set of equilib
This vision of the economic syste rium
m as a prices ground out by his equations. Se
set of equations is quite abstract. cond,
One Walras introduced the notions of th
question that naturally arises after w e
orking
through a mathematical proof for 5
the 5
LÉON WALRAS roducers
bring their goods to sell and wh
auctioneer and the tâtonnement (w ere
hich consumers come to buy goods. Produ
means groping) process. cers set
Imagine a big auction, where p prices for their goods and these pri
ces are d from
called out by the auctioneer. Of co reality as a set of mathematical eq
urse, at uations
some prices, some goods will have t proving general equilibrium. In the
oo many real
buyers and other goods will have world trades take place before the f
too few inal set
buyers. The auctioneer then notes the of general equilibrium prices is re
se cases ached
of too many buyers and too few bu through the groping process. Also, t
yers, and he final
raises prices in the former case equilibrium will likely be affected
while by any
lowering prices in the latter case. Bu exchanges that take place before the
yers and whole
sellers would then revise their offer system balances (Hicks 1934).
s to buy Another problem with the tâton
and sell goods. Again, there ma nement
y be process is that in the real world su
shortages of some goods while othe ppliers
r goods change prices rather than omnisci
will find too few buyers. The auc ent
tioneer auctioneers; and being human, they
would take this new information int may
o account make mistakes and raise rather tha
and again revise prices accordingly. n lower
Through
successive iterations of this process, 56
Walras
argued, the auctioneer would grope
towards
the set of equilibrium prices for th
e whole
auction. Only then would exchan
ge take
place and, at the set of equilibriu
m prices,
all markets would clear. Walras tho
ught that
market prices naturally behaved the
way that
the mythical auctioneer did. Mark
et prices
rise when there are more buyers tha
n sellers
and fall whenever there are more sel
lers than
buyers. In this way, the market syste
m gropes
its way to a position of general equ
ilibrium.
Unfortunately, the auctioneer a
nd the
tâtonnement process do not fully s
olve the
problem of real world applicabilit
y. The
groping process seems as divorce
He formalized the notion of gener
al
prices (or vice versa). Moreover, real equilibrium, and showed economists h
ow it
world was possible to study an interrelate
suppliers set prices based upon exp d
ected economy as a set of mathematical equ
demand in the future rather than cu ations.
rrent He raised the important issues of
conditions. convergence to equilibrium and the st
Finally, as von Neumann (see belo ability
w) was of economic equilibrium, and he atte
quick to recognize, the mathemati mpted
cal to explain how economies could rea
solution to a Walrasian set of equations ch
could general equilibrium. For these achieve
conceivably contain negative prices. I ments,
t could Walras must certainly be regarded amo
also contain prices whose value is zer ng the
o. Yet half dozen most important figures in
in the real world this is impossib the
le. history of economics.
Businesses will not give away goods f
or free.
Nor will they produce goods and th Works by Walras
en pay
people to purchase them, which is Elements of Pure Economics (1874 an
what d 1877),
would occur when we get negative Homewood, Illinois, Irwin, 1954
prices Correspondence of Léon Walras and
after we solve a set of Walrasian equ Related
ations. Papers, 3 vols., ed. W.Jaffé, Amerstam, N
All these problems, however, do orth-
not Holland, 1965
detract from the great achievement of
Walras.
Walras forced economists to focus Works about Walras
on the
interrelationships among different m Hicks, John R., “Léon Walras,” Econometric
arkets. a, 2,
4, October 1934, pp. 338–48
WILLI
AM STANLEY JEVONS
Jaffé, William, Essays on Walras, ed. in Ten Great Economists, New Yor

Donald A. k, Oxford
Walker, Cambridge, Cambridge University Press, 1951, pp. 74–9
University
Press, 1983
Jaffé, William, “The Antecedents and
Early Life WILLIAM STANLEY JEVONS
of Léon Walras,” History of Political
(1835–82)
Economy,
16, 1 (1984), pp. 1–57
Schumpeter, Joseph, “Marie Esprit Léon William Stanley Jevons (pronounced
Walras,”
Jev-ins,
with a soft e) is best known for dev A dispute over the funding of a ra
eloping a ilway
theory of relative prices, or exchang line for New South Wales initially sp
e values, arked
based upon the notion of marginal his interest in economics; and Jevons
utility. In was
contrast to early nineteenth-century soon reading the great classical econo
classical mists,
economists, who held that the co especially Smith, Malthus, and John
sts of Stuart
production determined relative price Mill. A powerful desire to do goo
s, Jevons d,
argued that relative prices depend especially a wish to help nations gro
upon w and
subjective assessments by people prosper, prompted Jevons to continue
of the his
satisfaction to be gained from pur education. Returning to England in 1
chasing 859,
different goods. Jevons and to University College in 1860, J
also made evons
contributions to growth theory and studied mathematics, political econo
business my,
cycle theory. philosophy, and history. Although he
Jevons was born into an upper was
middle disappointed with his political econo
class family in Liverpool, England my
in 1835. courses and felt that he got more fr
His father was an iron merchant om
and his reading on his own than from atten
mother came from a prosperous fa ding
mily of lectures, he continued with his studie
bankers and lawyers. The family s and
wealth received both an undergraduate and
enabled Jevons to receive an exc a
ellent master’s degree in political economy
education. At first he was tutored a from
t home; University College.
then he attended private schools Jevons then accepted a position at
and Owens
University College in London, w College in Manchester, where he taug
here he ht for
studied metallurgy and mathemati the next 13 years. In 1876, Jevons left
cs (with Owens
the world-famous Augustus DeMor College to become Professor of Polit
gan). ical
When the British railway boom Economy at University College, Lon
ended, don.
the family iron business went bankr This appointment had light teaching an
upt. To d few
help his family deal with their fin administrative duties, thus allowing J
ancial evons
problems Jevons abandoned his st the time to pursue his own writing. B
udies in ut by
1854. He then trained as an assayer 1880 Jevons again found it difficult to
and took juggle
a job at the Sydney Mint in Aus both his teaching duties and his wri
tralia ting
(Könekamp 1962, pp. 255f). ambitions, so he resigned from Univ
ersity al in
College in order to focus more on England. He then estimated the rate at
writing. which
Unfortunately, by that time his healt coal consumption was increasing. Pu
h had tting
deteriorated due to overwork, and tw these two estimates together, Jevons fo
o years und a
later he collapsed while swimming continually increasing demand for
and a
drowned. depleting supply of coal reserves. T
The first book that Jevons (18 he
65) consequences could only be sharply r
published, The Coal Question, was ising
alarmist coal prices. Even worse, at some poin
and Malthusian. It forecast a severe t the
energy
shortage for England. Jevons bega
n by 5
estimating the existing supply of co 7
WILLIAM STANLEY JEVONS
dwindling supply of coal would ment, and
stop a Royal Commission on Coal was
economic growth in England. established to investigate the probl
Jevons was not optimistic that em.
energy However, panic about an energy cri
substitutes for coal could be found. sis was
Nor did he premature. Jevons estimated that c
think conservation efforts could do oal
anything consumption in Britain would be 2
but push back slightly the date at ,607
which million tons by 1961 (based on 1861
economic growth would come to an end. levels
More of coal use and mid-nineteenth-
surprisingly, Jevons ignored two o century
bvious annual growth rates of 3.5 percent).
policy solutions—a tax on coal Yet in
and a 1962, actual coal usage in Englan
prohibition on British coal exports. Inst d was
ead, he around 10 percent of his estimate—
advocated repaying the national de 192 tons
bt so that (Black 1981, p. 16).
when the day of reckoning came, The primary reason Jevons was so
and the far off
existing supply of resources were e the mark is that he did not forese
xhausted, e the
there would be no other burdens o development of coal substitutes su
n future ch as
generations. petroleum, natural gas, and hydroel
The Coal Question brought inst ectric
ant fame power. A personal disposition to fea
to Jevons. Stories of the impendin r what
g coal the future had in store apparently als
shortage filled British newspapers o came
. John into play. Concerned about a short
Stuart Mill praised Jevons in Parlia age of
writing paper, Jevons purchased su utility. These were both important
ch large discoveries, as they brought consumer
stocks of paper that more than fifts and
y years consumer behavior into economic ana
after his death Jevons’ children had lysis
still not for the first time. But Jevons went e
used it all up (Keynes 1951). ven
Jevons’ lasting claim to fame, h further than Menger by drawing out
owever, the
stems not from his fears of en implications and possible application
ergy s of
shortages, but from his efforts to utility analysis.
bring The discovery of the principle
utility analysis into economics. Je of
vons, diminishing marginal utility appears t
J.B.Clark, and Menger, each indepe o have
ndently, taken place in the late 1850s while Jevo
discovered the notion of subjectiv ns was
e utility working in Australia. This idea is simp
and the principle of diminishing m ly and
arginal concisely encapsulated in a 1860 letter
that he
58 wrote to his brother: “One of the m
ost
important axioms is, that as the quantity of a
ny
commodity, for instance, plain food,
which a
man has to consume, increases, so the
utility
or benefit derived from the last portio
n used
decreases in degree” (quoted in Keynes
1951,
p. 280).
Several years later Jevons (1871) s
et forth
more precisely the important distinct
ion
between total utility and degree of u
tility or
marginal utility. This led to the devel
opment
of the modern theory of consumer be
havior.
Jevons noted that as people consume more
and
more of any good, the total utility they get fro
m
consuming that good generally increas
es. But
as people consume more and more, the
utility
they get from each additional quantity
of the
good declines. Thus, the first beer to a
thirsty
man provides more satisfaction than the sec
ond se total
or third beer. By the fifth or sixth glass the mutility. Whenever the consumer can f
an reely
begins to get sick of beer and deriv switch purchases, buying more goods that
es no give
additional utility from another one. a lot of utility and buying less of those
According to subjective utility t things
heory, providing little or negative utility, the consu
consumers buy those goods that provi mer
de them will be better off.
with the greatest satisfaction. Going This doctrine forms the basis for k
even eeping
further, Jevons argued that each consume government from regulating the good
r was s and
in equilibrium whenever any further c services that consumers can buy. For exa
hange in mple,
his or her spending could not increa
WILLI
AM STANLEY JEVONS
if cigarettes or alcohol or drugs ar s thus
e freely had to balance the disutility of work
available, consumers will buy only the against
amount the utility of the goods that could be
of these goods that maximize thei bought
r utility. with the fruits of one’s labor. As lon
When governments prevent the sales g as the
of these utility of consumption exceeded the
goods, or make their purchase diff disutility
icult by of work, people would continue to
imposing regulations on producers work
or taxes (Jevons 1957, Ch. 5). At the point w
on these goods, consumer satisfaction o here the
r well- disutility of work exceeded the util
being falls throughout the country. ity of
What is consumption, people would stop wor
true of cigarettes and alcohol is tr king and
ue of all enjoy leisure time.
other goods. This application of utility analysi
Jevons next applied the notion of s to the
utility to labor market had several impor
labor. By so doing, he helped show how tant
wages consequences. First, the distinction
get determined and how labor mark between
ets work. productive and unproductive labor,
Jevons assumed that labor was dis first set
agreeable forth by Quesnay, was shown to be m
and therefore involved negative ut istaken.
ility or All labor was productive in the sens
disutility for the worker. On the ot e that it
her hand, yielded utility to individual worker
labor also yielded positive utility, s, who
since could take their pay check and buy goods
workers were paid for their efforts with
and could it. Second, bringing utility theory to
use this income to buy goods. Individual a study
of labor cast doubt on the classical temployment. Capitalists also make si
heory of milar
wages (see also MALTHUS). Hum decisions when deciding whether or
ans were not to
not at the mercy of a subsistence wage; invest and hire more workers.
rather, Finally, no accounting of the econ
the labor supply depended upon t omic
he going thought of Jevons would be complete
wage. If wages got too low worke without
rs would mentioning his theory of the business
withdraw from the market and enjo cycle.
y leisure. While doing extensive research on ec
Third, in contrast to Ricardo and onomic
Marx, for growth, Jevons (1884) noted a clo
Jevons there is no opposition betw se
een labor relationship between sunspot activity
and capital. Labor makes its own and
decisions economic activity. Between 1721 and
about whether or not to work, ca 1878
refully business cycles had an average durati
balancing the gains and the losse on of
s from 10.46 years, while sunspot activity sho
wed a
periodicity of 10.45 years. Jevons felt that t
his
relationship was too close to be accid
ental.
He even set forth a few creative explan
ations
for this similarity. If sunspot activity af
fected
the weather, and the weather affected
British
harvests, then sunspot activity should
be
correlated with grain prices. A good h
arvest
would increase the supply of grain and
lower
its price, while bad harvests would le
ad to
higher grain prices. Jevons also look
ed to
foreign trade to explain the similar sol
ar and
economic cycles. A more active s
un,
according to Jevons, influenced the
rice
harvest in India. A good harvest in In
dia led
to high demand for British manufact
ured
goods. This, in turn, caused the Brit
ish
economy to expand. In contrast, less s
unspot
activity meant poor Indian harvests,
little years
demand by India for British goods, (Keynes 1951, p. 279). And in contra
and a st to
slumping British economy. Jevons, most economists in the lat
Few contemporaries of Jevons, ane
d few twentieth century look towards the eco
subsequent economists, have taken nomy
the itself, rather than outside forces, as
sunspot theory of business cycles seri the
ously. cause of periodic turns in prosperity
In addition, more recent data cast do and
ubt on depression. Nevertheless, Jevons dese
the figures Jevons used; astronomer rves
s have recognition as one of the originators
increased the solar sunspot cycle to of
11.1 business cycle theory.
years, while economists have reduc
ed the 5
length of the business cycle to 7 or 8 9
CARL MENGER Macmillan, 1865
“Notice of a General Mathematical T
Despite his linkages to the fu heory of
ture Political Economy,” Statistical Jo
through worries about the depleti urnal, 29
on of (June 1866). Reprinted as an App
energy resources, and despite his li endix in
nkages Jevons (1957), pp. 303–14
to the past as a business cycle hi The Theory of Political Economy, (f
storian, irst edition,
the major contribution of Jevons 1871) 5th edn., NewYork, Kelley & Mil
to lman,
economics remains his developm 1957
ent of The Principles of Science: A Treati
marginal utility theory and his use se on Logic
of this and Scientific Method (1874), Lon
theory to explain consumption an don,
d work Macmillan
decisions. In all his work, Jevons Investigations in Currency and Fina
was a nce (1884),
pioneer, and the many advances ed. H.S.Foxwell, London, Macmilla
due to n
Jevons makes him one of the three
or four
most important nineteenth- Works about Jevons
century
economists. Collison Black, R.D., “W.S.Jevons, 1835–
82,” in
Pioneers of Modern Economics in Bri
Works by Jevons tain, ed.
D.P.O’Brien and John R.Presley,
The Coal Question: An Inquiry Co London,
ncerning the Macmillan, 1981, pp. 1–35
Progress of the Nation, and the Keynes, John Maynard, “William Stanley
Probable Jevons
Exhaustion of Our Coal-Mines, 1835–1882,” in Essays in Biogra
London, phy, New
York, Norton, 1951, pp. 255–309
Könekamp, Rosamond, “William Stanle
y Jevons Schabas, Margaret, A World Ruled by
(1835–1882): Some Biographical
Notes,” Number
Manchester School of Economic William Stanley Jevons and the Ri
and Social se of
Studies, 30, 3 (1962), pp. 251–73 Mathematical Economics, Princeton,
New
Jersey, Princeton University Press, 19
60 90
CARL MENGER (1840–1921)
Carl Menger (pronounced MEN-
GIRR) is
regarded as the founding father of t
he
Austrian School of Economics. This
is
because he is responsible for developin
g two
pillars of Austrian Economics. First, M
enger
helped to establish a subjective theor
y of
value. Second, he argued that econo
mic
knowledge can come only from deduci
ng the
consequences of assumptions that are
known
to be true.
Menger was born in 1840 in Neu-
Sandec,
Galicia (then part of Austria but now p
art of
Poland). Very little is known about
his
upbringing or his education. His fathe
r was
a lawyer, and Menger followed in his f
ather’s
footsteps by studying law and politi
cal
science, first at the University of Vienn
a and
then at the University of Prague. In 18
67 he
received a doctorate in law from Kr
acow
University.
After graduating, Menger worked
first
as a financial journalist and then in
the years later he was promoted to th
p r e s s o ffi c e o f t h e A u s t r i a e
n P r i m e position of Professor Extraordinarius
Minister. It was during this time th ;
at he but he soon resigned this position i
worked on the Principles of Econo n
mics order to tutor Crown Prince Rudolph
(Menger 1871). and
With his reputation growing due t travel with him throughout Europe.
o the In
Principles, Menger was appointed to 1879, Menger accepted a teaching
a position in Vienna, and thereafter led
lectureship in the Law Faculty at the
the life of an academic economist—
University of Vienna in 1873. Thr devoting
ee
tury,
classical economics was held in low
all his energy and efforts to teachin esteem
on the European continent. Especi
g and ally
writing. Although he was made a dissatisfying was the highly abstrac
member t and
of the upper chamber of the Aus theoretical nature of British econo
trian mics.
Parliament in 1900, Menger preferr Menger sought to bring economics b
ed his ack to
work in economics to taking part i the real world. His starting point i
n any n this
political deliberations and debate endeavor was a recognition that good
s s have
(Hayek 1934, p. 417). value because they meet our needs.
Menger made two In contrast to the classical Brit
important ish
contributions to economics. One i economists, Menger argued that valu
nvolved e was
value theory and the other conc determined by subjective factors (u
erned tility
economic methodology. Menger w or demand) rather than by objecti
as one ve
of the first economists to discove fa c t o r s ( t h e c o s t s o f p r o d
r the u c t i o n o r
marginal utility theory of value a supply). Value, for Menger, comes
nd the from
principle of diminishing marginal the satisfaction of human needs. H
utility, uman
and he was one of the earliest ad needs create a demand for goods;
vocates they
of a subjective theory of value. Men become the driving force of econo
ger was mic
also involved in a heated debate o exchange and help determine pric
ver the es.
nature of economics and the prop Furthermore, Menger argued that s
er way ince
to do economic analysis. human needs were greater than the
During the late nineteenth cen goods
available to satisfy these needs, p CARL
eople MENGER
wo u l d c h o o s e r a t i o n a l l y
a m o n g a l l how important a particular good is to
alternative goods made available to some
them. individual, or the degree of satisfact
Menger (1985, p. 127) illustrate ion
d these obtained by consuming that good. G
principles with a table, which is re oods
produced must satisfy the subjective needs
here as Table 1. Each column in t of
he table consumers, according to Menger, a
represents a different type of goo nd
d. The consumers must recognize this fact if
numbers under the Roman numerals re goods
present are to have any value.
Table 1
Menger also recognized that as
one
purchases greater and greater quantitie
s of a
good, each succeeding quantity purc
hased
will yield less satisfaction to the cons
umer.
That is, people experience diminishin
g
marginal utility when they consume
more of
any good. Thus, Table 1 shows that th
e first
units consumed of any kind of good yi
eld the
greatest utility and that each succeedin
g unit
yields less and less utility.
Unfortunately, Menger gave few ex
amples
of the goods that belong in each catego
ry. He
stated that Category I goods are thos
e that
preserve life; Category II goods pres
erve
health; Category III goods provide f
or however, that the numbers are suppos
individual welfare (that is, future lif ed to
e and measure relative wants or the satisfa
health); and Category IV goods are ction
various received from consuming different g
types of diversions. Category I mig oods
ht thus (Menger 1985, pp. 163–76). Menger w
represent food; Category II medical c as also
are, and clear about how individuals make de
Category IV entertainment. cisions
Menger was also not clear about
what the 6
numbers in his table actually measure. It is 1
clear
CARL MENGER of value is that the classical labor
theory of
regarding what to consume or how value (see also RICARDO) had to b
to spend e wrong.
their money. Since consumers hav As Menger (1985, p. 145) noted:
e limited
income at their disposal, individuals The determining factor in the value of a
will first
buy those goods that satisfy more good,
important then, is neither the quantity of labor
needs. Goods with a subjective value of 1 or other
goods necessary for its production
0 will
nor the
get consumed before goods with a v quantity necessary for its reproduc
alue of 9, tion, but
which in turn get consumed befor rather the magnitude of importance
e goods of these
valued with an 8 or less. satisfactions with respect to which
One important consequence of t we are
his theory conscious.
of value is that all activities yielding
subjective Since value comes from the indi
satisfaction are productive activities. In
contrast vidual,
to the British classical economists, according to Menger, economic analy
trade was sis must
productive according to Menger because begin with studying the individual.
people This
would not trade unless they felt the position has come to be known as
goods that methodological individualism.
they received would give them more utili Menger also recognized that fac
ty than tors of
the goods they gave up. And in co production (land, labor, and capital) have
ntrast to value
Quesnay, agriculture and manufactur because they satisfy wants indirectl
ing could y; these
both be productive activities because factors are needed to produce the go
the goods ods that
produced by each of these econom people directly desire. To find the act
ic sectors ual value
yield satisfaction to consumers. of a factor, Menger thought that we
Another implication of the subjectiv should
e theory withdraw one unit of the factor (sa
y one
worker) and observe the loss in ou
tput. The produced by that worker. The value crea
value of this output is the value adde
d by that ted by
worker. It represents the consumer sati each factor of production thus depende
sfaction d upon
its marginal productivity; and the ret
urn or
62 payment to each factor used in producing go
ods
should depend on the anticipated value cre
ated
by that factor (Menger 1985, p. 124).
From 1875 to 1884 Menger was a
bsorbed
in a heated methodological dispute with Gu
stav
Schmoller, a leader of the German Hi
storical
School. Dispute might be a too euph
emistic
description of what was more an excha
nge of
insults than a true scholarly debate. Mo
reover,
the exchange itself was quite stran
ge
considering that Menger dedicated
The
Principles to Roscher, another leader
of the
Historical School.
According to the Historical Sch
ool,
economic laws have to be found in hi
storical
facts accumulated over long periods o
f time.
Until the facts were set forth, it woul
d be
premature to develop any economic t
heories.
The right way to understand an econo
my was
to look at historical data, find regulariti
es, and
then make inferences about how the ec
onomy
worked. The Historical School reject
ed the
abstract-deductive method of doing econo
mics,
where economic principles were derive
d from
assumed characteristics of people and
markets.
Instead, they accepted a relativism reg
arding prices
economic relations and economic policy. F for some good causes people to buy m
or the ore of
Historical School the world worked di that good). Historical or empirical eco
fferently nomics
at different times and in different place could not do this, since sometimes pric
s. es fall
In contrast, theory development and people expect further price declin
took es, so
precedence over data accumulation they buy less now. Consequently, hist
for orical
Menger. Menger thought that proper scie economics could not yield definitive r
ntific esults.
method involved the search for ess Only introspection yields absolute a
ential nd
characteristics of economic phenom necessary truths according to Menger. T
ena, or rying
necessary connections between eco to refute laws of economics by pointi
nomic ng to
variables (such as the fact that lower
these lead to observable phenomen
a like
contrary real world evidence was li different prices for different goods.
The Untersuchungen provoked h
ke trying ostile
to refute the laws of geometry by attacks from members of the Histo
measuring rical
the angles of a triangle to see if the School, including Schmoller. These
y equaled attacks
180°—attempting to do this sho were responded to in kind by Men
ws a ger’s
misunderstanding of geometry. students and followers. Schmoller ref
Menger’s Untersuchungen (188 used to
3) sought have any more books written by
to put economics on firm theoreti Menger
cal and reviewed in his journal, and he ann
methodological foundations. In so ounced
doing, publicly that followers of Menger w
Menger defended his method of ere not
doing fit to fill any teaching positions (Haye
economics and argued against the k 1934,
method of p. 407).
the Historical School. Menger str Eventually the debate ended, mo
ongly re as a
emphasized the individualistic met result of boredom than through a
hod of final
analysis and the fact that economic kno resolution of the issues. Menger’s
wledge method
is derived a priori or before the exp became the accepted method of d
erience of oing
real world economies. Studying e economics, although there have bee
conomics n many
for Menger involved studying ind prominent critics of this methodology (se
ividual e also
preferences (or demand) and explai LEONTIEF). The major effect of th
ning how e debate
has probably been to give eco CARL
nomic MENGER
methodology, a study of the method
s used to concepts and theories of economists
obtain economic knowledge, a bad …is
reputation. seldom, if ever, a waste of time.”
As Schumpeter (1951) notes, most eco Major economists usually leave a le
nomists gacy of
have felt this debate to be a total was ideas and theories that come to be accep
te of time ted by
and from it they have generalized t most other economists and form part
he lesson of the
that all methodological discussio economic wisdom taught to students of
n in future
economics is a waste of time. But this ou generations. A few make their mark b
tcome ecause
has probably hurt the economics p they dared to step outside the mainstrea
rofession, m and
for as Hutchinson (1973, p. 36) powere able to inspire a group of stude
ints out nts or
“critical examination of the assum followers. Menger is the rare figure w
ptions, ho fits
into both categories. His emphasis o
n the
individual, and his argument that we
must
explain the economic world as respon
ses to
subjective individual assessments, m
ake
Menger a founder of the Austrian Sc
hool of
Economics (Alter 1990; Vaughn 1994
). But
with his discovery of utility as a source of val
ue
and his discovery of the principle
of
diminishing marginal utility, Menger a
lso fits
into the former category.
Works by Menger
The Collected Works of Carl Menger,

ed. F.A.
Hayek, 4 vols., London, London Sc
hool of
Economics and Political Science, 19
34–6
Principles of Economics, trans. J.Ding
wall and
B. F.Hoselitz (1871), New York and L
ondon,
New York University Press, 1985
Problems of Economics and Sociology, tran
s. F.J.
Nock (1883), Urbana, Illinois, Univ f Political
ersity of Economy, 48, 3 (1940), pp. 428–33
Illinois Press, 1963 Caldwell, Bruce J., (ed.) Carl Menger
and His
Legacy in Economics, Durham &
Works about Menger London,
Duke University Press, 1990
Alter, Max, Carl Menger and the O Hayek, F., “Carl Menger,” Economica,
rigins of 1
Austrian Economics, Boulder, Colo (November 1934), pp. 393–420
rado,
Westview Press, 1990
Bloch, Henri-Simon, “Carl Menger: The F 6
ounder 3
of the Austrian School,” Journal o
ALFRED MARSHALL conomic
concepts into simple graphs. He is
Hutchison, T.W., “Some Themes also
from responsible for introducing many o
Investigations into Method” in H f these
icks and concepts into economic analysis. Finally
Weber (eds) Carl Menger and , more
the Austrian than anyone else, Marshall helped
School of Economics, Oxford, C make
larendon economics a field of study in its own
Press, 1973, pp. 15–37 right.
Schumpeter, Joseph, “Carl Menger, 1840 Marshall was born in Bermonds
–1921,” ey, a
in Joseph Schumpeter, Ten Great working-class suburb of London, in 1
Economists 842. His
From Marx to Keynes, New Yor father was a clerk at the Bank of Engl
k, Oxford and; his
University Press, 1951, pp. 80–90 mother was a butcher’s daughter. Althou
Stigler, George, “The Economics of gh the
Carl family was not well-to-do, they place
Menger,” Journal of Political d a high
Economy, 45 value on education and sent Marshall
(April 1973), pp. 229–50 to good
Vaughn, Karen I., Austrian Economics in schools. Like John Stuart Mill, Mars
America, hall was
New York, Cambridge University Pre pushed hard by his father and forced
ss, 1994 to study
late into the night. Despite the fact h
is father
stressed the classics and languages
ALFRED MARSHALL (1842– (and
perhaps because of this) Marshall wa
1924) s drawn
to mathematics rather than the huma
nities.
Alfred Marshall is responsible for what With financial help from his uncle, Ma
Keynes rshall
attended Cambridge University, wh
(1951, p. 157) called “diagram
ere he
matic
studied mathematics, philosophy, and p
economics,” or the translation of e
olitical
economy. His interests in philosop
hy were
particularly strong. During frequent classic works in philosophy. Howev
mountain
climbing excursions in the Alps, er,
Marshall Marshall decided to specialize in econ
would find a good spot for readi omics.
ng and One important factor in this decision
contemplation, and there he would was his
study the walks through “the poorest quarters of
several
cities…looking at the faces of the po
64
orest
people” (Keynes 1951, p. 137). After recei
ving
a degree in the moral sciences (there
was no
economics degree at Cambridge at the
time)
Marshall taught for nine years at St J
ohn’s
College in Cambridge. He then taught
briefly
at Bristol and at Balliol College, Oxf
ord. In
1885 he returned to Cambridge, whe
re he
taught until his retirement in 1908.
Many of the notions and modes of
analysis
introduced by Marshall still provide th
e basis
for undergraduate education
in
microeconomics, particularly in intro
ductory
microeconomics courses. Marshall st
udied
individual markets in isolation, pretty
much
ignoring the impact that one market
has on
other markets and that these other mar
kets, in
turn, have on every market. This made Mars
hall
the founder of partial equilibrium an
alysis. In
contrast, Leon Walras studied the m
any
interrelationships among all markets i
n the
economy, or general equilibrium an
alysis.
While neither as complete and compre
hensive
as general equilibrium analysis, parti
al
equilibrium analysis has the advant law of demand—as prices fall, cons
age of umers
focusing on the practical problems f buy greater quantities of a good. The
acing a “two
particular firm and industry. scissors” of supply and demand deter
In order to study individual mar mined
kets the price for each good and the amou
Marshall developed the tools of supp nt of
ly and each good that would be produced.
demand analysis. The upward sloping In
supply contrast to the demand-driven approa
curve demonstrated the law of sup ch of
ply—as Jevons, and in contrast to the supply-
prices rise firms will produce more an driven
d bring approach of Ricardo, Marshall empha
to market greater quantities of any goosized
d. The that supply and demand jointly deter
downward sloping demand curve sho mined
wed the prices and production.
either supply or demand).
Marshall recognized that his “
Marshall argued that competitio two
blades” were complex constructions.
n would He then
force actual prices towards the equ went on to analyze supply and de
ilibrium mand in
price. If prices were set above
the
equilibrium level, firms would not
be able
to sell what they produced and w
ould see
their inventories pile up. This woul
d signal
to the firm that it must lower prices
and cut
production. On the other hand, if pri
ces were
set below equilibrium, shortages
would
result. People would line up to buy
a limited
stock of goods and many consume
rs would
have to be told that some good w
as “sold
out.” Businesses would take this as
a sign to
increase prices and production. As
Figure 2
shows, only at the equilibrium poi
nt would
firms sell all they produced and tend
to keep
their prices the same (barring any c
hange in
ALFRED MA ns about
RSHALL future prices (Marshall 1920, Book 3,
Ch. 4).
Marshall (1920, p. 97) defined a c Greater wealth and a larger population
hange in would
demand as the purchase of more (or leincrease demand, as shown in Figure
ss) of a 3. This
good by people at the same price. would push up prices. Advertising c
Changes in ould
the demand relationship, or shifts i change consumer tastes and cause dem
n the and to
demand curve could result from se increase. Likewise, expectations of g
veral reater
causes—changes in wealth, popula prices in the future would push up demand a
tion nd
changes, changes in tastes, a change in the p prices since people would want to bu
rice y now,
of other goods, or changed expectatio before prices go up.
to purchase many other goods.
Figure 2 Supply, demand, and equil
ibrium
greater detail. Demand was governe
d by the
utility or satisfaction that people r
eceived
from consuming a particular g
ood.
Consumers were forever attempting t
o get the
greatest utility from what they purc
hase and
consume. They would compare
the
additional satisfaction from buying
one good
with the additional satisfaction tha
t would
result from alternative purchases.
When a
good was priced highly, consumer
s could
buy very little of that good becau
se they
could get more utility from using the
ir money
Figure 3 Shifts in demand s are sets
of goods usually consumed together. Any g
The impact of a change in the price of o ood
consumed with gasoline, like automo
ther
biles
goods is a bit more complicated to (especially gas guzzlers), would expe
analyze. rience
Normally, when the price of some go reduced demand if the price of gasoline
od, like
rose.
gasoline, increases, people buy less Supply, in contrast to demand,
gasoline
was
and spend their money on other ite governed by the costs of production. Produ
ms. Thus cers,
demand for goods other than gasolin like consumers, were always trying
e should
to
rise. However, there are some cases
when the
6
reverse is true. Complimentary good
5
ALFRED MARSHALL crease in
wages would therefore shift supply to
maximize; but the producer wan the left,
ted to as shown in Figure 4. The supply shi
maximize profits from production. ft would
Due to lead to higher prices. In contrast, i
diminishing returns and the rising cost mproved
of parts technology, by reducing the amount
and labor, greater output could be of labor
produced necessary to produce goods, would l
only at rising costs. Businesses would th ower unit
erefore costs, shift supply down (or to the ri
only produce more goods if they r ght) and
eceived a lower prices (Marshall 1920, Book 5,
higher price. Hence the Marshallia Ch. 3).
n supply
curve was positively sloped.
Like demand, the supply relationsh
ip could
shift. And like shifts in demand, a
shift in
supply means more (or less) of the
good gets
produced and sold at each price.
The main
factor causing supply to shift is a
change in Figure 4 Shifts in supply
the costs of production. Higher w
ages, for
example, would raise the costs of
production One of Marshall’s most impo
—no matter how much was produced. B rtant
usiness
contributions to economics was
could make the same amount of pro
his
fit only if
formulation of the notion of elasti
they pass these higher costs on to
city.
consumers
Virtually all economic relationships a
in the form of higher prices. An in
re cause
and effect relationships. The noti
on of a large effect, the relationship is said
elasticity attempts to ascertain how
much of to be
an effect a given cause has. If some elastic; if the cause has a small effec
cause has t the
relationship is inelastic. Marshall als
66
o
developed a mathematical formula to mea
sure
exactly how elastic or inelastic any ec
onomic
relationship was.
The price elasticity of demand concern
s how
much a given change in price alters the amo
unt
of a good consumers would purchase (Mars
hall
1890, Book 3, Ch. 3). Marshall ident
ified
several factors that determined wheth
er the
demand for a particular good was likel
y to be
elastic or inelastic. One important fact
or was
the ease of substitution. If goods w
ere
necessities and there were few alternatives, t
hen
demand for the good was likely to be
price
inelastic; consumers would have to k
eep
buying the good when its price incre
ased
because they had no alternatives. Duri
ng the
energy crisis of the 1970s, for example, des
pite
a quadrupling of gasoline prices, peop
le still
needed to drive. So they paid the higher
prices
and cut back very little on their consu
mption
of gasoline.
Marshall also explained why price itself
was
an important determinant of demand elasti
city.
For a container of salt, whose price is very lo
w,
a large percentage change in price woul
d have
little effect on consumption because th
e extra lastic.
money spent on salt due to a large Finally, Marshall stressed that time
price was an
increase would be rather trivial. In cimportant factor in determining the el
ontrast, asticity
whenever expensive items (such as of demand, with demand becoming
automobiles or a college education) more
increase elastic over time. After the large incre
in price by a large percentage, consumers ases in
must gasoline prices in the 1970s people fo
spend a good deal more of their incom und it
e to buy difficult to cut back on their gasoline purcha
these goods. Thus they are less lik ses.
ely to But over time, they started buying mo
purchase them. Consequently, dema re fuel
nd for efficient cars, automobile manufactur
expensive goods tends to be elastic and de ers
mand produced cars that got better gas mileage, m
for inexpensive goods tends to be ine ass
yees and
equipment for more hours. But equ
transit systems were improved and ipment
cannot be expanded in the short run,
expanded, and new
and people learned to carpool. All firms cannot enter an industry in the s
of these hort run.
changes eventually helped to redu So there are limits to how many mor
ce the e goods
amount of gasoline bought. can be supplied. Any increase in dem
Marshall also applied the notio and will
n of price lead to some increase in production;
elasticity to the supply relationship. but most
The price of the impact will be on prices.
elasticity of supply measured how m The long run is the period of ti
uch more me that
businesses would produce and attem allows firms to expand their plants
pt to sell and
in response to a given change in pr equipment. In addition, in the long r
ice. Here un firms
too time was an important factor. can enter and exit the industry. Out
The shortest time period of all put can
Marshall therefore be readily expanded at mor
called “the market period.” Everythi e or less
ng that is constant cost, making the long-run
brought to market must be sold or it supply
will spoil curve fairly flat. From this Marshall conc
and production does not respond t luded
o price that over short time periods demand
changes. In this case the supply cur was the
ve will be more important determinant of price; but
vertical, or nearly vertical, and d given
emand enough time, it was supply or the c
determines price. osts of
In the short run, in response to higher production that determined prices.
prices Since Marshall was drawn to econom
firms can work their current emplo ics by
moral considerations and a desire to ALFRED MA
help the RSHALL
poor, it is not surprising that he was
especially unskilled labor was determined b
concerned with the problems of i y a
ncome Malthusian population principle—in res
distribution and poverty. Marshall t ponse
raced the to higher wages, the population would incr
problem of poverty to the labor mar ease
ket (Rima and so would the labor supply. The d
1990). The labor market operated ju emand
st like the for unskilled labor, however, was con
market for any good. The only diffe stantly
rence was decreasing due to mechanization. The
that in the labor market businesses se two
were doing forces keep wages down for the unskill
the demanding and households were do ed and
ing the kept them earning poverty-level incom
supplying. For Marshall, the supp es.
ly of Marshall argued that individuals l
acking
broad and extensive skills, and indivi
duals
lacking any bargaining position in the
labor
market, could only get low wages. This
led to
poor health and poor education, which
in turn
led to low productivity and low wages for th
eir
children. Poverty persisted from genera
tion to
generation because nothing was done t
o break
the cycle of poverty (Marshall 1890, B
ook 6,
Chs 4–6). Unfortunately, Marshall sai
d little
about how to raise wages for those with few
or
no skills, and even less about how to
reduce
poverty. He refused to advocate eit
her
minimum wages or trade unions. His
only
suggestion was that the unskilled limi
t their
family size and that progressive taxati
on be
used to help the poor (Marshall 1920,
p. 719;
1917, pp. 317–29). Ultimately, he loo
ked to
education as a solution to the proble
m of
poverty (Marshall 1920, pp. 717f.).
Although most famous for cost of these goods from country to co
his untry
contributions to microeconomics, Ma we can obtain a good measure of the r
rshall elative
did make some macroecon value of two different currencies. If
omic a
contributions as well. He (Marshall McDonald’s hamburger sells for $1 i
1923) n the
employed the notion of purchasing United States and for 100 yen in Japan,
power then
parity to explain what determines exc $1 and 100 yen should represent equiv
hange alent
rates between the currencies of two d incomes. According to the purchasi
ifferent ng
countries. The idea behind this noti power parity theory, regardless of the
on is actual
rather simple and straightforward. exchange rate between the dollar an
Some d the
goods are sold virtually everywh
ere 6
throughout the world. By comparin 7
g the
ALFRED MARSHALL value of the dollar and moving us t
owards
yen, $1=100 yen should be used purchasing power parity.
when D e s p i t e t h e m a ny n ew c o n c e p t s
comparing incomes in the US and advanced by Marshall, his main
Japan, contribution to economics may ha
since $1 and 100 yen have the ve
same been institutional rather
purchasing power or can buy the than
same substantive. Marshall, more than an
things. Also, according to the pur yone
chasing else, is responsible for establishin
power parity theory, exchange rates g
between economics as a separate subject a
the yen and the dollar will tend tow nd
ards this discipline. When Marshall returned
level. If goods are cheaper in Japa to
n, those Cambridge University in
holding US dollars will seek to 1885,
buy economics was still part of the
Japanese yen so that they can bu curriculum in the moral sciences
y goods and
more cheaply in Japan. This will history. It was merely one subject
push up that
the value of the yen (and push do historians and philosophers were
wn the required to take in order to get t
value of the dollar) until purchasin heir
g power degree. Marshall set out to mak
parity is reached. Conversely, if go e
ods are economics an independent field of s
cheaper in the US, the Japanese w tudy
ill seek t h a t s t o o d o n i t s ow n , a n d
to buy US dollars, thereby pushing t h a t h a d
up the scientific standards as high as the
physical and biological sciences.
Yet
Marshall also wanted economics to result, students throughout the world
be a
practical science, aiding and assis were
ting able to major in economics, and to st
g ove r n m e n t o ffi c i a l s a n d bu s i n e s s udy
leaders in making important decisithe many notions introduced by Mars
ons. hall.
In 1903 Marshall succeeded i For all these reasons Marshall was
n this the
endeavor; a separate school and de most eminent economist of his day,
gree in and
Economics was started at Cambr remains among the half dozen or so
idge most
University. Other academic institu important figures in the long history
tions of
soon followed the lead of Cambridg economics.
e, and
economics became a Works by Marshall
recognized
discipline throughout the world.
Elements of Economics of Industry, L
As a
ondon,
Macmillan, 1879
68
Principles of Economics (1890), Londo
n,
Macmillan, 8th edn., 1920
“National Taxation after the War,” in
W.H.
Dawson (ed.) After-War Problems,
London,
Allen & Unwin, 1917, pp. 313–45
Industry and Trade, London, Macmillan
, 1919
Money, Credit and Commerce, Lond
on,
Macmillan, 1923
The Pure Theory of Foreign Trade, L
ondon,
London School of Economics and
Political
Science, 1930
The Early Writings of Alfred Marshal
l, 1867–
1890, 2 vols., ed. John K.Whitaker, NewY
ork,
Free Press, 1975
Works about Marshall
Groenewegen, Peter, A Soaring Eagle:

Alfred
Marshall 1842–1924, Brookfield, V
ermont,
Edward Elgar, 1995
Keynes, John Maynard, “Alfred Marshall, 1
842–
1924,” Economic Journal, 34 (Se Alfred
ptember Marshall, New York, St Martin’s Press
1924), pp. 311–72. Reprinted in E , 1986
ssays in Reisman, David, Alfred Marshall’s Mission
Biography, NewYork, Norton, 1951, p , New
p. 125– York, St Martin’s Press, 1990
217 Rima, Ingrid, “Marshall’s Concern About Po
Pigou, A.C., (ed.), Memorials of Alfred M verty:
arshall, A Hundredth Anniversary Retrospe
London, Macmillan, 1925 ctive,”
Reisman, David, The Economics of
FRANCIS
YSIDRO EDGEWORTH
Review of Social Economy, 48 (Wint of private tutors. At the age of 17, he
er 1990), entered
pp. 415–35 Trinity College, Dublin to study la
nguages.
Then, in 1867, Edgeworth went to
Oxford
FRANCIS YSIDRO EDGEWO University to study the humanities. He obt
ained
RTH an MA degree in 1877 and also publi
(1845–1926) shed his
first book, a work on ethics (Edgewor
th 1877)
Francis Edgeworth studied how e that attempted to bring other moral
theories
conomies
under the rubric of utilitarianism. E
could achieve the best or optimal di dgeworth
stribution
then began to study commercial law;
of its resources. His main contributi
he also
on was to
read and studied mathematics on his
apply advanced mathematical techniqu
own.
es in an
In the late 1870s Edgeworth lect
attempt to answer this question. I ured at
n this
Bedford College in London. His ne
endeavor, Edgeworth developed many
ighbor,
modern
William Stanley Jevons, interested E
tools of microeconomic analysis-
dgeworth
utility
in mathematics and statistics, and h
functions, indifference curves, contr ow they
act curves
could be applied to economics. Edg
and the Edgeworth box.
eworth
Edgeworth was born in Edgewo
quickly saw that mathematics coul
rthstown,
d aid
Ireland in 1845 into a famous and
economic reasoning and could chec
wealthy
k the
family. His grandfather was Richar
arguments made in ordinary English
d Lovell
(Creddy
Edgeworth, and his aunt was the novelist
1986, p. 15). He then began publishing ar
Maria
ticles
Edgeworth. Edgeworth received an
and books that employed mathema
excellent
tical
classical and humanistic education at th
techniques to demonstrate economic pri
e hands
nciples.
These publications eventually earn Drummond Professor of Political Econ
ed him a omy at
position as professor at King’s Co All Souls College, Oxford.
llege in In 1891, Edgeworth became the first
London and then a highly-prized c editor
hair—the of the Economic Journal. Over the n
ext 35
years, Edgeworth molded and develop
ed the
journal, making it into one of the
most
distinguished and important economic jou
rnals
in the world. During this time period, he serv
ed
either as editor or joint editor (with Ke
ynes).
In all his work, Edgeworth looked
to the
differential calculus as a “master key
” that
would unlock all the wisdom of econ
omics.
Starting with clear definitions
and
mathematically precise axioms, and proce
eding
with rigorous demonstrations of
his
conclusions, Edgeworth hoped to
put
economics on the same footing as mathem
atics
and the hard sciences. Only then, he felt, co
uld
questions of economic policy be ade
quately
addressed and solved. Edgeworth als
o felt
mathematics was aesthetically more e
legant
than mere prose, was more precise than
prose,
and was therefore philosophically supe
rior to
the verbal arguments of Adam Smith
and the
other classical economists. Ironically, his
poor
prose and his convoluted mathematics
make
Edgeworth difficult to read, even for
those
economists who have specialized trai
ned in
mathematical economics.
Edgeworth was primarily interested
in the
issues of exchange and distribution utility, which required that consumers
; in know
particular, he studied how the benefits how much more utility they received from g
of trade ood
or exchange get distributed between indiv A than they received from good B.Edg
iduals eworth
and between countries. moved economists from focusing on c
One important contribution du ardinal
e to utility to focusing on ordinal utility,
Edgeworth (and Pareto) concerned th which
e notion involved a rank ordering of consu
of much more utility, a concept tha mer
t had preferences based upon the utility derived f
become popular among British economis rom
ts due each good. Ordinal utility was less st
to the influence of Bentham and Mil ringent
l. Early
utilitarians relied upon the notion of 6
cardinal 9
FRANCIS YSIDRO EDGEWORTH
than cardinal utility because it re have more beer then I must have fewer pre
quired tzels
consumers to know only that they (and vice versa). We can consider co
preferred ntinually
good A to good B (or vice versa), or increasing the quantity of one good
that they and
were indifferent between the two g
oods (see
also PARETO).
Edgeworth then used the ordina
l view of
utility to develop the notion of an i
ndifference
curve. This curve is a set of points repres
enting
combinations of two goods that pr
ovide the
same amount of utility to a part Figure 5 The indifference curve
icular
individual. This notion is easiest to und
erstand decreasing the quantity of the other
if we consider a simple case with
just two to make
goods—pretzels and beer. To start, l sure that utility stays the same for the cons
et us take umer.
some combination of these goods, The set of all such points would b
say three e an
beers and three bags of pretzels. If I have indifference curve for beer and pretze
either ls. Such
more beer or more pretzels, my util acurve is shown in Figure 5.
ity should Starting with more beer or more
increase since I have more things. pretzels
For my we could trace out another indifference c
utility to remain at the same level, urve,
whenever I one yielding greater utility than our
original curve would represent more utility, or a
curve. This new curve would be better
to the situation for our consumer. Similarly, s
northeast of the indifference curve tarting
sketched with fewer beers or fewer pretzels wo
in Figure 5, and would include comuld let
binations us trace out a new indifference curve yi
like 4 beers and 4 bags of pretzels. Since elding
more less utility than our original indiffere
goods yield greater utility, this ind nce
ifference curve. This would lie to the southwest
of the
70 curve sketched in Figure 5.
Edgeworth assumed that indiffere
nce
curves would be convex to the origi
n, as
shown in Figure 5 , rather than a str
aight
line. This is because of diminishing
marginal utility. As I consume more
and
more beer the extra utility I receive
from
another beer declines. The first bee
r
quenches my thirst and helps me relax
after
a hard day at work; the second beer
also
helps me to relax. But the ninth be
er
provides few additional benefits over
and
above the eighth beer, and as cases
of
extreme drunkenness and alcohol pois
oning
show, may even provide negative uti
lity.
What is true of beer is also true of pret
zels.
A first bag satisfies my hunger, a se
cond
and subsequent bags provide less uti
lity,
while a tenth bag of pretzels is only li
kely
to make me sick.
Edgeworth next applied the tool
of
indifference curves to analyze excha
nge.
Exchange can occur between two pe
ople
(barter), which is how Edgeworth th
ought
of it, or as trade between two count
ries, Consider two countries (Germany
which is how many contemporary and
economists employ the Edgeworth a Belgium), each of which produces t
nalysis. wo
This theory of exchange constitutes goods (again, pretzels and beer). Ea
the ch
main contribution to economics ma country has their own set of indiffer
de by ence
Edgeworth. It shows diagrammaticall curves, and each will want to maxi
y how mize
exchange could benefit both parties, their utility or reach their highest
and indifference curve (the best combinati
also shows how the final result of on of
such the two goods as possible). With their
exchange was likely to be indetermi own
nate. national resources, Belgium finds it
s
FRANCIS
YSIDRO EDGEWORTH
highest indifference curve, and pr being by
oduces moving from point A to any point w
40 million cases of beer and 10 ithin the
million ellipse or eyepiece formed by the int
tons of pretzels. Likewise, Germany ersection
seeks of their two indifference curves. Point
its highest indifference curve, pro s like B
ducing and C lie on higher indifference curves for
40 million cases of beer and 60 each
million country, and make each country bet
tons of pretzels. The Edgeworth ter off.
Box is
constructed by flipping one coun
try’s
indifference curve upside down and
linking
it with the indifference curve for th
e other
country. In Figure 6 Germany is f
lipped
around, so that higher indifference
curves
for Germany are further down or
to the
southwest. Point A in Figure 6 sho
ws the
optimal situation for the two cou
ntries
before any trade takes place. It sho
uld be
thought of as the best each countr
y could
do on its own, without trade.
Edgeworth noted that both Bel
gium and
Germany could improve their well-
These points could be reached only if Ger to a higher indifference curve, then B
many elgium
and Belgium trade with one another. must be on a lower indifference curv
Belgium e, and
moves to a higher indifference curve by tra vice versa.
ding Edgeworth called the set of points at
beer to Germany for more pretzels; which
and the indifference curves of Germany
Germany moves to a higher indifference and
curve Belgium can be tangent to each other
by giving up pretzels in exchange for (points
beer. between D and E in Figure 6) the “
In contrast to this situation, consid contract
er what curve.” These points represent the best poss
happens as we move along the line ible
segment trades for the two countries (starting a
drawn between D and E.Belgium can t point
become A). In reality, however, the curve is as
better off only if Germany becomes wors much a
e off, conflict curve as a contract curve. Each cou
and Germany can become better off ntry
only if is better off when on the contract curv
Belgium becomes worse off. If Germany e than
goes
Figure 6 The Edgeworth Box
71
FRANCIS YSIDRO EDGEWORTH
when they reject trade (and remain at poi are in conflict—one country gets mo
nt A); re if the
yet once on the contract curve the two cou other country gets less. At point E,
ntries Germany
goes to a much higher indifference producers, the trading advantage wou
curve and ld favor
receives all the gains from trade, while B Germany. Everyone wants Germany’s p
elgium retzels,
is neither better off nor worse off. C but Germany can go to many differe
onversely, nt places
at point D, all the gains from trad to get beer. Edgeworth showed that only
e go to under
Belgium. conditions of perfect competition, where
Edgeworth next sought to find o many
ut whether countries sell both pretzels and beer
there would be one unique solutio , would
n in a there be only one possible outcome. All p
situation like this, or how the gains f arties
rom trade would be price takers and each would
would actually get divided up between t lose any
he two bargaining power they had over the other
parties. He discovered that there is party.
not likely In addition to his work in economi
to be just one trading equilibrium p c theory,
oint. The Edgeworth (1996) made several cont
point on the contract curve that t ributions
he two to statistical analysis, including wo
countries eventually settle on will rk on
involve drawing statistical inferences and de
bargaining between Belgium and veloping
Germany the correlation coefficient (see Stigl
over the gains from trade. The cou er 1978).
ntry that
gains more will be the one that is 72
better at
bargaining, or the country that can more
easily
do without the good produced by t
he other
country.
Edgeworth next went on to sho
w that the
degree of indeterminacy in the final
outcome
was a function of the number of traders o
n each
side. If many countries produced pr
etzels for
export and only a few produced beer, Ge
rmany
would not be able to extract such
a good
bargain against Belgium. All the
pretzel-
producing countries would compet
e against
each other by offering lots of pretzel
s for each
beer received from Belgium. Simil
arly, with
many beer producers and no other
pretzel
This number, which can vary from zero to as a contingency fund against deposi
one, tors
shows the association between two e coming to the bank to withdraw their
conomic money.
variables; in particular it shows how Notwithstanding this practical appl
closely ication
two variables are related to one anotof his work, Edgeworth wanted above
her. A all to
correlation coefficient of zero shows establish theorems about economic pri
that the nciples.
two variables are not related at all and This approach to the study of economi
do not cs has
move together. A value of one shows greatly influenced other economist
the two s.
variables move in unison, wheneve Edgeworth also developed several im
r one portant
variable changes we can predict wit tools of economic analysis. For these r
h 100 easons,
percent certainty how the other varia Edgeworth was one of the five or six
ble will most
change. important economists of the early tw
Rather uncharacteristically, his w entieth
ork in century.
mathematical statistics had a very practica
l side
to it, which Edgeworth drew out and expla Works by Edgeworth
ined.
In two papers Edgeworth (1886, 1888) sh New and Old Methods of Ethics: Or
owed ‘Physical
how the past history of demand for withdra Ethics’ and ‘Methods of Ethics’,
wals Oxford,
would let a bank estimate the probabi Parker, 1877
lity that Mathematical Psychics: An Essay on t
a certain level of cash would be ade he
quate to Application of Mathematics to the
meet future demand for withdrawals on a Moral
daily Sciences, London, Kegan Paul, 1881
basis. This computation allowed a b “Problems in Probabilities,” Philosophi
ank to cal
determine how much money it could Magazine, 22 (1886), pp. 371–84
lend out Metretike, or the Method of Measuring Pro
and how much money it had to keep bability
on hand and Utility, London, Temple, 1887
3 vols., ed. Charles R.McCann, Jr.
, Hants,
“The Mathematical Theory of Banking,” Edward Elgar, 1996
Journal
of the Royal Statistical Society, 51 (18 Works about Edgeworth
88), pp.
113–27 Creedy, John, Edgeworth and the D
Papers Relating to Political Econo evelopment
my, 3 vols., of Neoclassical Economics, Oxfo
London, Macmillan, 1925 rd,
Writings in Probability, Statistics and E Blackwell, 1986
conomics, Creedy, John, “F.Y.Edgeworth, 1845–
1926,” in American economy; and he argued th
Pioneers of Modern Economics in B at when
ritain, ed.
D. P.O’Brien and John R.Presley, Toto
wa, New
Jersey, Barnes & Noble, 1981, pp.
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Hicks, John, “Francis Ysidro Edgew
orth,” in
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my from the
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Antoin E.Murphy, Dublin, Irish
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Edgeworth: 1845–1926,” in Ess
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Biography by John Maynard Key
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York, Norton, 1951, pp. 218–38
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dgeworth,
Statistician,” Journal of the Roy
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Society, 141, 3 (1978), pp. 287–
322
JOHN BATES CLARK (1847–
1938)
John Bates Clark was one of sever
al people
who independently discovered the
ideas of
marginal utility and marginal produ
ctivity in
the late nineteenth century. Clark also us
ed the
notion of marginal productivity to
develop a
theory of income distribution. He then us
ed this
theory to justify the existing in
come
distribution as fair and equitable. In
addition,
Clark studied the impact of large mono
polistic
firms and powerful labor unions
on the
JOHN BATES ho was
CLARK recovering from a case of tuberculosis). In 1
880
such economic power existed, it sh Clark helped to found the American Econo
ould be mic
restrained. Association, now the largest and m
Clark was born in Providence, Rhode Iost
sland prestigious organization of economists
in 1847. His father owned a dry- in the
goods store world. Three years later he became
there; but poor health caused him to its
move to President.
Minnesota, where he started a small While teaching at Columbia Univ
plow ersity,
business. Clark attended Brown Universi Clark became active in the peace mov
ty and ement.
Amherst College, where he acquired Convinced that the threat of war was
interests a great
in both philosophy and ethics. After gradu obstacle to improving the economic co
ating, ndition
he spent three years studying in Swi of man, he joined the League to Enforce Pea
tzerland ce,
and Germany at the Universities of Zu actively supported the League of Natio
rich and ns, and
Heidelberg respectively. At this time there he became director of the Economic
were and
few graduate programs in the Unite History Division of the Carnegie End
d States, owment
and travel to Europe was necessary tofor International Peace, which studi
pursue ed
advanced studies. When Clark returne international war and militarism.
d to the Clark’s most important contributio
United States he accepted a teaching n to
job at economics was undoubtedly his devel
Carleton College, where he taught T opment
horstein of the marginal productivity theory
Veblen. Other teaching positions foll of
owed at distribution. The theory was designed
Smith College, Amherst College an to
d Johns explain the principles that determine how m
Hopkins. Clark finally settled dow uch
n at income different people receive, and t
Columbia University, where he ta hus the
ught principles affecting the distribution of
economics from 1895 to 1923 (wit income
h the in an economy.
exception of the 1898–9 academic ye
ar when 7
he replaced Irving Fisher at Yale w 3
JOHN BATES CLARK 1965, pp.
viii, 84–5) himself stated that the the
The precise inspiration for the ory was
marginal developed in response to Henry Geo
productivity theory of distribution rge, and
remains was intended to prove George wron
somewhat obscure. Clark ([1899] g about
income distribution. George ([1879] pragmatic one. Late nineteenth-
1929, pp. century
167–9) had held that rents stemmed America was the age of the robber
from the baron
monopoly power of landowners, and th (Josephson 1934). Labor organization
at rents s such
existed only because there was a fi as the Knights of Labor and the A
xed stock merican
of land and someone was willing to Federation Labor arose in respons
pay to use e to
that land. Rents, therefore, were no growing business power and union
t morally attacks
justified and were not the result of on capitalism grew. Quite possibly,
human the
exertion. As a result, he proposed marginal productivity theory also ste
(like mmed
Quesnay) abolishing all existing ta from a desire by Clark to justify b
xes and usiness
instituting a single tax on land value profits and thus defend capitalism
s. from
Yet Clark’s son (J.M.Clark 1952) an these attacks.
d John
Henry (1983) both contend that
Clark 74
developed the marginal productivity
theory as
a response to Marx, who claimed that w
orkers
were exploited because employers k
ept some
of the value (the surplus value) th
at workers
created. Numerous passages in the
writings
of Clark ([1899] 1965, p. 7; 1890a
, p. 43;
1914, pp. 34–6) appear to suppor
t this
interpretation.
But more than likely, Clark ha
d both
George and Marx in mind when wo
rking on
his marginal productivity theory
of
distribution. Contra George, the t
heory
shows that rental income is earned
income;
and contra Marx, it shows that wor
kers are
not exploited because the income
they
receive is equal to the income they
earn. A
third motivation for the marginal
productivity theory may have been
a more
say an educational institution. Whenev
er the
Whatever its inspiration, Clark used m school hires an additional teacher it can
offer
arginal more classes and more courses of study,
productivity theory to argue that the so it
existing should experience increased enrollm
distribution of income was fair— so long a ents.
s the From each new student the school will rece
incomes were received as part of a co ive
mpetitive additional revenue. If the new faculty me
process. Clark ([1899] 1965, p. v) set f mber
orth the has a national or international reputati
essence of his theory in the introductioon the
n to his gain will be even greater; students fro
book The Distribution of Wealth: m all
over the country or around the world
It is purpose of this work to show
will
that the come to the college in order to have
the
distribution of the income of soci
ety is opportunity to learn from the new fa
controlled by a natural law, and this culty
law, if member. The marginal productivity of the
it worked without friction, would new
give to faculty member is the increased reve
every agent of production the am nue
ount of coming to the school hiring that perso
wealth which that agent creates. H n.
owever Clark took the position that if eve
wages may be adjusted by bargain
ryone
s freely
made between individual men, the was paid the value of their margi
rates of nal
pay that result from such transact productivity, no one could legitimat
ions ely
tend…to equal that part of the pro complain about how much income t
duct of hey
industry which is traceable to the received. Everyone would get exactly
labor what
itself…. So far as it is not obstruct they contributed to the production of
ed, [the goods
economic system] assigns to everyo
ne what
and services. The resulting distribution
he has specifically produced. would
be fair and everyone would be jus
To understand marginal producti tly
compensated. On the other hand, if so
vity meone
theory it helps to consider a particul received less than the value of their ma
ar firm, rginal
x
recognized.
product they were being robbed or Under the marginal productivity t
heory of
exploited. distribution, land is treated just like l
Such a condition, Clark felt, woul abor. It
d lead to contributes to the value of output b
potential social problems, as Mar
ecause someone will be exploited because
things could not be produced withou they
t a place receive less than their actual contrib
to put buildings and factories. Simil ution to
arly, the the revenue of the school. Second, if ever
land contains important raw material yone
s that are gets paid their marginal product, and
needed in producing goods and serv you add
ices. For up all such payments, is there anyth
land’s contribution to the value of ing left
output over? This is a potential problem be
landowners must be paid some re cause if
nt. Thus, anything is left over after Monmouth
Henry George was wrong to claim pays all
that such its faculty members and all other fa
incomes were not earned. Land co ctors of
ntributes production, we need some way to de
something to production, and the o termine
wners of who gets this income and we need so
this land deserve some reward fo me way
r this of deciding whether this division of t
contribution. he extra
Similarly, according to the ma
rginal
productivity theory, profits are justifi
ed by the
contribution that capital equipme
nt or
machinery makes towards produci
ng goods.
Thus profits are not robbery; they ar
e a return
to capital. Moreover, as long as workers r
eceive
their marginal product, they receive a fair
return
even though they do not receive th
e surplus
value that they create when working
.
One question immediately raise
d by this
theory has come to be called the
product
exhaustion or adding up problem.
There are
two ways to look at this problem.
First, is
there enough money from the sale
of a good
to pay all factors of production their
marginal
product? Does my school, Mon
mouth
University, receive enough revenue t
o pay all
faculties their marginal product? I
f not,
JOHN BATES productivity theory of distribution.
CLARK Clark also made important contrib
utions
revenue will lead to a fair distributi to economics through his study of competi
on of tion
income overall. and monopolies. Beginning with Adam S
Clark (1890a, 1891) asserted that t mith,
he sum economists have worried about t
of all marginal productivities equals t he
he total concentration of economic power in the ha
value of goods and services produce nds
d by a of a few firms. Monopolies, through
firm, and even developed a set of diag their
rams in market power, could restrict output an
an attempt to show this result ([1899 d raise
] 1965, prices, thus giving consumers fewer an
Ch. 13). He argued that any other result wod more
uld expensive goods.
tend to be eliminated through comp As we saw above, Clark held t
etition. hat
Clark’s argument, however, was competition was a positive force in
not the
mathematically rigorous and he fail economy because it tended to make su
ed to re that
identify the restrictive circumstances everyone got their fair share, or the va
under lue of
which this result held. It was left to their marginal contribution to produc
Knut tion.
Wicksell (see below) to demonstrat With competition, if an employer tried
e the to pay
correct solution to the adding up pr a worker less than her marginal produ
oblem. ct, she
Wicksell showed that only in the ca would offer her services to another em
se of ployer.
constant returns to scale would all And she should be able to find rea
factor dy
payments equal the value of the g employment because other firms wo
ood uld
produced. Wicksell then argued t benefit from hiring her. The firm woul
hat d gain
competition would lead to constant additional profits plus the worker’s m
returns. arginal
Nonetheless, Clark got the gist of the product. This would exceed the wage rat
solution e that
right; only when the forces of competi the employer would pay to the worker.
tion are But in
strong will product exhaustion or ad
ding up 7
not be a real problem for the marg 5
inal
JOHN BATES CLARK the wage offered by her employer.
This analysis had several importan
the absence of competition among f t policy
irms, this implications. Anything
worker has limited options and mu disturbing
st accept competition was anathema and to be opp
osed. domestically, this practice is called “pre
This included unions that threatened datory
to strike pricing” and when done by a foreign f
and used this threat to extract wage irm it is
s higher called “dumping.” To deal with this
than worker marginal products. Clar potential
k (1894, problem Clark emphasized the need to p
p. 494) thus led the fight for right revent
-to-work any unfair methods of competition.
(open shop) laws in the late nine The Sherman Act of 1890 and the
teenth Standard
century. Restraints on competition, Oil case of 1911, made predatory pricing il
however, legal
could also come from businesses; in the US. Unfortunately, it is always
so Clark difficult
began to study monopolies, other in practice to prove whether firms are eng
forms of aging
imperfect competition, and business in predatory pricing and Clark provi
practices ded no
that restrained competition. clear test to help us determine wheth
In a number of articles, Clark (1890b er firms
, 1901, are engaging in this practice. If a firm is pri
1904) defended large firms, holdi cing
ng that below cost, this may be due to lack of
monopolies and oligopolies were demand
natural
phenomena. Large firms with monopol 76
y power,
Clark held, were never really a pr
oblem
because of potential competition. I
f a firm
earned excessive or monopolistic profit
s, other
firms would soon enter the industry
seeking a
share of these high profits. In additi
on, Clark
argued that if a large firm abused its mon
opoly
power, consumers and labor union
s would
attempt to use the legislature and the
courts to
reduce prices and break up the mon
opoly.
However, Clark (1900) did reco
gnize that
in the competitive process some p
roducers
might set their prices below their c
osts. Such
actions attempt to drive competitor
s out of
business and lead to monopoly po
wer and
greater profits in the future. Whe
n done
what they contribute to the production
process
for their product or because competit and that we have a fair distribution of i
ncome;
ors can and competition is also necessary to kee
produce and sell goods at this low pric p large
e. In the firms from abusing their economic power
latter case, to remain competitive, the firm .
will Although Clark’s achievements do not
have to cut its price to the same low l rank
evel and him with the major British economists
hope it can survive by cutting costs. or the
Arguments over this issue have continental marginalists, they do make
recently Clark
been raised by American businesses the most distinguished American economi
, which st in
have accused Japanese firms of dumping the late nineteenth and early twentieth cent
goods ury.
in the US in order to develop a large Europe was the center of economic t
market hought
share and drive US firms into bankruptcy. when Clark was alive and writing. But
Like Clark
predatory pricing, dumping is regard lead a parade of major American eco
ed as an nomists
illegitimate form of business compe that would soon grow very large.
tition,
because its goal is to develop monopoly po
wer. Works by Clark
The General Agreement on Tariffs an
d Trade The Philosophy of Wealth (1886), New
(GATT) has an antidumping code th York,
at all Augustus M.Kelley, 1967
nations are supposed to adhere to. B“The Law of Wages and Interest,” Annal
ut like s of the
predatory pricing, dumping has been American Academy of Political an
difficult d Social
to prove in practice. Science, 1 (July 1890a), pp. 43–65
The one dominant theme running throu “The ‘Trust’: A New Agent for Doing
gh the an Old
economics of J.B.Clark is the impor Work: Or Freedom Doing the Wor
tance of k of
competition among business firms. Comp Monopoly,” The New Englander a
etition nd Yale
is necessary to make sure that everyone gets Review, 16, 3 (March 1890b), pp. 223
paid –30
Economic
Association, (December 1894), pp.
“Distribution as Determined by a Law 481–502,
(Presidential address)
of Rent,” The Distribution of Wealth (1899), N
Quarterly Journal of Economics, 5 (1 ew York,
891), pp. Augustus M.Kelley, 1965
289–318 “Trusts,” Political Science Quarterly,
“The Modern Appeal to Legal Forces in E 15, 2
conomic (January 1900), pp. 181–95
Life,” Publications of the American The Control of Trusts, New York, M
acmillan, VILFREDO P
1901 ARETO
The Problem of Monopoly, New York
, Columbia late in life, Pareto rejected the trend
University Press, 1904 to
formalize economics. He came to belie
ve that
Works about Clark this approach was too narrow and co
uld not
Clark, J.M., “J.M.Clark on J.B.Clark,yield a comprehensive understanding
” in The of how
Development of Economic Though real economies worked. He then trie
t, ed. H.W. d to
Spiegel, New York, Wiley, 1952, pp. broaden economics by incorporating p
592–612 olitical
Henry, John, “John Bates Clark and the M and sociological variables into his anal
arginal ysis of
Product: An Historical Inquiry inthe economic system.
to The Pareto was born in Paris in 1848 w
Origins of Value-Free Economic hile his
Theory,” father, a civil engineer, was in exile beca
History of Political Economy, 15, 3 (1 use of
983), pp. his opposition to the policies of the I
375–89 talian
Henry, John, John Bates Clark: The government. His family was middle cl
Making of a ass and
Neoclassical Economist, New Yor provided Pareto with a good educatio
k, St n. They
Martin’s Press, 1995 also imparted to him the values of har
d work
and moderate living. In 1858 the fa
Other references mily
returned to Italy, so Pareto was educated mai
George, Henry, Progress and Poverty (18 nly
79), New in Italian public schools. He then went
York, Robert Schalkenback Foundati on to
on, 1929 attend the Polytechnic Institute of T
Josephson, Matthew, The Robber B urin,
arons: The receiving an engineering degree in 18
Great American Capitalists, 1861– 69 and
1901, New finishing first in his graduating class.
York, Harcourt Brace, 1934 After receiving his degree, Pareto
worked
as a civil engineer for a government-
owned
VILFREDO PARETO (1848– railroad. Other engineering positions follo
wed.
1923) These jobs required that Pareto trave
l to
England and Scotland at times, and
Vilfredo Pareto (pronounced pa- thus
RAY-tow) is enabled him to observe the British ec
remembered by economists primari onomy.
ly as one The success of the British governme
of the fathers of mathematical econo nt in
mics. Yet, promoting a free market, and the ben
eficial
effects of this laissez-faire policy, we
re his government job to become an engi
especially striking. As a result, Paret neering
o joined consultant, and he began to write politi
the Adam Smith Society and became a cal and
n active economic commentaries that attracted a great
member of the society in the 1870s and 18 deal
80s. of attention. Pareto also put his traini
He contributed frequently to the so ng in
ciety mathematics and engineering to good
newsletter, supporting democracy, fre use by
e trade, translating economic theories from v
competition, and reduced govern erbal,
ment declarative sentences into mathemat
regulation of business and individual acti ical
vities. equations. This work led to a faculty appoint
In his spare time, and during evenin ment
gs filled
with insomnia, Pareto read extensively in po
litical 7
economy and sociology. In 1882 he retired 7
from
VILFREDO PARETO peace
on his project to broaden economic
at the University of Lausanne in 1893 analysis.
where he He also became an eccentric hermit,
succeeded Léon Walras. living in
At Lausanne, Pareto developed a w a large house with more than a dozen
orldwide cats.
reputation as a pioneer in making e In addition to making economic
conomics s more
more mathematical. Despite his success mathematical, Pareto made three su
, Pareto bstantive
became troubled by the increasing n contributions to economics—he dev
arrowness eloped a
of mathematical economics and did law of income distribution that still
an about- bears his
face. He argued that to understan name, he is responsible for switching the
d real focus
economies one needed to understa of economists from cardinal to ordina
nd the l utility,
cultural and political context in and he developed a test of whether e
which conomic
economic events took place. Paret outcomes could be improved.
o also While teaching at Lausanne, Paret
attempted to incorporate sociological, o became
political, interested in income distribution and he be
and psychological factors into his a gan to
nalysis of study income inequality in various nations.
how economies change. These
In 1898, when his uncle died, studies led to the discovery of a simpl
Pareto e pattern
inherited a substantial fortune. He governing income distribution. Pareto fou
used this nd that
money to purchase a country villa if you were to rank order families in one cou
on Lake ntry
Geneva. There Pareto was able to work in by their income level, and then recor
d family
income levels, you would find that inc
ome does 7). When income increases geometrically, in
not increase proportionately or arith
metically. come
Rather, Pareto found that income i disparities grow as one moves along the orde
ncreases red
geometrically as we move along our rank o list of incomes. For example, if a family
rdering at the
from the poorest to the wealthiest fam 30th percentile makes 10 percent more
ily. When than a
income increases proportionately, if a family at the 20 percentile, a family at t
family at he 50th
the 30th percentile makes 20 percent percentile may make 40 percent more
more than than a
a family at the 20th percentile, a fam family at the 50th percentile and a family
ily at the at the
40th percentile would make 20 percent mo100th percentile may make twice as much as (
re than 100
a family at the 30th percentile and a family percent more than) a family at the 90th percen
at the tile
100th percentile would make 20 per (see Figure 8).
cent more
than a family at the 90th percentile (s
ee Figure
78
Figure 7 Arithmetic or proportional
increases in income
Figure 8 Geometric increases in in
come
Examining income statistics from t
found the pattern of income distributio
he US
n to be
and numerous European countries, pretty much the same everywhere. As a
Pareto result,
have been ignored by most subseq
uent
he called this pattern a “law” of i economists.
Pareto made another important contr
ncome ibution
distribution. Because he found in to economics when he argued that
come ordinal
distribution to be rigid and invaria utility rather than cardinal utility sh
nt, some ould form
economists have criticized Pareto for ju the basis of economic analysis. Mea
stifying sured in
existing patterns of income inequa ordinal terms, the individual consu
lity. But mer is
other explanations of the remarkab assumed to know that good A is pre
ly similar ferred to
income patterns found everywhere are good B. Measured in cardinal term
possible. s, the
For example, Pareto believed that the consumer is assumed to know not o
rich will nly that
try to protect what they have and t good A is preferred to good B, but also
hat they by how
usually have the power to do so. Pr much good A is preferred to good B.
ograms to Shifting the focus from cardinal t
redistribute income and reduce ineq o ordinal
uality will utility reduces the demands that ec
thus fail due to the political clout onomists
of the made of each consumer. Consumers
wealthy, a universal phenomenon. need to
Despite the great controversy it know only that they prefer peaches t
generated, o plums.
Pareto’s work on income distributio This is something most consumers do
n marked actually
a major advance in economics. Paret know. It is also something that most consu
o was the mers
first economist to seriously study reveal through their everyday expen
income ditures.
distribution data from around the Consumers, however, are not likely
world. He to know
was thus a pioneer in this area. Pa that they want peaches twice as much as p
reto also lums
made a major contribution by sugge or three times as much as plums. The
sting how shift to
income inequality could be measure ordinal utility thus made economics
d. In this more
way, his work was path-breaking. Fi
nally, the
suggestion that income distributio
n might
display some law-like order, raises
intriguing
economic, social and political question
s which
VILFREDO “ophelimos.” His goal was to argue
PARETO that
certain economic outcomes could not
realistic in the way it described hu be
man improved upon. Pareto Optimal outco
behavior. mes are
Also, by moving from cardinal to situations where making one person
ordinal better
utility it was no longer necessary to worry a off requires that someone else be made
bout worse
how utility could be measured or ho off. Thus, no clear overall improvem
w it was ent is
possible to compare the utility of di possible; the Pareto Optimal condition
fferent is the
people. Since the times of Bentham a best that we can do.
nd Mill, Pareto began by noting that t
utilitarianism was plagued by these p wo
roblems. individuals in a market will trade only i
With ordinal utility a measuring rod f each
was no of them gains something from the exc
longer needed. The fact that two peopl hange.
e traded If one party gains and the other loses
with each other demonstrated that t there
hey will be no trading. If the two parties
preferred the goods they received to th are
e goods unwilling to trade on their own, any at
they traded away. Likewise, interpe tempt
rsonal to redistribute goods between these p
utility comparisons no longer had to b eople
e made. will make one party better off but will
Ordinal utility could guarantee that total umake
tility the other party worse off. Therefor
would rise as a result of any trade be,
ecause economies that allow free exchange i
utility for each party to the exchan n the
ge was market will be Pareto Optimal.
greater; if each person was not made better The notion of Pareto Optimality c
off, an also
they would not have traded. be used to evaluate proposed policy c
A third contribution made by Pare hanges.
to was Tax cuts for the wealthy may incre
the introduction of the notion of an ase
optimal investment and spur economic growth. If t
state of economic affairs, now called hose
“Pareto with low incomes gain as a result of
Optimality.” Pareto himself called sugreater
ch a
state “ophelimité,” from the Gre 7
ek 9
VILFREDO PARETO hose with
low incomes wind up worse off (because
growth, this tax policy would lead to these
a Pareto tax cuts will have to be paid for by s
Superior result. But if the tax cuts omeone).
do not In this case, the current tax system
generate sufficient income growth, t would be
Pareto Optimal. off, the society as a whole is bette
In the 1930s, economists thought r off.
that the While this may very well be true,
notion of Pareto Optimality could Sen
help points out it is still an individual op
evaluate economic performance w inion
ithout rather than a scientific truth. Finally,
resorting to value judgments. Thi Sen
s, they (1987) has also argued that there is r
thought, would give economics a eally
more nothing desirable about Pareto Opt
scientific grounding. As a result, ec imal
onomists situations, since a famine could be P
spent a great deal of effort trying areto
to prove Optimal, while redistribution to pr
theorems about the existence of event
Pareto mass starvation would not be Par
Optimality under certain condition eto
s and to Optimal (see also SEN).
determine whether Pareto Optimal
situations
were stable or likely to change. T
he main 80
finding of this work is that comp
etitive
capitalism leads to an outcome tha
t is both
Pareto Optimal and stable.
However, this work has more
recently
received a good deal of criticism.
First,
situations are Pareto Optimal giv
en an
initial distribution of income or res
ources.
If we were to begin with other i
nitial
distributions of income we would
reach
very different results. These outc
omes
would be Pareto Optimal also, an
d there
is no way to decide among the v
arious
possible Pareto Optimal outcome
s.
Second, as Sen (1982) has pointe
d out,
Pareto Optimality does not really y
ield a
va l u e - f r e e o r s c i e n t i fi c
w e l f a r e
economics. It assumes that if a c
hange
makes every individual in society
better
their incomes rise, people become
more
Despite his many important subs hedonistic—they borrow and spend, an
d they
tantive engage in speculative activities to m
contributions, Pareto is best known ake
for money quickly. At some point, Pare
introducing mathematical forms of re to
asoning thought, excessive consumer debt w
and analysis into economics. Howeve ould
r, later reduce consumer confidence and spe
in his life, Pareto grew dissatisfied nding.
with This would slow down economic growt
mathematical formalization and with h; but
abstract it would also lay the foundation for f
economic theory. Important questions uture
about growth by reinvigorating social norm
economic growth and overall econos and
mic by providing more saving for futu
performance, he thought, could onl re
y be investment.
understood within an historical a It is somewhat ironic that Pareto
nd is
sociopolitical context. Pareto then so remembered for contributing to th
ught to e
incorporate these factors into a theory mathematical economics that he cam
of the e to
business cycle. He noted that social criticize and reject. But it is hardl
factors y
influenced decisions to save, work surprising that a discipline which h
and as
consume, and thus the state of the ec become increasingly mathematical w
onomy. ould
Pareto then began to develop a socio praise the mathematical Pareto and ig
logical nore
theory of economic growth and stag the sociological Pareto. Nonetheless, fo
nation. r his
Economic growth, according to Par many contributions to so many diffe
eto, rent
required hard work and a willingness t areas within economics, and for hi
o delay s
gratification. Social norms of hard pioneering efforts to make economics
work, more
frugality, and professional commit mathematical and scientific, as well as
ment more
contribute to these behaviors; econ historical and sociological, Pareto mus
omic t be
growth tends to soften and relax them. regarded among the dozen or so m
When ost
EUGEN
VON BÖHM-BAWERK
important figures in the history
of Works by Pareto
economics.
Manual of Political Economy (1906),
New York, Bawerk was
A. M.Kelly, 1971 also among the first economists to incor
The Mind and Society, NewYork, Harcour porate
t, Brace, time into economic analysis and to
1935 develop
Sociological Writings, ed. S.E.Finer,
New York,
Praeger, 1966
Works about Pareto
Cirillo, Renato, The Economics of Vilfre

do Pareto,
London, Frank Cass, 1979
Powers, Charles H., Vilfredo Pareto
, Newbury
Park, Sage Publications, 1987
Schumpeter, Joseph, “Vilfredo Pareto: 184
8–1923,”
Quarterly Journal of Economics,
63, 2 (May
1949), pp. 147–73. Reprinted in
Ten Great
Economists: From Marx to Walras,
New York,
Oxford University Press, 1965, pp. 11
0–42
Other references
Sen, Amartya, Social Choice and Welfa
re, Oxford,
Basil Blackwell, 1982
Sen, Amartya, On Ethics and Economics
, Oxford,
Basil Blackwell, 1987
EUGEN VON BÖHM-
BAWERK
(1851–1914)
Eugen von Böhm-Bawerk (prono
unced
BAUM-BOW-work) made several
related
contributions to economics. He he
lped to
develop the economic theories of ca
pital and
interest, and he explained why real
interest
rates had to be positive. Böhm-
an economic theory in which time p certified to teach in 1880, he accepted a
lays a job in
crucial role. Innsbruck, Austria.
Böhm-Bawerk was born in 1851 in the Four years later he was promoted
town to full
of Brünn (now Brno) in Moravia (then professor. In 1889, Böhm-Bawerk l
part of eft
the Austro-Hungarian Empire and now academia to become a government ec
part of onomist
the Czech Republic). His father was in the Ministry of Finance. There he
a high studied
government official. As a student, how to return Austria to the gold standa
Böhm- rd and
Bawerk studied law, administration, worked on reforming the Austrian inco
and me tax
political science, and planned for a c so it would be a better source of reve
areer in nue for
the civil service. But because his fa the government (at the time, Austria
mily was relied
facing financial difficulties, he decided to heavily on sales taxes). In 1893 he beca
study me the
law at the University of Vienna and f Austrian Finance Minister, and over t
ollow a he next
more financially rewarding career pa decade he held this position several ti
th. The mes.
law curriculum required students to take se Böhm-Bawerk left the government i
veral n 1904
courses in economics. These course and returned to the University of Vienna, w
s likely here
sparked Böhm-Bawerk’s interest in eco he was given a chair in political econo
nomics my. For
and led to another change in career the next ten years, until his death in
plans 1914,
(Hennings 1997, p. 9). Böhm-Bawerk spent most of his ti
After obtaining a doctorate in law me
from the defending himself from his many politi
University of Vienna in 1875, Böhm cal and
-Bawerk economic critics.
received a government grant to study Today Böhm-Bawerk is remembe
abroad red
and prepare for a teaching career in econo primarily for his theory of capital and i
mics. nterest.
Over the next five years, he studied in Germ He made three important and interrel
any ated
at Universities in Heidelberg, Leipzi
g, and 8
Jena; and he wrote a doctoral thesis. 1
Being
EUGEN VON BÖHM-BAWERK
contributions in this area—an anal be positive, and an equilibrium the
ysis of ory of
production as a roundabout proce interest rates that included time as an imp
ss, an ortant
explanation for why real interest rat variable affecting interest rates.
es had to Economists usually view econo
mies as in many
moving towards equilibrium and ignore different stages. Large assembly pla
the fact nts were
that this process takes place over time. Si just beginning to appear when Böhm
nce it -Bawerk
may take considerable time before an e was writing. With larger and more
conomy technologically advanced plants it
can reach a state of rest or equilibri was
um, many necessary to wait longer for the fina
other changes can occur which upset the l output
initial (for example, automobiles), since a pl
equilibrium, and move the econom ant must
y down be built before any goods can be made and
another path. Böhm-Bawerk refused sold.
to ignore Using robots will get us even more go
time, and he stressed that time was an imp ods than
ortant an automated assembly line; but in t
factor in understanding how econ his case
omies we first have to build the robots a
actually behaved. nd the
Of greatest importance, time w automated plant and then stock the pl
as a key ant with
factor in the decisions made by busi
ness firms 82
to produce goods and services. Busi
ness firms
could use production techniques th
at yield
goods relatively quickly; unfortunat
ely, these
methods give us relatively few
goods.
Alternatively, the firm could use
more
roundabout techniques of producti
on, wait
longer for the goods to be produce
d, and in
the end get more goods. To take one
of Böhm-
Bawerk’s (1889, Vol. 2, Ch. 2) f
avorite
examples, we can produce drinking wat
er from
a spring either by hand, by bucket or
by pipes.
Each successive method of production
is more
roundabout; and each method is al
so more
efficient and yields more water.
Roundabout production means u
sing more
tools or capital to produce final goo
ds for the
consumer, producing more intermediat
e goods,
and having production take place
robots. This is an even more round soon, but having few things, and havin
about g more
production process. It requires more t things, but having them in the distant
ime and future.
a longer waiting period for the final output One could have more goods in the fut
than ure by
the assembly line. But this more rou giving up consumption for a long per
ndabout iod of
production method also yields more goods time; or one could consume goods no
over w, but
a long time period. have fewer goods over the long haul.
One problem with this theory w Böhm-Bawerk analyzed this choice in t
as the erms
difficulty of measuring roundaboutn of the subjective time preferences of econo
ess in mic
production, or determining which of agents. People decided whether they
two wanted
production processes was more roun goods now or whether they prefer to g
dabout. ive up
While this task is easy when compa something now in order to get more i
ring an n the
automated assembly line with some future; and business owners determi
one ned
building a car in his garage, it is whether more or less roundabout tech
more niques
complicated when two different asse get employed in producing goods bas
mbly line ed on
techniques have to be compared or w whether they wanted to make some money n
hen two ow
different systems of piping water int or more money in the future.
o homes This idea of subjective time preference
must be compared. And it is these also
latter forms the basis for Böhm-Bawerk’s th
decisions that most firms must make. eory of
Böhm- interest. Böhm-Bawerk first laid t
Bawerk did attempt to deal with the he
problem groundwork for his theory of interest
of measuring roundaboutness, but hi by
s efforts presenting and critiquing all previous theo
met with little success. ries.
However, the notion of roundaThis was done in Volume 1 of his (1
bout 884)
production contains a key insight— Capital and Interest, which showed t
production hat prior
involves a trade-off between having attempts to explain interest based on
things the
EUGEN
VON BÖHM-BAWERK
productivity of capital, the abstine theory of
nce from interest based on time. It also tried to show
consumption, or the exploitation of that
workers, a positive rate of interest was inevit
lacked any merit and made little sense. V able and
olume therefore justified.
2 (1889) then went on to present a For centuries economists had been
trying, Incomes usually grow over time. If pe
without success, to explain why real ople are
interest going be richer in the future, they sh
rates had to be positive. One can thin ould be
k of the willing to give up more than one dolla
nominal interest rate as the rate of r in the
interest future in order to get one dollar now.
two parties agree upon. In simple te Second, Böhm-Bawerk argued tha
rms, if I t people
borrow money from a bank for one had a positive time preference; that
year at a is, they
rate of 10 percent, I am paying back preferred consuming goods now beca
a stack use the
of dollar bills that is 10 percent tal future was uncertain. In the future on
ler than e might
the stack of bills that I borrowed. not have the desire to consume goods
The real , or the
interest rate measures how much ability to do so (because no one kno
more the ws how
bank can buy with the stack of bills long they are going to live). Since
I repay we want
it compared to the purchasing powe
r of the
stack of bills I borrowed. If over the
past year
the price of goods rises by 10 per
cent, the
money I repay is worth less becaus
e it can
buy less. In this case, a 10 percen
t bigger
stack of bills and 10 percent inflatio
n means
the money I repay can buy no mo
re (real)
things than the money I borrowed,
and the
real interest rate is zero. By definit
ion, the
real rate of interest equals the nomi
nal rate
minus the rate of inflation. Alternativ
ely, one
can think of the real rate of interest a
s Böhm-
Bawerk did—the real rate of interest
paid by
a consumer represents how many
future
goods he has to give up in order to
consume
goods now.
Böhm-Bawerk provided three expl
anations
for positive real interest rates. First,
there was
an argument based on economic g
rowth.
things now, we have to be bribed to in the past. These goods must be pai
give up d for
goods now in exchange for goods i somehow. Also, to produce intermed
n the iate
future. This bribe can only be more goods will require labor and raw mat
future erials;
goods. but workers must be paid and materia
Finally, Böhm-Bawerk argued th l must
at since be purchased before final goods are s
roundabout production processes we old to
re also consumers. Roundabout production thus
more productive processes, borrower leads
s could to a demand for money on the part of b
easily afford to pay positive real inter usiness
est rates firms. How many intermediate goods
and should be willing to pay positi had to
ve real be stockpiled and how long the prod
interest rates. uction
After explaining why real interest rate process takes determines the demand
s had for
to be positive, Böhm-Bawerk went money.
on to Also, the supply of money for B
explain how interest rates actually get öhm-
set. His Bawerk was determined by preferences
analysis rested on standard supply and de on the
mand part of lenders for more goods in the
analysis—the supply and demand for borr future
owed relative to having goods now. If people
money determined its price, or the take a
rate of long-term perspective, and are willin
interest. g to
Böhm-Bawerk’s contribution here sacrifice now in order to have more late
was to r, they
explain how roundabout production will be more willing to supply money.
and On the
consumer time preferences influenc other hand, if people desire immedi
ed the ate
demand for money and the supply of gratification, a high real rate of intere
money, st (or
respectively. As we have seen, for many future goods) will be needed to
Böhm- obtain
Bawerk production was a process the money necessary for more round
for about
transforming goods. It was a round production to take place.
about
process that required other goods pr 8
oduced 3
KNUT WICKSELL ers were
paid the going wage rate. The diff
After setting forth this theory, erence
Böhm- between the output they produced an
Bawerk (1896) used the theory to d their
explain wages was the profit of the entrepr
why, contra Marx, workers were eneur.
not Workers could not receive the full
exploited. He assumed that all work future
value of what they produced bec Karl Marx and the Close of His Syst
ause em (1896),
employers had to pay interest duri New York, A.M.Kelley, 1949
ng the Further Essays on Capital and Interes
time production was taking place. t, South
Profits Holland, Illinois, Libertarian Press,
were thus justified as a reward to ca 1959
pitalists Shorter Classics of Böhm-Bawerk, So
for employing more roundabout pr uth
oduction Holland, Illinois, Libertarian Press,
methods and therefore for producin 1962
g more
goods. Profits also covered the inter
est cost 84
that firms had to pay to borrow mo
ney and
use more roundabout
production
techniques.
Schumpeter (1965, p. 147) haile
d Böhm-
Bawerk as one of the five or six
greatest
economists of all time. But since
Schumpeter was a student of Böhm
-Bawerk,
this assessment must be regarded as
a rather
biased assessment. For most econ
omists,
Böhm-Bawerk lacks the stature of t
he very
best and most important figures i
n the
history of the discipline. However,
he did
make several key contributions to e
conomic
theory. He recognized that time
was
important in understanding the ec
onomic
role of capital and interest. And h
e also
recognized that time played an im
portant
role in the production process.
Works by Böhm-Bawerk
Capital and Interest, 3 vols. (1884 an

d 1889),
trans. G.D.Huncke and H.F.Senn
hole,
South Holland, Illinois, Libertaria
n Press,
1959
Works about Böhm-Bawerk Throughout his life Knut Wicksell was a hig
hly
Buechner, M.Northrup, “Roundaboutn controversial figure. On principle he ref
ess and used to
Productivity in Böhm-Bawerk,” S marry the woman with whom he chose
outhern to live
Economic Journal, 62, 2 (October 1 and raise a family. In 1909 he served two mon
989), pp. ths
499–510 in jail for a speech that mocked the story
Hennings, Klaus H., The Austrian Theory of the
of Value Immaculate Conception. And he cham
and Capital: Studies in the Life a pioned
nd Works of the rights of women, birth control and unive
Eugen von Böhm-Bawerk, Chelten rsal
ham, UK, voting long before these ideas gained accept
Edward Elgar, 1997 ance
Hirshleifer, Jack, “A Note on the Böhm- in Sweden.
Bawerk/ The economics of Wicksell was li
Wicksell Theory of Interest,” Revi kewise
ew of controversial. An early advocate of t
Economic Studies, 34 (1967), pp. 1 he
91–9 marginal productivity theory of dist
Kuenne, Robert E., Eugen von Böhm ribution,
-Bawerk, Wicksell, in contradistinction to oth
New York, Columbia University Pres er
s, 1971 proponents of this theory, drew poli
Schumpeter, Joseph, “Eugen von Böhm- cy
Bawerk, conclusions from the theory that req
1851–1914,” in Ten Great Economists uired
: From greater government intervention in ec
Marx to Walras by Joseph Schumpet onomic
er, New life. And in contrast to virtually all
York, Oxford University Press, 19 his
65, pp. contemporaries, Wicksell held that inflati
143–90 on or
unemployment would continue indefi
nitely
unless appropriate economic policies
KNUT WICKSELL (1851–1926) were
employed.
In 1869,
Wicksell enrolled at Uppsala Univers
Wicksell was born in Stockholm ity with
the goal of soon becoming a Doct
, Sweden or of
in 1851 to middle-class parents. Be Philosophy and Professor of Mathemati
cause his cs. But
mother died when he was very young W his academic career turned out to be
icksell long and
was raised by an uncle and aunt. He r varied. He developed interests in p
eceived a oetry,
good high school education, showin feminism, and politics, and he publ
g talent in ished a
mathematics and natural sciences. collection of twenty-five poems in 18
78. Then ry, and
in the 1880s he became an arden public finance.
t neo- Wicksell and British economist
Malthusian, and traveled throughou Philip
t Sweden Wicksteed each (independently) sol
lecturing about the dangers of over ved the
population adding up or product exhaustion prob
and the need to control population lem (see
growth also CLARK). This involved describi
through celibacy and birth control. A ng when
s a result
of these diversions, it was not until
1885 (15
years after he first enrolled at Upp
sala) that
Wicksell received a graduate degr
ee in
mathematics.
However, his interests continu
ed their
metamorphosis, moving from math
ematics to
economics and social reform. Wi
th an
inheritance he received after the de
ath of his
father, Wicksell went to London in order t
o read
the classics of economics at the
British
Museum. He returned to Sweden wit
h a desire
to teach and write about economics. But,
at the
time, economics was taught by the l
aw faculty
in Swedish universities. So Wickse
ll had to
study law and obtain a law degree
before he
could receive an appointment tea
ching
economics. In 1899, at the age of 48
, Wicksell
passed his law examinations and b
ecame a
lecturer in political economy and
law at
Uppsala University. His academic
career,
understandably, was very short; W
icksell
retired in 1916.
Wicksell made substantive contri
butions in
three distinct areas of economics—
marginal
productivity theory, monetary theo
KNUT W increasing returns to scale.
ICKSELL Wicksell showed that if and only i
f there
the marginal productivity theory could e are constant returns to scale would the
xplain sum of
the distribution of all the output pro all marginal products equal the value of out
duced by put
one firm. Wicksell was an early prop produced. In contrast, with increasing
onent of returns
the marginal productivity theory of distribto scale the sum of marginal payments
ution, would
which held that an individual’s income de exceed the value of the product prod
pends uced;
upon their (marginal) contribution t while with decreasing returns to scale t
o firm he sum
revenues. One question left unanswer of marginal payments would be less th
ed about an the
this theory was whether the sum of all margtotal value of output. In the latter case,
inal some
productivities, and hence all income value created in the production process
s, was could
equal to the value of the output prod not be explained by marginal producti
uced by vity. In
the firm. the former case, the theory explained too m
Wicksell demonstrated that whet uch.
her this Wicksell next explained how com
was true or not depended upon returns to s petition
cale. forced firms to operate at an optimal si
This notion concerns how output in ze, and
creases argued that this optimal size would r
given a certain increase in inputs. To take a equire
very constant returns to scale. He began by
simple example, consider a farm de noting
voted that firms face U-shaped cost curves.
exclusively to growing corn. If we do For the
uble the typical firm, costs fall as output rises
number of acres used for growing corn and , then
get remain constant for a while, and final
exactly twice as much corn we have ly they
constant begin to rise. It is not hard to understa
returns to scale. If we double the n nd why
umber of this should be so. As the size of a farm starts t
acres used, but output increases by l o
ess than grow the farmer can take advantage
100 percent we have decreasing ret of
urns to economies of scale. A second tractor
scale. Finally, if we double our acreage and will not
our
output of corn more than doubles w 8
e have 5
KNUT WICKSELL barn will not be required. The output
of corn
have to be purchased to grow more can be doubled without doubling th
corn; one e inputs
tractor can till more land. Likewise, needed to grow that corn. At some
a second point,
though, economies of scale will be had on the real economy— eithe
exhausted r on
and the firm will reach its optimal production or on employment. Wic
or most ksell
efficient size. The firm now faces changed monetary theory by arguin
constant g that
returns to scale and constant cost changes in the rate of interest could a
s for ffect the
producing additional corn. Beyond t real economy.
his level, Wicksell assumed that there was
additional capital equipment will be a natural
required, rate of interest, or natural rate of re
worse quality land will have to be turn, on
employed capital. He took this natural rate to be
to grow corn, and the farm will be the rate
come too of return (or the yield) on newly created pl
large to run efficiently. Decreasing r ants
eturns to and equipment. Innovations, or impr
scale thus set in. ovements
Due to competition, firms are f in production technology, would incr
orced to ease the
operate at the most efficient level of prod natural rate of interest, making investment
uction. yield
This will be the point of minimum a bigger return. In contrast, the marke
average t rate of
costs, or the level of production where c
onstant 86
returns hold. Firms that do not prod
uce at this
level will be forced out of busines
s by its
competitors, which do produce at
minimum
cost. Thus, competition forces firms to p
roduce
at minimum average cost and with
constant
returns to scale. As a result, Wickse
ll argued,
the marginal products paid to all f
actors of
production will tend to equal the val
ue of the
products they produce, and the m
arginal
productivity theory will be able to expla
in how
all income gets distributed.
A second major contribution m
ade by
Wicksell concerned monetary theor
y. During
the time of Wicksell, monetary theory pr
imarily
studied the impact of money on prices. I
gnored
were any effects that money or inte
rest rates
This
process of greater investment and rising
interest is the rate charged by banks prices
for consumer goods will continue un
to those abated.
who want to borrow money. This ra Nothing will cause a slowdown in the
te was process
determined by the banking system. of growth and investment according
Whenever the natural rate of int to
erest Wicksell.
exceeds the market rate of intere In contrast, if the natural rate falls
st, below
businesses will want to invest and pr the market rate, the demand for inves
oduce tment
since their gains from investment ( falls. Businesses will not want to bo
the rrow
natural rate) will exceed their cost money for expansion since the cost of borro
of wed
borrowed funds (the market ratefunds (the market rate of interest) exce
). eds the
Investment is able to exceed savin gains from investment (the natural ra
gs, te of
Wicksell argued, because investmen interest). As a result, business productio
t is n falls
financed not with savings, but with and employment drops. Deficient demand
credit, will
or through the creation of new bank d lower prices and spending. But with sales d
eposits own
when banks make new loans. and prices low, business profits will s
The economic expansion that begi uffer.
ns under Moreover, firms with excess capacity
these circumstances will be cumulat will not
ive and want to invest. The economic contracti
self-perpetuating. Rising investment on will
demand continue until investment rises. But th
will shift workers out of industries pris will
oducing not happen unless either the natural r
goods for consumption, and into industrie ate of
s that interest rises or the market rate of interest fa
produce investment goods. With fells.
wer The policy implication that follow
consumption goods, the prices of consu s this
mption analysis is both simple and straightfor
goods rise. As such, producers of c ward—
onsumer monetary authorities must prevent a
goods make greater profits and will ny
want to divergence between the market and n
expand production, or invest more. atural
continued
growth and rising inflation or cont
rates. Only by setting the market rate of i inued
stagnation and rising unemployment.
nterest Another
equal to the natural rate of intere implication of this analysis concerns the
st can casual
monetary authorities prevent either relationship between money and interest
rates. not think it was necessary for state
For Wicksell, in contrast to much t -owned
wentieth- firms to make profits. Rather, the sta
century monetary theory (see also te was
FISHER), to assume ownership of firms in or
it is the rate of interest that determi der to
nes bank improve the allocation of national ec
lending and the supply of money (r onomic
ather than resources relative to a situation of mo
it being the money supply that deter nopoly.
mines the A second aspect of Wicksell’s th
rate of interest). eory of
The third main contribution of public finance involved reducing the
Wicksell heavy
concerns public finance. Wicksell s reliance on regressive taxation in
upported Sweden
a mixed economy containing a large during the 1890s. Towards this en
role for d he
government. Using cost-benefit an advocated lowering excise taxes and
alysis as tariffs,
his justification, he advocated a su which fell heavily on low-income
bstantial groups,
increase in public ownership of f and developing progressive taxes o
irms. n
Wicksell pressed for public owner
ship of
natural monopolies, such as utilities,
as well
as any other enterprises that sho
wed a
tendency towards monopoly or th
at began
forming cartels for the purpose of r
estricting
output and raising prices. It was
better,
Wicksell believed, that these firms b
e owned
and operated by the
government.
Government ownership
would
give
consumers more goods and services
plus the
benefits of lower prices.
Since price would most likely fa
ll below
the average cost of production, gov
ernment-
owned firms would be incurring los
ses on a
continual basis. Wicksell suggeste
d that
these losses be financed from revenu
es raised
through general taxation. He there
fore did
KNUT W government benefits to workers, a
ICKSELL nd
substantial government ownership o
individual and corporate incomes as f
well as production facilities.
on estates or inheritances. Wicksell O f o u r fi f t y m a j o r e c o n o
also m i s t s ,
advocated modifying the Swedish prWicksell is one of the most underra
operty ted.
tax system so that it better taxed the One likely reason for this is that Wick
rising sell
share of “unearned” increases in land made contributions in so many differ
values. ent
He stressed that earned income sho and diverse areas. Another reason is t
uld be hat
taxed at lower rates than unearned in Wi c k s e l l d i d n o t d eve l o p a n
come. y key
As to the other side of the fiscal e economic notions, nor did he contrib
quation, ute
Wicksell advocated more governm to the mathematization of economic
ent analysis. Finally, Wicksell himself m
spending for social services, especi ust
ally share some of the blame. He was t
education, in order to compensate for oo
income controversial, and too readily expres
inequalities that arise when income sed
gets great contempt for other economists
distributed based on marginal produc and
tivities. their theories. This was true of those
However, Wicksell also stressed t with
he whom Wicksell agreed and those w
importance of broadly distr ith
ibuting whom he disagreed.
government expenditures so that e
very
member of society felt that they be Works by Wicksell
nefited
from their tax payments. Value, Capital and Rent (1893), Londo
These many proposals concerning n, Allen
public & Unwin, 1954
expenditure and taxation make Wicks Interest and Prices (1898), London, M
ell the acmillan,
founder of the Swedish mixed econ 1936
omy—
with high taxes, progressive tax rates 8
, large
7
THORSTEIN VEBLEN Harvard University Press, 1958
Lectures on Political Economy (190

1, 1906), 2 Works about Wicksell
vols., London, Routledge & Keg
an Paul, Firsch, Ragnar, “Frisch on Wicksell,”
1934–5 in The
Selected Papers on Economic Theory, C Development of Economic Thoug
ambridge, ht: Great
Economists in Perspective, ed. H.
W.Spiegel, viduals as
New York, Wiley, 1952, pp. 652–99 driven by rationality and self-
Garlund, Torsten, The Life of Knut interest. Veblen
Wicksell, then used these behavioral dispositi
Stockholm, Almqvist & Wicksell, 1 ons to
958 explain the changes economies reg
“Symposium on the Theoretical Contribu ularly
tions of undergo.
Knut Wicksell,” Scandinavian Jo
urnal of 88
Economics, 80, 2 (1978), pp. 127–
249
Uhr, Carl G., “Knut Wicksell—A C
entennial
Evaluation,” American Economic R
eview, 41,
5 (1951), pp. 829–60
Uhr, Carl G., The Economic Doctri
nes of Knut
Wicksell, Berkeley, University of
California
Press, 1960
Uhr, Carl G., “Knut Wicksell, Neocla
ssicist and
Iconoclast,” in The History of
Swedish
Economic Thought, ed. Bo Sandel
in, London
and New York, Routledge, 1991, pp
. 76–120
THORSTEIN VEBLEN (1857–
1929)
Thorstein Veblen (pronounced VEB-
LIN, the
first syllable rhyming with WEB) is o
ne of the
sharpest and wittiest critics of ort
hodox
economic theory. His criticism of t
raditional
theory, and his own positive contri
bution to
economics, stressed the impact tha
t societal
institutions have on individual beh
avior. In
addition, Veblen saw behavior as motiv
ated by
habit, by envy, and by other psych
ological
dispositions, rather than seeing indi
find a
position teaching philosophy. He spent the
Veblen was born to Norwegian im next
seven years reading on his own, and then fina
migrants lly
in 1857 on a small farm in Wisconsin. decided it was time to switch fields;
He was so he
raised in rural Wisconsin and rural Mi entered Cornell to study economics. O
nnesota. ne year
His parents stressed the importance later, Veblen moved to the Universit
of y of
education, and pushed their children Chicago with his Cornell mentor J.La
to excel urence
and to pursue higher education. Veblen st Laughlin. He taught at Chicago for f
udied ourteen
economics at Carleton College unde years but never rose beyond the ran
r John k of
Bates Clark, who first formulated the ma Assistant Professor, even though he wro
rginal te two
productivity theory of income distributi highly successful and critically acclai
on (see med
also CLARK). He then studied philo books (Veblen 1899, 1904), publish
sophy at ed
Johns Hopkins University under Chnumerous essays, and edited the pres
arles tigious
Peirce, a world-famous philosopher Journal of Political Economy.
and After leaving Chicago, Veblen m
founder of American pragmatism. At oved
Johns constantly from school to school, us
Hopkins he also studied political ec ually
onomy encouraged by college administrators t
under Richard Ely, an eminent econo o seek
mist who employment elsewhere. Part of the p
founded the American Economic Asso roblem
ciation. was the affairs he had with young co-
Despite having such distinguished teeds and
achers, faculty wives. Another problem was t
Veblen was rather dissatisfied with hat his
Johns caustic criticism—especially of acad
Hopkins and so he transferred to Yal emia
e. There (Veblen 1918) and other economists—
he studied philosophy under Social did not
Darwinist endear him to his colleagues. A furt
William Graham Sumner, earning a her
Ph.D. in difficulty was that Veblen had no rega
philosophy in 1884. rd for
Because of the bad job marke academic rituals like department mee
t for tings,
philosophers, Veblen was unable to
“C” regardless of the quality of thei
r work.
taking attendance in class, holding offic Finally, there was the problem with Veble
n the
e hours, teacher. According to Dorfman (1934, p. 2
and grading. He usually gave all his 48f.),
students a Veblen “mumbled, he rambled, he di
gressed. irrationally and following customs an
His classes dwindled; one ended up d habits
with but rather than maximizing utility. In fact
one student….” , Veblen
Veblen was also renowned for turned traditional economic analysis
his quirky upside
lifestyle. Dorfman (1934, p. 239) re down, arguing that human institutio
ports that ns and
Veblen furnished his living quarters wit experience help determine what people b
h boxes elieve
that served as tables and chairs. to be pleasurable and painful.
Mundane Veblen is best known for his first
household chores such as making book, a
up a bed, work that instantly made him famo
were deplored as a waste of time. Di us. The
rty dishes Theory of the Leisure Class (Vebl
were stacked in a tub until no clea en 1899)
n dishes rejects the traditional view of consum
remained; then Veblen hosed them ption as
down. a means to human happiness, and re
According to Diggins (1978, p. 33– jects the
8), while view that individuals look inside th
teaching at the University of Misso emselves
uri in the
1910s, Veblen lived in the baseme
nt of a
friend’s house, entering and leavin
g through
the basement window.
Veblen’s economics was nearly
as quirky
as his lifestyle. While other economists
studied
human behavior from their ivory towers,
Veblen
studied human behavior within the
context of
anthropology and other social scie
nces. For
Veblen many forces influenced h
uman
behavior, and he brought these other forc
es into
his economic analysis. As such, he
sought to
broaden and enrich economics with the i
nsights
from other disciplines.
Using the insights from other
social
sciences, Veblen rejected the econ
omic
assumption that much behavior wa
s rational
and that people sought only thei
r own
pleasures. Instead, he saw people as
behaving
THORSTEIN The doctrine of conspicuous consu
VEBLEN mption
undermines the traditional view of ec
to determine the happiness that they onomic
would man. Money is not spent because it
receive from consuming different good yields
s. In its utility to the individual consumer. Rat
place Veblen develops a cultural the her, the
ory of doctrine of conspicuous consumption
consumption. Habit, convention, holds
and that consumers spend money in order t
superstitious irrationality all determine o make
human their friends and neighbors jealous, and to k
consumption. eep
Another important purpose of consu up with the spending of their friends
mption, and
according to Veblen, is to impress neighbors.
others. This analysis has several import
Veblen called this “conspi ant
cuous consequences. If I buy an expensive
consumption.” He then went on to pr car
ovide an because it makes my neighbor envious,
historical account of this phenomen and if
on. He my neighbor buys a similar car to keep up wi
demonstrated that in early, predatory th
cultures me, neither one of us is better off. We both ha
unproductive consumption was a m ve
ark of more expensive cars, but we have both
human prowess and dignity. In more failed
modern to show up each other.
cultures, conspicuous consumption i Things can be even worse than t
nvolves his.
various sorts of ostentation—giving Suppose my neighbor buys a more exp
valuable ensive
gifts to others, driving expensive spo car than I bought in order to make
rts cars, me
and arranging expensive and extravagant jealous. Not to be undone, I trade up
feasts. to an
These acts provide evidence of one’s even more expensive model. This proce
wealth ss can
and importance. Even in lower eco continue indefinitely, with me and
nomic my
classes, conspicuous consumption c neighbor continually buying more and
an be more
demonstrated through a spouse who expensive cars. As a result of this pr
stays at ocess
home and does no work in the market
place for 8
remuneration. 9
THORSTEIN VEBLEN engaged
in a competition that neither one of
both of us seem to be far worse off us can
—we have win and that is destructive to both
incurred a great deal of debt buyin of us.
g things Because of human desires to emula
we do not really want, and we have te and
“one up” others, human decisions es, and
may the rise of near monopolies like US
actually reduce individual well- Steel and
being. Standard Oil. Unlike most
Conspicuous consumption also un of his
dermines contemporaries, who focused on ho
the doctrines of consumer rational w the
ity and economy would move towards a s
consumer sovereignty. Once it is r table
ecognized equilibrium, Veblen attempted to un
that consumption patterns stem from ha derstand
bits and and explain the changes he saw taki
customs, then consumption is no l ng place
onger the in the world.
outcome of rational calculation. And Towards this end, Veblen disting
once it is uished
recognized that consumption patter business activities from the machine
ns depend process,
upon the consumption of others and that and analogously the capitalist from
culture the
can affect consumption decisions, engineer. The business enterprise for
then Veblen
consumers are no longer autonomo was run by capitalists who were only inter
us beings ested
who know what they want and then
buy these 90
things. Rather, people are human be
ings with
human flaws, who usually do not k
now what
they really want. Thus they look to adver
tising,
to culture, and to what others are d
oing in an
attempt to make consumption decisi
ons. They
are not, according to Veblen, passi
ve agents
who merely add up the pleasure th
ey might
receive from doing different thin
gs or
consuming different goods.
Besides studying consumer spendin
g habits,
Veblen (1904) also studied the do
minant
characteristics of American capitali
sm at the
beginning of the twentieth century
. These
included the rise of an industrial
economy
dominated by machines and robber baro
ns, the
inability of moral systems to control the
power
of modern business, severe business cycl
future
profits. And with things going so w
in making profits. The capitalist was a pre ell,
businesses were able to borrow more
dator, and
interested in making money rather than g make even more money. At some p
oods. oint,
Goods could be useless and of poor however, unease about continued pr
quality, ofits
but as long as they made money noth would arise and some businessmen wou
ing else ld see
was important. the possibility of making money in
In contrast, machine processes w a
ere the contraction. Loans would get called in,
technical procedures used in producing gsmall
oods. businesses would start to go under, a
These processes were designed and nd a
run by recession would follow. Stagnation
engineers. Unlike the capitalist- would
businessman, then continue until businessmen saw e
engineers were concerned with prod nough
uctivity, opportunities for greater profit and
serviceability, and efficiency. And u were
nlike willing to borrow and expand their operati
business activities, the machine process v ons.
alued In sharp contrast to other economists wri
workmanship. Its output was functio ting
nal or on business cycles in the early twent
useful goods that satisfied man’s need ieth
s to eat, century, Veblen saw no tendencies for
to work constructively, and to satisf the
y his economic system to equilibrate. Rather, he
curiosity. saw
Business activities were the root caunending instability and oscillation.
uses of Any
the business cycle (Veblen 1904, p. analysis of how economies reached
237). an
Businessmen borrowed money based equilibrium was therefore unscientif
on their ic
expectations of future profits. This bor according to Veblen. For economic anal
rowing ysis to
increased economic activity and pri be scientific, it had to focus on the evolution
ces, ary
leading to higher profits. With th changes of institutions over time rath
eir er than
expectations confirmed, businessmen on the way an economy moves to a
would static
form even more optimistic views of equilibrium point.
er would
help solve the many economic pro
Where did Veblen think this pro blems
facing America. The machine proces
cess was s would
heading? Somewhat naively, Veblen allow greater planning of productio
thought n and
the machine process and the engine distribution. It would allow us to do away
with 9
the price system. It would also end t The Engineers and the Price System (192
he waste 1), New
of unemployment on the one hand Brunswick, Transaction Publishers,
and the 1983
waste of conspicuous consumption Absentee Ownership and Business E
on the nterprise in
other hand. Recent Times, NewYork, B.W.Huebsc
Veblen was one of two or three h, 1923
bestknown A Veblen Treasury: From Leisure C
American economists in the early lass to War,
twentieth Peace and Capitalism, ed. Rick T
century. He attempted to give eco ilman,
nomics Armonk, New York, M.E.Sharpe, 19
greater breadth by bringing to it th 93
e insights
from other social sciences. More sp
ecifically,
he showed how habits, culture, and insti
tutions
mold human behavior, and how c
hanging
human behavior affects the econo
my. As a
result of this work, Veblen has bec
ome the
intellectual father of the institutional
ist school
of economics.
Works by Veblen
The Theory of the Leisure Class (1899),

NewYork,
Macmillan, 1908
The Theory of Business Enterprise (
1904), New
Brunswick, Transaction Publishers,
1978
The Instinct of Workmanship and the
State of the
Industrial Arts, New York, Macmil
lan, 1914
The Higher Learning in America: A Me
morandum
on the Conduct of Universities
by Business
Men, New York, B.W.Huebsch, 191
8
The Place of Science in Modern
Civilization
(1919), New Brunswick, Trans
action
Publishers, 1990
The Vested Interests and the State of the
Industrial
Arts, New York, B.W.Huebsch, 191
IRVIN
G FISHER ying
questions about money and the econ
Works about Veblen omy—
how money affects interest rates, how
Diggins, Jack, The Bard of Savagery, money
New York, affects inflation, and the impact of mon
Seaburg Press, 1978 ey on
Dorfman, Joseph, Thorstein Veblen a overall economic activity. For this wo
nd His rk, he
America (1934), New York, Augu is regarded as the father of moneta
stus ry
M.Kelley, 1972 economics.
Mitchell, Wesley C., “Thorstein Veblen” Fisher was born in 1867 in Saugerties,
in The New
Backward Art of Spending Money York. His father was a clergyman, and so Fis
and Other her
Essays, NewYork, Augustus Kelley, 19 grew up in a highly religious environ
50, pp. ment.
279–312 More than likely, this contributed to the
Riesman, David, Thorstein Veblen: A sense
Critical of mission that characterized his perso
Interpretation, New York, Charles S nal life
cribner’s as well as his professional life.
Sons, 1953 Fisher received a good public sc
Rosenberg, Bernard, The Values of hool
Veblen, education and excelled in mathematics.
Washington, D.C., Public Affairs Pre When
ss, 1956 he decided to attend college at Yale, his
Tilman, Rick, Thorstein Veblen and family
His Critics, moved with him to New Haven. Grad
1891–1963: Conservative, Liberal uating
and first in his class, Fisher remained at Yale
Radical Critics, Princeton, New Je to do
rsey, graduate work in both mathematics
Princeton University Press, 1992 and
economics. He began studying economics
with
William Graham Sumner, an advocate of S
IRVING FISHER (1867–1947) ocial
Irving Fisher spent his career stud 9
1
IRVING FISHER every economics and social science
course
Darwinism, the philosophy holding offered at Yale (Allen 1993). Howe
that in ver, it
social life the best competitors wou appears that the philosophy of Sumner had
ld always little
win out and that human improvemen influence on Fisher. Most of his w
t requires ork in
a competitive struggle (see Hofstadt economics at Yale, as well as his d
er 1944). octoral
Under the influence of Sumner, Fi dissertation, involved making economic
sher took s more
quantative rather than bringing phil drinking
osophy or alcohol. And he devoted much time an
social issues into the realm of econ d effort
omics. to causes such as Prohibition and US entry
When Fisher graduated from Yal into
e in 1892 the League of Nations.
he was already regarded as one of t Fisher was also an economic p
he leading olicy
mathematical economists of his day, crusader. His success in this arena, h
and Yale owever,
immediately hired him as an eco was no better than his success on Wa
nomics ll Street
professor. Many accolades and aw or his success in getting the US to
ards soon join the
followed. In 1918 Fisher was elected Pr
esident 92
of the American Economic Associ
ation. In
1930 he helped to found the Econ
ometrics
Society and became its first Preside
nt.
During the 1920s Fisher appli
ed his
knowledge of economics and financial
markets
to Wall Street. Speculating heavily
in stocks,
he soon became a multimillionaire.
But Fisher
lost half his net worth in the crash
of 1929.
Believing that stocks were a good
bargain
following the crash, Fisher borrowe
d heavily
to buy more stock. When the market con
tinued
to fall, Fisher lost his entire fortune
and then
some. He remained heavily in debt f
or the rest
of his life and lived the simple life
style that
comes with such indebtedness.
Fisher devoted his life to many c
auses and
wrote many popular books advocat
ing those
causes. He was a crusader for healt
hy living
and a wholesome lifestyle. He advocate
d eating
well and getting sufficient exercise
, and he
started the Life Extension Institute in 19
13. He
opposed smoking, eating meat, and
own
a mountain into pools of water (Allen 1
League of Nations. Neither his (Fish 993, p.
66f.). The pools of water at the bottom
er 1935) of the
proposal to require that banks keep mountain constituted a stock; the water flo
all their wing
deposits on hand instead of lending o down the mountain was an addition to the st
ut these ock
funds, nor his (Fisher 1942) plan for and increased the size of the stock.
taxing Fisher (1906) used this distinction to cla
individual expenditures rather than incom rify
e (see several economic notions. He defined
also KALDOR), nor his (Fisher 1920) capital
plan to as a stock of wealth at one point in
control inflation by backing the dolla time,
r with a analogous to a stock of water in a pool
diverse set of goods (see Patinkin 19 at the
93) was bottom of a mountain. Out of current
ever taken seriously. income
In contrast to his policy proposals, would come a flow of savings which, l
Fisher’s ike the
theoretical work earned him the reput water cascading down the Swiss mou
ation of ntain,
being a first-rate economist. His main int adds to our stock of wealth. Too much spendi
erests ng
were monetary theory—money, intere (or spending more than your income)
st rates, would
prices, and how they were all related. His cause a flow out of current wealth, t
main hus
contributions were to explain mone reducing the stock of wealth.
tary Fisher (1896, Chs 1–3; 1907, Ch.
concepts and how money affected 5) also
the distinguished real interest rates from
economy. nominal
It is Fisher who first defined preci interest rates (see also BÖHM-
sely the BAWERK), and
notions of income, capital, and wealhe (Fisher 1920, pp. 35–9; 1928) coin
th. To ed the
understand these terms requires know term “money illusion” to refer to an
ledge of inability
the differences between stocks and to distinguish a dollar from the purc
flows. hasing
Fisher claimed this distinction clicked power of the dollar (or what the dollar
into his could
mind during a mountain climbing tri buy after inflation). Interest rates on
p to the bank
Swiss Alps when he saw water cascading d
ain about
the low returns they are getting. Yet
deposits provide one good example , these
people may have been doing worse with h
of money igher
illusion. When the rates on certifi nominal interest rates and higher in
cates of flation.
deposit fall, people generally compl Money illusion also frequently occu
rs when prices faced by a typical family. Sin
workers get pay increases. Since wa ce each
ges are a family purchases a diverse set of go
major component of business cost ods, and
s, higher since the goods it buys changes re
wages usually lead to higher prices. gularly,
Workers developing a single number to repre
suffering from money illusion will sent the
be happy average change in prices becomes a
with a bigger pay check even though the complex
bigger problem.
check can buy fewer things. The simple solution to this prob
For Fisher (1923, 1925), money illus lem of
ion was measuring inflation is to measure th
a prevalent phenomenon. He also t e price
hought it change for a set of goods that the typical fa
was responsible for the business mily
cycle. buys at one point in time. One probl
Business firms, believing that real intere em with
st rates this method is that when prices cha
are high during times of inflation nge for
and high some good, people buy less of that go
nominal interest rates, stop borrow od. This
ing and
investing. This slows down economi
c activity.
Then, when a slowing economy r
educes
nominal rates, businesses mistake this fo
r a cut
in real rates and increase their borr
owing and
investment. As the economy expand
s, money
illusion eventually brings the expan
sion to a
halt. As the expanding economy g
enerates
inflationary pressures, banks must
raise
nominal rates to maintain the real
rate of
interest they make on their loans.
Again,
businesses mistake this for higher real ra
tes and
investment falls. According to Fisher, ec
onomic
expansion and contraction follow on
e another
continually as a result of this proces
s.
Fisher also tackled the difficult p
roblem of
how to measure inflation for the
entire
economy. Inflation is simply the c
hange in
IRVIN the price change, would underestimate the
G FISHER loss
in purchasing power to the family whe
problem became particularly acute i n some
n the good rises in price by a large amount.
1970s, when oil prices rose dramatic Fisher
ally and suggested that an ideal index number
energy consumption fell. Do we us , or
e the inflation measure, should employ the
original quantities here or do we usaverage
e the of quantities bought before the price
quantities bought after the price change? I change
n the and quantities bought after the price ch
late twentieth century, all nations use ange.
d the set While Fisher devoted a great deal o
of goods bought by people before f effort
prices and energy to clarifying economic noti
change when calculating inflation. ons, he
Nations did more than just help define concep
have adopted this method for practical re ts. His
asons main contributions to economics inv
more than anything else. It is both e olved
xpensive analyzing what factors determined interest
and time consuming to take survey rates
s of and what factors caused inflation.
consumer purchases. Surveys therefore ar Fisher’s theory of the rate of interest
e only is still
taken every few years. But this deci taught to most economics students tod
sion has ay, and
important consequences for our meas is regarded by most economists as a
urement correct
of inflation; it implicitly assumes analysis of what determines interest rate
that s for a
consumers will not change their sp particular economy. Fisher (1930) pro
ending posed
patterns when prices change. that interest should be viewed as an i
Fisher (1922) recognized that using or ncome
iginal flow that comes from using anythin
purchases would overstate the actual g in
inflation production. In particular, interest is the inc
rate because it assumes that people are ome
buying flowing to someone who allows their st
large quantities of the good (gasoline ock of
, in our wealth to be used in producing goods.
example) that increases most in price. When
He also wealth gets used in the production pr
recognized that taking the opposite a ocess,
pproach,
and using quantities bought by famili 9
es after 3
IRVING FISHER for not consuming things today, and
Fisher’s
someone lends money to a business theory is usually referred to as a t
firm and ime-
does not spend it. Interest was thus preference theory of interest. Becau
a reward se most
people desire to consume things now, the nd were
y have also affected by social and psychol
to be paid to wait until next year or ogical
the year factors such as the habits, intelligenc
after to consume goods. e, self-
Two forces determined interest control, and foresight of both borrow
rates ers and
according to Fisher. On the supply lenders.
side, the Finally, Fisher (1911) set forth th
preferences of individuals for pres e now-
ent and famous equation of exchange, and
future income is important. The rate of i he used
nterest it to identify the causes of price inf
gives the additional amount of go lation.
ods that The equation, MV=PQ, says that the
people will be able to consume in t money
he future supply (M) times its velocity (V, the
by not consuming today and lending the number
money of times a unit of money is used d
they save to someone else. Intere uring a
st thus year to purchase goods and services
becomes a payment to lenders wh ) must
o forgo equal the output of goods and servi
consumption now and consume (mo ces (P
re) goods
at some later time. 94
On the demand side, interest rat
es depend
upon available investment opportu
nities and
the productivity of capital (includi
ng human
capital). Greater productivity will
lead to
greater demand for borrowed mon
ey. With
greater productivity, profits increa
se and
business owners will want to expand
more. To
do this they will need to borrow or will de
mand
more money.
The equilibrium rate of interest is
the rate
of interest at which the quantity o
f funds
that borrowers want to lend equa
ls the
quantity of funds that lenders are
willing
to give up. Fisher made it clear t
hat the
forces affecting both supply and d
emand
were unstable. Moreover, in addit
ion to
economic factors, supply and dema
their
money too quickly, or trying to buy
times Q). This equality must be true more
goods than the economic system ca
as a n
result of the definitions of the various produce. Finally, if M and V are con
terms. stant,
If an economy has a money supply prices go up if quantities go down. He
of 1 re, a
trillion francs, and if each franc is u shortage of goods leads to inflation.
sed 7 Taking his analysis one step furt
times during the year to purchase t her,
hings, Fisher (1910) analyzed the factors t
then 7 trillion francs worth of good hat
s and affect M, V, and Q. Most important wa
services will be purchased during the s his
year. explanation of how the spending habi
This is the national output or gross dots of
mestic individuals, and the means by which p
product of the French economy. This eople
output, get paid, affect the velocity of money
in turn, can be further divided into pri . To
ce (P) keep things simple, suppose all worker
and quantity (Q) components. The q s get
uantity paid at the beginning of every mont
represents real things that are prod h.
uced, During the month they will normally
while the price component measure use
s how just about all their pay to buy goods
much each thing costs on average (Fi and
sher’s services. By the end of the month, the
price index). n, all
Using this equation Fisher was a money is again held by employers an
ble to d can
explain the three potential causes be used to pay next month’s wages. In
of this
inflation. First, if V and Q are both co case, each 1franc will be used 12 ti
nstant, mes
prices will vary with changes in the during the year to purchase goods (o
money nce
supply; that is, inflation will be due teach month), and the velocity of mone
o too y will
much money in the economy. Second be 12. On the other hand, if French wo
, if M rkers
and Q are constant, prices will vary were paid two times a month, the s
with ame
changes in velocity. In this case, inf process of wage payments followed
lation by
stems from people trying to spend
A
RTHUR CECIL PIGOU
spending would occur 24 times a y of 12. Because the frequency with
ear, and which
the velocity of money would be 24 people are paid is relatively consta
instead nt, the
velocity of money should also be re “The Business Cycle Largely a ‘Danc
latively e of the
constant. This leaves changes in the Dollar’,” Journal of the America
money n Statistical
supply (M) as the main cause of e Association, 18 (December 1923), pp.
conomic 1,024–
fluctuations. For Fisher, changes in 8
M could “Our Unstable Dollar and the So-Called Bu
affect either prices or real out siness
put. Cycle,” Journal of the American
Contemporary monetary economists Statistical
follow Association, 20 (June 1925), pp. 17
Friedman and contend that changes 9–202
in the The Money Illusion, New York, Adelphi
money supply affect only prices in , 1928
the long The Theory of Interest, New York,
run. Macmillan,
Although probably not as well- 1930
known by
the general public as Thorstein Vebl
en, Fisher
ranks as the most important Am
erican
economist in the first half of the t
wentieth
century. Lacking Veblen’s breadth an
d vision,
Fisher made up for this with the lar
ge number
of contributions he made to monetary th
eory—
both defining important notions, sho
wing how
money affects the economy, and e
xplaining
what determines interest rates.
Works by Fisher
Appreciation of Interest, New York,

Macmillan,
1892
The Nature of Capital and Income,
New York,
Macmillan, 1906
The Rate of Interest, New York, Macmill
an, 1907
The Purchasing Power of Money,
New York,
Macmillan, 1910. Revised edn . 19
22
Stabilizing the Dollar, New York,
Macmillan,
1920
The Making of Index Numbers, Ne
w York,
Houghton Mifflin, 1922
100% Money: Designed to Keep Checkin
g Banks Other references
100% Liquid; to Prevent Inflation
and Hofstadter, Richard, Social Darwinism
Deflation; Largely to Cure or Pr in
event American Thought, Philadelphia, Univer
Depressions; and to Wipe Out sity of
Much of the Pennsylvania Press, 1944
National Debt, New York, Adelphi, 1
935
Constructive Income Taxation, NewYork,
Harper, ARTHUR CECIL PIGOU (1877–
1942
1959)
Works about Fisher
A.C.Pigou (pronounced PIG-GOO)
Allen, Robert Loring, Irving Fisher: A Bio
is
graphy,
Cambridge, Blackwell, 1993
known as the father of modern welf
Fisher, Irving Norton, My Father, Irv
are
economics, which studies how to ma
ing Fisher,
New York, Comet Press, 1956
ke
Patinkin, Don, “Irving Fisher and
economies operate more efficiently as
His
well
Compensated Dollar Plan,” Econ
as the trade-offs between efficiency
and
omic
equity. Pigou is also one of the founder
Quarterly (Federal Reserve Bank
of
s of
Richmond), 79, 3 (Summer 1993), p
modern public finance. This work
p. 1–33
developed the means to analyze how
taxes
Schumpter, Joseph, “Irving Fish
impact the economy and the justificatio
er’s
n for
Econometrics,” Econometrica, Vol. 16,
3 (July
government intervention in economi
1948). Reprinted in Ten Great Ec
c
onomists,
affairs.
NewYork, Oxford University Press, 19
65, pp. 9
222–38
5
ARTHUR CECIL PIGOU n his third
year he came under the influence of
Pigou was born in 1877 at Ryde, on th Alfred
e Isle Marshall and Henry Sidgwick, who con
of Wright. His father was an office vinced
r in the him to study political economy. Like Mar
British army; his mother came from a lo shall,
ng line Pigou was attracted to economics f
of Irish government officials. Pigou stud or its
ied first practical value. He sought to teach his stu
at Harrow, an elite English private s dents
chool, and that “the main purpose of learning e
then at King’s College, Cambridge. conomics
He began was to be able to see through the
studying history at Cambridge; but i bogus
economic arguments of the politi y Keynes.
cians” Pigou’s (1906, 1912) first wor
(Champernowne 1959, p. 264). ks in
When Marshall retired from Ca economics were on industrial relati
mbridge in ons and
1908 Pigou succeeded him in the import duties. These studies led to a
Chair of n interest
Political Economy. From then unt
il his 96
retirement in 1943, Pigou was th
e main
expositor of Marshallian econom
ics at
Cambridge.
World War I became a life-
altering
experience for Pigou. He continue
d teaching
at Cambridge, but also served in the amb
ulance
corps close to the front line during
vacations.
Johnson (1960, p. 153) reports th
at “this
experience was responsible for tra
nsforming
the gay, joke-loving, sociable, hos
pitable
young bachelor of the Edwardian p
eriod into
[an] eccentric recluse.” Besides being a
recluse,
Pigou was also known as an extrem
ely frugal
human being, especially when it c
ame to
clothing. He frequently wore ratty a
nd stained
clothing, and showed up “at the
Marshall
Library one day in the fifties proudl
y wearing
a suit bought before the First Worl
d War”
(Johnson 1960, p. 150).
The main economic contributions
of Pigou
fall into two broad categories. First, his a
nalysis
of externalities provides the found
ation for
modern public finance, environm
ental
economics and welfare economics.
Second,
Pigou was the first major opponen
t of the
macroeconomic revolution started b
outcomes are not the best possible out
comes
in how government policy could in in this situation. We get too many goo
ds that
crease pollute the environment; and firms tend
national well-being. Pigou (1912) rai to use
sed this technology that creates excessive pol
general question, and then spent mos lution
t of his since the costs of pollution are impos
life trying to answer it. In so doing, he invened on
ted third parties but free to the firm. As a
a good deal of modern public fina result,
nce, the market system produces too much poll
especially the arguments and ration uted
ale for air and water, as well as excessive noi
government intervention in the econo se and
my. congestion in urban areas.
For some goods, all production c On the other hand, production can
osts are yield
borne by the firm and passed on t benefits to society that exceed the be
o the nefits
consumer via the price of the good. received by the consumers who buy
Pigou that
(1920) showed that the (private) pro good. The lighthouse, an example dev
duction eloped
costs to a firm may not reflect all th by British economist and philosopher
e social Henry
costs of production. When produ Sidgwick in 1883, is typically used
cers by
manufacture a good they take into economists to illustrate this case. Ot
account her
only their private costs—the labor, t examples of this sort include police an
he raw d fire
materials, and the capital that they hprotection, national defense, and spend
ave to ing on
purchase. But production inevitably health care and education. The indiv
pollutes idual
the environment and these costs are who purchases a cold remedy benef
paid for its
by third parties who neither produc because they feel better as a result of t
e nor aking
consume the good. Here the social c this medication. But if this medication
osts of also
production exceed the private costs; t makes it less likely that others will
he firm be
and the consumer get others to pay infected, there are greater social benefit
part of s than
the cost of producing that good. M private benefits.
arket
A
RTHUR CECIL PIGOU
Such divergences between private c “spillover effects,” and “third-party
osts and effects.”
social costs have been called “ext Pigou stressed that when marginal private
ernalities” costs
and marginal social costs diverge, t to improve upon market-based outco
he market mes. The
system was inefficient. These dive government must develop a defense syste
rgences m and
between private and social costs mi must tax all beneficiaries (its citizens
ght justify ) for the
government intervention into the mark cost of its construction.
et place. In many cases the government ca
Whenever there are large po n remedy
sitive problems that stem from externalities
externalities, people gain whether or through
not they taxes and subsidies. But sometimes
pay anything. This ability to obtain the b legal
enefits remedies are sufficient to solve the
of some good or service without havi problem.
ng to pay For example, in the Economics of
for it gives rise to what is now called Welfare,
“the free Pigou (1920, pp. 129–30) argued that rail
rider problem.” Each person, looking a roads
t things should compensate farmers and other pr
from their own individual point of operty
view, will owners who suffered losses from the
recognize that if they do not contrib damage
ute money of sparks and smoke emitted from t
towards the national defense, a defense rains. In
system this case, the main policy change nee
will get built anyway; and they will ded was
still reap in British liability laws. If the railroad
the benefits of greater defense spendi s had to
ng. If the
US gets attacked from abroad, my
house will
be protected whether or not I helped t
o pay for
the national defense. Moreover, if
I do not
contribute to the national defense,
a defense
system will still be constructed. And my
failure
to contribute anything will make
little
difference to the type of defense sy
stem that
gets built or the quality of that defense s
ystem.
By not contributing to the national
defense I
save my hard-earned money, but I lose n
othing.
The problem here is that when
everyone
reasons in this manner no money
gets spent
for defense and everyone is worse
off. The
solution to this problem is for the g
overnment
compensate others for the damages economists had a moral responsibilit
done by y to
their trains, Pigou thought they would be identify externalities. But Pigou was n
more ot only
careful and would run fewer trains. Privat interested in eliminating externalities. His
e and main
social benefits would thus no longer concern was how to increase the eco
diverge, nomic
and externalities would be internaliz well-being of a nation. This, he not
ed, or ed,
become part of the cost of transportin depended on both the size of the econo
g goods mic pie
via railroads. and its distribution.
Finally, in some cases no gover More output would increase gen
nment eral
intervention is justified to remedy the pro welfare, since people desire to have things,
blems and
stemming from externalities. When t the more things they have (in general) the bet
he costs ter
imposed on third parties are small and the c off they are. Redistributive economic
osts policies
of any remedy are large, cost-benefit would likewise increase general welfar
analysis e. This
leads to the conclusion that externalities s conclusion followed from Pigou’s beli
hould ef that
be allowed to persist. Consider the the satisfaction derived from money d
noise eclines
coming from trains. If this imposes only mas one has more and more money. Another f
inor ew
inconveniences on local residents, then th hundred dollars means little to Bill Gates,
e cost who
of forcing the railroads to move their is fabulously wealthy, but to someone
lines or who is
develop quieter trains may far exceed unemployed this extra money may ma
the cost ke the
to people of hearing trains go by the difference between life and d
ir home eath.
every few hours. Consequently, the loss of welfare from
Pigou (1920, Ch. 1) asserted that taxing
one job the rich must be less than the gain in econom
of the economist was to identify ext ic
ernalities welfare from giving that money to th
and to help eliminate them by showi e poor.
ng how Progressive taxation and transfer prog
and when government action would rams to
improve
upon market outcomes. He even tho 9
ught that 7
ARTHUR CECIL PIGOU and transfers might reduce the size
of the
aid the poor could thus be justifi economic pie, and that there could be
ed as a trade-
improving the overall well-being of the off between growth and equity. When ther
nation. e was
Pigou did recognize that progres no trade-off the implications were
sive taxes clear.
Anything that increased national output, 1930s. Keynes (1936) made Pigou
but did his
not make the poor worse off, increased n whipping boy in the General Theo
ational ry. For
welfare. And anything that increased many reasons, Pigou was an easy tar
the share get. He
of national output going to the poor was a recluse with few followers wh
, but did o would
not reduce the total size of the out come to his defense; he dressed badly and
put, also was
increased well-being. a comic figure at Cambridge; and he
However, when these two criteri was part
a clashed of the older establishment against
(when transfers to the poor reduce whom
d output) Keynes was rebelling.
the situation was quite different. J Keynes lumped Pigou with the
udgments classical
would be required about how much school of economics and attributed
output to to this
give up in order to improve the po school the belief that supply would
sition of always
the poor. Arthur Okun (1975, Ch.
4) has 98
vividly described this trade-off in te
rms of a
leaky bucket. Transfers from the ric
h to the
poor are always made with a leak
y bucket,
which will lose some income as it redist
ributes
income. The leaking water represe
nts the
inefficiencies or the reduced nation
al output
due to these transfers. Okun (1975,
p. 94), a
strong supporter of equality, thought
transfers
should be stopped when the leakag
e hit 60
percent. Pigou (1920), was not quite as
precise
but he did state that sacrificing a litt
le output
was worth the gains that come fro
m greater
equity.
Despite his many contributions t
o welfare
economics and to public finance, P
igou has
probably attained greatest notoriet
y as an
opponent of the Keynesian Revolu
tion that
began in Cambridge, England duri
ng the
that
worker. Although Pigou never advoc
create its own demand. According to ated
wage cuts (see Aslanbeigui forthcomin
Keynes, g), in
the classical economists held that this was all these cases the solution to the
true unemployment problem seemed to b
for both goods and labor; they belie e a
ved that reduction in wages. And it was for this r
unemployment was impossible becau eason
se when that Keynes criticized Pigou.
people offered their services to some emp Pigou was deeply offended by t
loyer he
there would have to be some demand General Theory, both for its attacks
for their on
labor services. If not, wages would f himself and its attacks on the Marsh
all until allian
someone was willing to hire these wo tradition at Cambridge. Reviewing t
rkers. he
There is a certain degree of validity General Theory, Pigou (1936) accuse
to this d
picture of Pigou. Pigou (1914) publi Keynes of misrepresenting his views,
shed a and
popular work entitled Unemployment, claimed there was nothing at all of m
which erit in
argued that in the long run unempl the book. He argued that in his previous
oyment work
was due to inflexible and high wages. he recognized that expansionary poli
Many cies
years later, Pigou (1927) argued that could increase prices, thereby reducin
reduced g real
demand by businesses for workers wages and increasing employment in
would the
lead to higher unemployment, but th short run.
at this Pigou (1943, pp. 349f.) later deve
problem could be remedied if work loped
ers let his own criticisms of Keynesian econ
their real wages fall. And The The omics.
ory of He formulated the real balance or
Unemployment (Pigou 1933) argued tPigou
hat if effect, which described one way that
wage levels were greater than the m the
arginal problem of high unemployment would
productivity of workers, businesses tend
would to be self-correcting and not requir
not hire anyone since the cost of do e
ing so Keynesian economic policies. Pigou p
would exceed the benefits of hiring ointed
JOH
N MAYNARD KEYNES
out that prices generally fall during wealth,
periods or the purchasing power of prior sa
of high unemployment because firm vings,
s cannot increases during a recession. Bei
sell goods otherwise. As a result, real ng
wealthier, people tend to spend mo The Theory of Unemployment, Lond
re. This on,
additional spending will then s Macmillan, 1933
pur The Economics of Stationary States,
production, and businesses will hi London,
re more Macmillan, 1935
workers. Unemployment would th “Mr. J.M.Keynes’ General Theory o
us end f
automatically and macroeconomic Employment, Interest and Money,
policy ”
was unnecessary. Economica, 3, 10 (May 1936), pp. 1
Pigou spent most of his career w 15–32
ithin the “The Classical Stationary State,” Eco
shadows of two giant Cambridge ec nomic
onomists Journal, 53 (1943), pp. 343–51
—Marshall and Keynes. For this re
ason, his
contributions have seemed smal
l by
comparison. While not achieving th
e stature
of either Keynes or Marshall, the i
nfluence
of Pigou remains large. The wa
y that
economists analyze and justify gov
ernment
intervention in economic affairs ste
ms from
Pigou. It is for this reason that Pigou
became
the father of modern public finan
ce and
modern welfare theory. It is also f
or this
reason that the relatively new fie
ld of
environmental economics rests sq
uarely
upon his shoulders.
Works by Pigou
Protective and Preferential Import

Duties,
London, Frank Cass, 1906
Wealth and Welfare, London, Macmill
an, 1912
Unemployment, New York, Holt, 1914
The Economics of Welfare (1920),
4th edn.,
London, Macmillan, 1932
Industrial Fluctuations, London, Macmi
llan, 1927
A Study in Public Finance (1928),
3rd edn.,
London, Macmillan, 1951
Works about Pigou Big Tradeoff, Washington, D.C., Br
ookings
Aslanbeigui, Nahid, A.C.Pigou, Lond Institution, 1975
on,
Macmillan, forthcoming
Champernowne, D.G., “Arthur Cecil Pigou
1877– JOHN MAYNARD KEYNES
1959,” Journal of the Royal Statistical (1883–1946)1
Society,
122, pt II (1959), pp. 263–5
Collard, David, “A.C.Pigou, 1877– With Adam Smith and Karl Marx,
1959,” in John
Pioneers of Modern Economics in Bri
Maynard Keynes (pronounced CANES) st
tain, ed.
ands
D.P.O’Brien and John R.Presley, L
as one of three giant figures in the hist
ondon,
ory of
Macmillan, 1981, pp. 105–39
economics. As Smith can be viewed
Johnson, Harry, “Arthur Cecil Pigou,
as the
1877–
optimist of this trio, seeing econo
1959,” Canadian Journal of Eco
mic
nomics and
improvement as the main consequen
Political Science, 26, 1 (February
ce of
1960), pp.
capitalism; and as Marx can be viewed
150–5
as the
Saltmarsh, John and Wilkinson, Patrick
pessimist, believing that its many ser
, Arthur
ious
Cecil Pigou, 1877–1959, Cambri
problems would cause capitalism to
dge,
self-
Cambridge University Press, 1960
destruct; Keynes can be viewed as
the
Other references pragmatic savior of capitalism. Reco
gnizing
Keynes, John Maynard, The General both the benefits and flaws of capital
Theory of ism,
Employment, Interest and Money (193 Keynes looked to economic policy as a
6), New means
York, Harcourt, Brace & World 1964
Okun, Arthur M., Equality and Effici 9
ency: The 9
JOHN MAYNARD KEYNES
of mitigating the problems with c the registrar at Cambridge Universit
apitalism. y and a
Intelligent government policy, he t distinguished economist and philosopher
hought, at the
could save capitalism, allowing us t University. His mother, for a time,
o reap its was the
benefits without experiencing its dar mayor of Cambridge.
k side. Keynes was educated at the best s
Keynes was born in Cambridge chools in
, England England—Eton and King’s
in 1883 with the proverbial silver sp College,
oon in his Cambridge. At Cambridge, he studi
mouth. His father, John Neville Ke ed the
ynes, was classics, philosophy with G.E.Mo
ore, get any more interesting after this
mathematics with Alfred North Whiteh and
ead, and Keynes, understandably, became bore
economics with Alfred Marshall. Ke d with
ynes also his job. Two years later, in 1908, he r
became part of an exclusive club of intell eturned
ectuals to Cambridge to teach economics.
at Cambridge, which later beca Three
me the
Bloomsbury group. The group includ 100
ed major
literary and artistic figures such as
Virginia
Woolf, E.M.Forster, and Lytton Stra
chey.
After graduation, Keynes sat for the
British
Civil Service exam and received th
e second
highest score of all those taking the
test. This
gave Keynes the second choice a
mong all
open civil service positions. Altho
ugh he
craved a job at the Treasury, this pos
ition was
taken by Otto Niemeyer, who had fir
st choice
by virtue of scoring highest on th
e exam.
Ironically, Keynes received the high
est scores
in Logic, Psychology, Political Scie
nce, and
Essays; but he scored second overal
l because
of a relatively low score in Economi
cs. Later
in life, Keynes would quip that he “knew
more
about Economics than my examiners”
(Harrod
1951, p. 121).
Settling for a post in the India
Office,
Keynes helped to organize and co-
ordinate
British interests involving India. “
His first
major job, lasting for several mont
hs, was
ordering and arranging for the ship
ment to
Bombay of ten young Ayrshire
bulls”
(Moggridge 1992, p. 168). Things
did not
years after that he assumed editorship be the impoverishment of Germany, and ri
of the sing
Economic Journal, which at the tim German hostility towards France and Engl
e was and.
the most prestigious economics jour The political consequence, which Ke
nal in ynes
the world. equally feared, would be the rise of an
Public acclaim first came to Ke angry
ynes and militant Germany in the future.
following publication of The Econ Now a figure of national promine
omic nce,
Consequences of the Peace, a book Keynes turned his attention to questio
about the ns of
Versailles Peace Treaty ending World economic theory and policy. His Tra
War I. ct on
During World War I Keynes served Monetary Reform (Keynes 1971–89,
in the Vol. 4)
British Treasury and was primarily respo warned of the dangers from inflation. It loo
nsible ked
for obtaining external finance to sup to central bank control of the money su
port the pply as
British war effort. As the end of the w a means of stabilizing the price level
ar drew and
near, Keynes was made a member of the Br keeping inflation under control. This work
itish also
delegation at Versailles that was neg contained Keynes’ famous and misund
otiating erstood
German war reparations. Besides co dictum “in the long run we are all dead.” Ma
ntaining ny
biting portraits of the major participan have taken this phrase to mean that Keynes
ts at the was
peace conference (US President Wilson, willing to sacrifice long-term econo
French mic
Chancellor Clemenceau, and British performance for short-term economic ben
Prime efits.
Minister Lloyd George), Keynes (19 Yet this is not at all what Keynes was d
71–89, riving
Vol. 2) also provided an angry critiqu at. Keynes meant to criticize others
e of the who
peace treaty itself. According to believed that the problem of inflation
his would
calculations, Germany could not possibly eventually remedy itself, without any
make active
good on the British and French dem government involvement. To the cont
ands for rary,
reparations. The economic consequence Keynes felt that rather than waiting
would for
JOH
N MAYNARD KEYNES
inflationary problems to correct the point was that there was no reason to
mselves in wait for
the distant future, it would be better elusive future gains, when more rapid pr
to employ ogress
economic policy and improve things could be made solving economic pro
now. His blems by
intelligently employing economic p e two
olicies. would be equal. Keynes then argued that it
In the 1920s, inflation receded a was
nd Britain the responsibility of the central bank
found itself increasingly subject to to keep
economic these two variables equal to one anot
fluctuations and prolonged periods her, and
of high thus the responsibility of the central
unemployment. Keynes thus turne bank to
d his prevent inflation and recessions. If
attention to these new problems. A savings
Treatise on exceeded investment, the central ban
Money (Keynes 1971–89, Vols. 5 k would
and 6) need to lower interest rates, thus both red
examined in detail the relationship ucing
s between savings and stimulating borrowing.
money, prices, and unemployment. On the
Keynes other hand, if investment exceeded saving
singled out the saving-investment re s, the
lationship central bank would need to raise inter
as the main cause of economic flu est rates,
ctuations. thus increasing savings and redu
According to Keynes, when people cing
attempted borrowing for investment purposes.
to save more than businesses wanted
to invest,
businesses would soon find themse
lves with
excess capacity to produce goods an
d too few
buyers for the goods it could produc
e. On the
other hand, when investment exceeded
savings,
there would be too much spending takin
g place
in the economy. Consumers would be sp
ending
rather than saving, and businesses
would
demand more workers to produce
goods and
more workers to build plants and e
quipment.
All this spending would bid up wage
s as well
as other costs of production, and als
o increase
the price of all consumer goods. I
nflation
would be the outcome.
The problem, Keynes stressed,
was that
savings decisions and investment
decisions
were made by different groups of i
ndividuals.
As a result, there was no guarantee that th
Keynes, though, is best known for Law on its head, arguing that aggregate or to
his 1936 tal
classic, The General Theory and E demand determined the supply of outp
mployment, ut and
Interest and Money (Keynes 1971– level of employment. Whenever dema
89, Vol. 7). nd was
This work has been responsible for high, economies would prosper, busi
the nesses
development of a whole branch of ec would expand and hire more workers
onomics , and
(macroeconomics), and has been the unemployment would cease to be a pr
most oblem.
referenced and debated work in twe But when demand was low, firms wo
ntieth- uld be
century economics. The work itself is unable to sell their goods and they wo
both an uld be
attack on the predecessors of Keynes forced to cut back on production and hir
, and a ing. If
theory of what determines the amo things got very bad, there would be
unt of massive
production and employment in a co lay-offs, high unemployment, and a depres
untry. sion.
Although the book says very little For obvious reasons, Keynes turned
about next to
economic policy, it provided the the study aggregate demand and the caus
oretical es of
foundation for government policy action t changes in aggregate demand. Analyzi
o end ng the
the Depression that was plaguing vi two most important components of d
rtually emand,
every country in the 1930s. Keynes developed the modern theori
Keynes begins The General Th es of
eory by consumer spending and business inves
attacking Say’s Law, the view that “ tment.
supply Keynes identified two broad deter
creates its own demand.” According minants
to this of consumer spending—subjective factor
dictum, unemployment was not pos s and
sible objective factors. Among the subjecti
because whatever the existing supp ve or
ly of psychological factors affecting consu
workers (or whatever the existing su mption
pply of were uncertainty regarding the future, the de
goods in the economy), there will be a dem sire
and to bequeath a fortune, and a desire to
for these workers (or a demand for enjoy
these
goods). Keynes then proceeded to tu 1
rn Say’s 01
JOHN MAYNARD KEYNES
independence and power. Greater fe ire for
ars about independence, would lead to more sa
one’s economic future, a greater desire t ving and
o leave less spending. Conversely, a secure e
money to one’s children, or a greater des conomic
future, no heirs and indifference t d rate of
o one’s return on investment, that investment
economic independence would reduce will not
savings take place.
and increase spending. Changes in expectations and cha
The objective factors affecting cons nges in
umption interest rates lead to changes in bu
were economic influences like inte siness
rest rates, investment. When business owner
taxes, the distribution of income an s are
d wealth, optimistic about the economy (belie
expected future income and most im ving that
portant of they will be able to sell many goods
all, current income. When interest r in the
ates rose, future and get a good price from co
consumers would become reluctant t nsumers
o borrow for these goods), they will expect high
money in order to buy homes, new rates of
cars, and return on money used to build new pl
other goods on credit. Conversely, ants and
with low equipment. However, when pessimism
interest rates, consumers would fre sets in,
ely incur business decision makers expect fewer sa
debt and spend money. Likewise, when les to
wealth, consumers and think that only if th
current income, or expected future ey offer
income
went up, people would spend more 102
and save
less; and with less wealth, less curre
nt income
and lower expected income in the
future,
people would spend less and save m
ore.
In contrast to the many factors
affecting
consumption, business investment d
epends on
just two factors according to Key
nes—
expected return on investment and t
he rate of
interest. The former constitutes the
benefits
from investing in new plants and e
quipment;
the latter constitutes the cost of obtainin
g funds
to purchase the plants and equipme
nt. If the
expected rate of return on investment e
xceeded
the interest rate, business firms will expa
nd and
build new plants of equipment. Ho
wever, if
interest rates exceeded the expecte
goods at low prices will consumers my interest rate, or the rate of return o
purchase n the
these goods. In this case, expectations money I lent to whoever printed the
are for bond,
meager rates of return on new investm will be 25 percent (a $200 gain on the
ent, and $800
few new plants get built. I paid for the bond). If the price for the
Keynes next had to explain bond
what were $909 rather than $800, I would
determined interest rates. The interest rat be
e was getting back around 10 percent on
determined, according to Keynes, in my
money money (a $91 gain on the $909 I pai
markets where people and businesses d for
demand the bond). And had I bought the bon
money and where central banks cont d for
rol the $990, I would be making only 1 perce
money supply. The demand for mone nt on
y came my money ($10 additional on the $990
from portfolio decisions made by peo I lay
ple and out now). Consequently, bond prices
businesses—they could hold money and
or they interest rates are inversely related—as
could hold their wealth in the form of one
stocks, goes up, the other goes down, and
bonds and other assets. vice
By necessity, the supply of mo versa.
ney When central banks buy bonds t
existing in the economy must by he his
ld by drives up the price of bonds and lower
someone. When central banks increa s the
se the rate of return on these assets. On the
money supply they buy government other
bonds. hand, when central banks want to reduc
A bond is merely a promise to pa e the
y the money supply they must sell bonds. T
person who owns the bond a fixed s o get
um of people to hold these bonds the central
money at some point in the future. T bank
o keep must offer them at a low price. Those b
things simple, consider a bond that pr uying
omises the bonds will thus be receiving a good
to pay its owner $1,000 one year from rate
today. of return on their money, or interest
If I were to purchase this bond for rates
$800, will rise.
JOH
N MAYNARD KEYNES
After his critique of classical ec little to
onomic say about how to reduce unemploym
theory, and his presentation of ent and
the end Depressions. This is especial
determinants of total demand for go ly
ods and surprising since Keynes was intereste
services, Keynes, surprisingly, had d first
and foremost in economic policy. driven by fickle “animal spirits.” Ch
He supported both money cr anges in
eation business confidence or expectations a
(monetary policy) and government bout the
spending future of the economy would change
and tax cuts (fiscal policy). In a m the level
uch quoted of investment and would have a majo
passage, Keynes writes about the need fo r impact
r more on the economy. Moreover, self-
houses, hospitals, schools and road fulfilling
s. But he prophesies were likely to be at wor
notes that many people are likely to k. When
object to businesses were confident about the e
such “wasteful” government spending. conomy,
Another they would invest more and the ec
approach (money creation) was th onomy
erefore would expand. This boom would re
necessary. inforce
expectations about profits, and lead
If the Treasury were to fill old b to even
ottles with
banknotes, bury them at suitable
depths in
disused coal mines which are then fille
d up to
the surface with town rubbish…
private
enterprise [would] dig the notes up
and there
need be no more unemployment.
(Keynes 1971–89, Vol.
7, p. 129)
And in a much maligned passag
e, Keynes
(1971–89, Vol. 7, p. 378) calls for “a som
ewhat
comprehensive socialization of inv
estment.”
While many have taken Keynes
to be
advocating government control of al
l business
investment decisions, what Keyne
s really
advanced was government spendin
g policies
to stabilize the aggregate level of i
nvestment
in the national economy (Pressma
n 1987).
Keynes believed that consumer spe
nding was
relatively stable, and changed little
from year
to year. Business investment, howe
ver, was
greater optimism and investment. On the US to help fight World War II; and
other he
hand, expectations about a poorly pe developed a proposal to help Britain fi
rforming nance
economy will lower investment, slow eco its war effort. Rather than raising ta
nomic xes
activity, and reinforce and strengthen (which would reduce British incomes)
business , and
pessimism about future profits. As a rrather than doing nothing to finance
esult of war
all this, when optimism took hold the econ spending (which would generate infl
omy ation
would boom, but when pessimism set due to shortages of goods and high de
in there mand),
would be dramatic declines in invest Keynes proposed a plan of compuls
ment and ory
massive unemployment. savings or deferred pay. His idea was
Keynes’ solution was to have go that
vernment all British citizens with incomes greate
stabilize the level of investment. When r than
private some minimal level would have money
investment was low, the government taken
should out of their regular paychecks and pu
borrow money (i.e., run a budget def t into
icit) and special bank accounts to help finance th
engage in public investments such as e war.
building These accounts would earn interest d
new roads and bridges and spendin uring
g more the war, but the money in them could
money on schools and better educati not be
on. This withdrawn except under emergenc
would expand the economy as well as imp y
rove circumstances. These savings could th
expectations. In contrast, when busien be
ness lent to the government and used to fi
investment was high due to great op nance
timism, the war effort. After the war, the mon
government should stop borrowing ey in
and cut these accounts could be freely withdra
back on its public investment. wn and
The 1940s found Keynes again used for consumption needs. As an a
working dded
for the British government. He also r benefit, this additional spending would
eturned help
to policy issues surrounding the war prevent another Depression.
effort.
He helped negotiate British loans fr 1
om the 03
JOHN MAYNARD KEYNES
When World War II ended, Keyne victorious governments. He believed
s worked that one
on the new international major cause of the world Depressio
monetary n in the
arrangements being developed b 1930s was that every country tried t
y the o export
unemployment to its trading partn and came to be known as the Br
ers. By etton
running a trade surplus, each coun Woods system. Bretton Woods req
try could uired
produce more and create more do that each country peg its currency
mestic to an
employment; its trading partners woul ounce of gold and keep it there. Be
d import cause
goods instead of producing them w every currency was tied to gold, the
ithin their value
borders. As a result, fewer workers of every currency was tied to every
would be other
needed abroad and unemployment currency. If the US government said
would rise each
abroad. dollar was worth 0.1 ounces of gol
Most countries attempted to g d, and
enerate if the British government decreed tha
trade surpluses through devaluatin t each
g their pound would be worth 0.2 ounces of
currencies. By making foreign moni gold,
es and then $2 had to equal £1, since both
foreign goods more expensive, na were
tional equal to 0.2 of an ounce of gold.
governments knew that their citi
zens 104
would buy fewer foreign goods a
nd buy
more goods made by domestic f
irms.
Similarly, by making domestic mon
ey and
domestic goods cheaper for people i
n other
countries, devaluation would incr
ease
exports. The problem was that wh
enever
one country devalued its currency
in an
attempt to create exports and empl
oyment
for its citizens, other countries w
ould
follow suit. The result was a seri
es of
currency devaluations that did not
benefit
any country.
In order to prevent competitive
currency
devaluations, Keynes proposed a sy
stem of
relatively fixed exchange rates.
This
system was agreed to by the Allied
victors
at Bretton Woods, New Hampshire i
n 1944,
Bretton Woods operated for aro ize
und countries that persistently ran trad
twenty-five years. During this time th e
e world surpluses. Like the fiscal and mone
economy grew at unprecedented rat y
es and policies contained in The General T
unemployment rates in developed co heory,
untries this would encourage countries to sp
reached their lowest levels in the tw end
entieth money on foreign goods and thereby
century. would
But difficult problems simmered counter any tendencies towards anot
below her
the surface. At the agreed upon fi depression. The clearing mechanism an
xed d the
exchange rates gold was rapidly leavi lending facility Keynes wanted were
ng the also
US and the US feared it would soon r established at Bretton Woods; these ar
un out e the
of gold. Something had to be done t International Monetary Fund and the
o stop World
this. Bretton Woods died in August Bank. But the US expected it would
1971, be
when President Nixon ended running trade surpluses because it
the s
convertibility of dollars into gold, an manufacturing capacity was not destr
d then oyed
announced that he would let the doll in the war; so it refused to support
ar float any
relative to an ounce of gold. The c system that would penalize countries
urrent with
system of flexible and variable exc persistent surpluses. Keynes pushed ha
hange rd for
rates was born. this policy proposal; but the US had al
A second way to stem the deflat l the
ionary bargaining chips because of all the m
impact of each country attempting t oney
o run it had lent to Britain and would not b
trade surpluses was to set up an udge
international mechanism to help clear (see Block 1977). While negotiating
trade the
imbalances. Keynes wanted to estab details of the final compromise, Key
lish a nes
system that would lend money to co suffered a series of fatal heart attacks.
untries He
running trade deficits, and to penal died at his home in Cambridge.
s, and
macroeconomics as it is taught in c
Without doubt, no twentieth- olleges
and universities today still relies o
century n the
economist has had a greater impa concepts and modes of analysis de
ct than veloped
Keynes. At the theoretical level by Keynes. Even
Keynes contemporary
developed macroeconomic analysi macroeconomists opposed to the id
eas of Harrod, Roy, The Life of John Mayn
Keynes (see also FRIEDMAN and ard Keynes,
LUCAS) New York, Norton, 1951
find it necessary to start with Key
nes and
then explain the limitations and p
roblems
with his theory. At the policy level, t
he many
tools employed by central banks an
d central
governments to help control the b
usiness
cycle, and the international mechani
sms that
exist to deal with trade imbalanc
es, are
primarily due to Keynes.
Note
1 An earlier version of this piece appea
red in the
Encyclopedia of Political Econo
my, ed. Phil
O’Hara et al., New York and
London,
Routledge, 1998
Works by Keynes
The Collected Writings of John Maynar
d Keynes,
ed. D.Moggridge, 30 vols., Lo
ndon,
Macmillan, 1971–89. Paperback
editions of
Essays in Biography and Essays in P
ersuasion
are published by Norton. Harcourt
, Brace &
World publishes a paperback editi
on of The
General Theory of Employment,
Interest and
Money.
Works about Keynes
Dillard, Dudley, The Economics of

J.M.Keynes,
New York, Prentice Hall, 1948
Hansen, Alvin, A Guide to Keynes,
New York,
McGraw Hill, 1953
JOSEPH SCHU tendencies of capitalism. In these studi
MPETER es he
identified the phases and causes of bus
Lekachman, Robert, The Age of Key iness
nes, New cycles. He also examined the factor
York, Random House, 1966 s
Moggeridge, Donald, Maynard Keyne contributing to the rise and decline
s: An of
Economist’s Biography, London an capitalism.
d New Schumpeter was born to middle-
York, Routledge, 1992 class
Pressman, Steven, “The Policy Relevanc parents in Triesch, Moravia (then part o
e of The f the
General Theory,” Journal of Eco Austro-Hungarian Empire and now pa
nomic rt of
Studies, 14 (1987), pp. 13–23 the Czech Republic) in 1883. His fa
Skidelsky, Robert, John Maynard Keynes, ther,
2 vols., who owned a textile factory, died wh
New York, Viking, 1983 and 1992 en he
was very young. His mother soon rem
Other references arried
and moved to Vienna, where Schum
peter
Block, Fred L., Origins of the Inter attended high school with the aristoc
national
ratic
Economic Order, Berkeley, Califor
elite. He received an excellent educati
nia,
on in
University of California Press, 1977
the humanities, but inadequate groun
ding
in mathematics and science. As a la
w
JOSEPH SCHUMPETER (1883– student at the University of Vienn
a,
1950) Schumpeter took several courses i
n
economics. A seminar taught by Bö
For Joseph Schumpeter (pronounc
hm-
ed Bawerk sparked his interest in the long
SHUM-PAY-ter) economics was all -term
about future of capitalism.
change. He studied both short-run ec
onomic 1
fluctuations as well as the long-
05
run
JOSEPH SCHUMPETER was appointed to a chair in political
economy
After receiving a doctorate of la at the University of Graz.
w in 1906, Schumpeter then became interes
Schumpeter went to Cairo to practic ted in
e law and politics. In 1918 he became a mem
to manage the finances of an Egyptian pr ber of
incess. the German Socialization Commiss
In 1909 he accepted a teaching jo ion,
b at the which argued for socializing Ger
University of Czernowitz, and two man
years later industry in order to make it more eff
icient. d growth.
In 1919, he became Finance Mini Schumpeter sought to analyze and un
ster of derstand
Austria. His political career, howev these features of capitalism.
er, was Schumpeter (1939) was one of t
both short and unsuccessful. He p he first
roposed economists to study business cycles, the r
an unpopular tax on capital to co egular
ntrol fluctuations that economies experie
inflation. A flippant remark about nce. He
the identified three different cycles occ
Austrian dollar (“a crown remains a urring
crown”)
in the face of rampant inflation was 106
viewed
as insensitive to the plight of
most
Austrians. And there was much criti
cism of
his plans to nationalize Austrian fir
ms.
Unable to handle the pressures o
f political
life, Schumpeter resigned after jus
t seven
months in office (Shionoya 1955, p
. 18). He
then became President of a small private
bank.
At the same time he invested in
highly
speculative activities and lost his s
hirt while
incurring massive debts, which it t
ook him
many years to repay.
In 1925, Schumpeter accept
ed an
appointment as Professor of Econo
mics at the
University of Bonn. Seven years l
ater he
accepted a position at Harvard, w
here he
remained until his death in 1950. I
n 1949,
Schumpeter served as President
of the
American Economic Association,
thus
becoming the first non-American t
o be so
honored.
For Schumpeter, all capitalist e
conomies
had two prominent characteristics—
they were
unstable and they experienced rapi
g four
to five years, Schumpeter thought, we
simultaneously. First, there were sh re due
to the desire of businesses to expand
ort-run and
fluctuations of three to four years, modernize their capital equipment. Bu
which t after
Schumpeter called “Kitchin Cycles, most businesses have expanded a
” after nd
economist Joseph Kitchin who first disco modernized, they have little need for
vered new
them. These cycles were due to cha investment. Consequently, spending on
nges in plants
business inventories. For one to two and equipment gets cut back during t
years, he next
businesses would expand their invent four or five years. Over this period,
ories in capital
order to keep ahead of rising sales. B equipment gets worn out and outdate
ut when d, thus
the growth of sales slowed, inventorie setting the stage for another investment
s would boom
begin to pile up in warehouses. As a of four to five years.
result, Finally, there are long-run cycles,
businesses would cut back productio or
n for a Kondratieff waves, lasting 45 to 60 y
year or so in order to reduce their i ears.
nventory Schumpeter named these cycles aft
backlog. When inventories finally ret er
urned to Russian economist Nikolai Kondratie
more desirable levels, and sales pick ff,
ed up, who first noticed them but could not e
businesses would again seek to expa xplain
nd their what caused them (see also KUZNE
inventories. TS).
A second cycle was associated with ch Schumpeter saw invention and innov
anges ation
in business investment in new plant as the driving force behind long-run cy
s and cles.
equipment. These cycles lasted eight to In times of slow growth businesses
eleven would
years, and Schumpeter called them not be likely to introduce new innovat
“Juglar ions.
Cycles,” after Clement Juglar who As a result, new discoveries and innov
first ations
discovered them. Usually when peop would pile up for several decades.
le speak When
of “the business cycle,” they refer t rapid economic growth finally begins
o these , the
economic fluctuations. Expansions lastin
rapidly. Schumpeter regarded the Ind
ustrial
stockpile of innovations gets empl Revolution, which introduced the s
team
oyed in engine, the spinning jenny, and ot
the production process and economi her
es grow discoveries, as the beginning of one
long- rive; on
term economic expansion. Railr the other hand, if the entrepreneuria
oad l spirit
construction in the mid-nineteenth was destroyed or severely hinder
century ed,
began a second Kondratieff wave. capitalism would quietly transform it
In the self into
early twentieth century, electrici socialism.
ty, For entrepreneurs to succeed, Sch
automobiles, and chemicals sparked umpeter
a third held that they had to mold and s
Kondratieff wave. hape
In his early work, Schumpeter (1 consumer tastes. In contrast to ot
911) held her
that invention was economists, who saw firms respond
determined by ing to
noneconomic forces and could no consumer tastes, Schumpeter held th
t be at “the
understood through studying econo great majority of changes in comm
mics. In odities
later work, Schumpeter (1942) he consumed has been forced by produ
ld that cers on
innovation was shaped by economi consumers who, more often than no
c forces t, have
inside the large firm. But throughout
his life,
Schumpeter refused to believe
that
innovation was a rational activity; i
nstead he
thought it was a creative activity th
at could
neither be explained nor understoo
d as the
result of rational thinking process
es. The
agent of innovation and invention
was the
entrepreneur.
Unlike many of his contempor
aries,
Schumpeter did not
believe that
entrepreneurs merely hired resources
in order
to produce goods and meet cons
umer
demand at minimum cost. Rather,
like
Cantillon, he thought that entreprene
urs were
individuals willing to take risks.
As such,
they were the key force causing c
apitalist
economies to grow. When there we
re many
entrepreneurs, capitalism would th
JOSEPH SCHU ot find
MPETER the funds to convert them into innov
ations
resisted the change and have had t that spark growth, and thus remain p
o be oised
educated up by elaborate psychotech to start a new cycle of growth.
nics of In Capitalism, Socialism and De
advertising” (Schumpeter 1939, Vol. mocracy,
1, p. Schumpeter (1942) adopted an even br
73). Consumer preferences do not l oader
ead to perspective on economic change. Rathe
production and innovation; rather inn r than
ovation examining the cyclical changes that
leads to new goods and services t a
hat capitalist economy goes through, h
consumers either reject or develop tas e
tes for. examined the very future of capitalism
Invention and innovation by . The
the big question he asked was “Can capit
entrepreneur was the driving force alism
behind survive?” The answer he gave was “No.
long-run economic cycles accordin I do
g to not think it can” (Schumpeter 1942, p
Schumpeter (1911). Invention, back . 61).
ed by In essence, he thought that Marx was
bank credit, leads to innovation and g right
rowing in believing that socialism would rep
prosperity. This soon attracts imitator lace
s, and capitalism. However, rather than bei
the original innovation leads to eco ng
nomic destroyed by its failures, as Marx pred
prosperity. But imitators are always icted,
less Schumpeter believed that capitalism
effective than innovators, and many would
arrive be destroyed by its many successes.
too late in the expansion c Schumpeter (1942, p. 83) thought
ycle. that
Miscalculation and tighter credit wil creative destruction was one main reas
l push on for
some firms into bankruptcy, and leathe success of capitalism. Capitalism i
d to s not
recession or depression. But the only about successful innovation; it is
se also
bankruptcies also weed out inefficient about destroying old and inefficien
firms, t
thus correcting the errors of the p processes and products. This replace
ast ment
expansion. Inventions accumulate dur
ing the 1
contraction, when entrepreneurs cann 07
JOSEPH SCHUMPETER arise, however, because smaller fir
ms are
process makes capitalism dynami constantly being replaced by larger
c and firms.
causes incomes to grow rapidly. P Through this process,
roblems managerial
bureaucrats, rather than innova one’s desires and compromising. The
tive family,
entrepreneurs, come to run the fir however, is important for capitalism
m. These because
managers are employees rather than it is a main reason for saving. Families
owners. save so
They prefer a steady income and job that if anything happens to the
security main
to innovation and risk-taking. As breadwinner, other family members
a result, will be
capitalism loses its dynamic tend provided for. By undermining the m
ency otivation
towards innovation and its spirit of to save, capitalism destroys its
continual own
improvement and change. foundation—the capital needed for
Schumpeter (1942, pp. 121–5) future
also saw growth.
potential problems stemming from the f Long-term economic growth has
act that always
capitalism requires rational calcula been a central economic concern. Adam
tion and Smith
logical choice from all participants. and most classical economists saw c
This leads apitalism
people to develop a skeptical and critical as the best way to achieve rapid gro
frame wth. By
of mind. In addition, because capita
lism is so 108
successful at increasing incomes, it can
support
a large number of middle-class int
ellectuals.
With much free time on their han
ds, these
individuals will criticize the capitali
st system
and push for measures that enhan
ce the
economic role of government bure
aucrats.
Resentment against the income inequali
ties that
make capitalism possible will also
be strong
among intellectuals, and they will
push for
measures that try to keep incomes equal.
These
actions will reduce the incentive to
take risks
and innovate.
Finally, Schumpeter (1942, pp.
160–1)
thought that capitalism undermines the
family.
Capitalism is all about satisfying i
ndividual
wants, while the family requires s
ublimating
Capitalism, Socialism and Democracy, Ne
wYork,
the late nineteenth century, howe Harper, 1942
Ten Great Economists, New York, Oxf
ver, ord
economists came to focus more on the que University Press, 1951
stion History of Economic Analysis, NewYork, O
of economic efficiency, and they lost xford
interest University Press, 1954
in the issue of growth. The main con
tribution
of Schumpeter has been to redirect the atte Works about Schumpeter
ntion
of economists to the issue of long- Allen, Robert Loring, Opening Doors:
term The Life
economic growth. In so doing, he stre and Work of Joseph Schumpeter, 2 vo
ssed the ls., New
importance of noneconomic factors Brunswick, Transaction Publishers, 1
like 994
innovation and the entrepreneur for a Heertje, Arnold (ed.), Schumpeter’s Vi
healthy, sion:
thriving, and growing capitalism. Capitalism, Socialism and Democr
acy After
40 Years, New York, Praeger, 1981
Works by Schumpeter Heilbroner, Robert, “Was Schumpeter
Right?,”
Theory of Economic Development (19 Social Research, 48, 3 (Autumn 19
11), 81), pp.
Cambridge, Massachusetts, 456–71
Harvard Oakley, Allen, Schumpeter’s Theory of Ca
University Press, 1954 pitalist
Economic Doctrine and Method: An Motion: A Critical Exposition a
Historical nd
Sketch (1914), London, George Al Reassessment, Hants, Edward Elgar,
len & 1990
Unwin, 1954 Rosenberg, Nathan, “Joseph Schumpeter: R
Business Cycles: A Theoretical, Hist adical
orical and Economist,” in Exploring the Blac
Statistical Analysis of the Capitali k Box:
st Process, Technology, Economics, and Histor
2 vols., New York, McGraw Hill, 193y,
9
an, Princeton,
New Jersey, Princeton University Pres
Cambridge, Cambridge Universit s, 1994
y Press,
1994, pp. 47–61
Shionoya, Yuichi, Schumpeter and t PIERO SRAFFA (1898–1983)
he Idea of
Social Science, New York, Camb
ridge Piero Sraffa (pronounced SRAH-
University Press, 1995
Stolper, Wolfgang F., Joseph Alois
fah) made
Schumpeter two contributions to economics. Fir
The Public Life of a Private M st, he
pointed out that the marginalist theory of
value wrote two articles on Italian banking. One
is logically inconsistent. Second, was
Sraffa
attempted to construct an adequate
theory of
value based upon the work of Ricard
o and the
classical notion of a surplus that gets ge
nerated
during the production process.
Sraffa was born in Turin, Italy
in 1898
into a wealthy and distinguished
Jewish
family. His father was a well-known
lawyer,
who both practiced his profession a
nd taught
law at various Italian universities.
As his
father moved from one university to
another,
Sraffa moved from city to city an
d from
school to school. After graduating
from
secondary school, Sraffa enrolled in
the law
faculty at the University of Turin.
At Turin
he studied political economy unde
r Luigi
Einaudi, a well-known specialist i
n public
finance and later President of the
Italian
Republic. Following a brief stint
in the
Italian army, Sraffa completed his d
egree in
1920, writing his doctoral thesis
under
Einaudi on monetary inflation in Ital
y during
the 1914–20 period.
After graduation Sraffa worked at an
Italian
bank, but he left this job in the Sprin
g of 1921
in order to spend time in England
studying
British monetary problems. Throug
h a friend
of his father, Sraffa made the acquai
ntance of
John Maynard Keynes.
In 1922, at the invitation of Key
nes, Sraffa
PIERO Sardinia.
SRAFFA As the Fascist government beca
me
published in the Economic Journal, a sch increasingly repressive, Sraffa sou
olarly ght
journal edited by Keynes (Sraffa 192 employment outside Italy and Keynes
2a), and helped
concerned the bankruptcy of an Italiaarrange a lectureship for Sraffa at Ca
n bank. mbridge
The second article appeared in the Manc University. Sraffa, however, found lec
hester turing
Guardian (Sraffa 1922b), and critici difficult. He disliked delivering his id
zed the eas in
reporting procedures of Italian bank public and felt uncomfortable having to lec
s and ture
government supervision of bank rep in English. Again Keynes came to the
orting rescue,
procedures. This article was soon tragetting Sraffa a job as head of the M
nslated arshall
into four languages, including Italian Library of Economics. Keynes also ar
. As a ranged
result, it came to the attention of M for Sraffa to edit the works of David R
ussolini, icardo
who became enraged and called it “a for the Royal Economic Society. This
n act of project
true and real sabotage of Italian fin helped shift Sraffa’s interests from mon
ance” ey and
(Kaldor 1985, p. 618). Mussolini co economic policy to the abstract and theoret
ntacted ical
Sraffa’s father, insisting on a full and com issues of value theory. Sraffa spent a good d
plete eal
retraction. Sraffa refused; but he had of time in the 1930s, 1940s, and early
to flee 1950s
Italy until Mussolini calmed down. compiling the ten-volume edition of Ricar
Despite his precarious relationshido’s
p with Works and Correspondence (Sraffa
Mussolini, Sraffa held numerous jobs 1951–5).
in Italy While he received many awards for
during the 1920s. He set up a gover this
nment scholarly endeavor (including the Söd
department in Milan to collect labor s erström
tatistics, Gold Medal of the Swedish Royal Ac
but resigned as soon the fascist regi ademy
me took of Sciences, a precursor to the Nobel P
power. Then he lectured in Public Fina rize in
nce and Economics), it is mainly for his theor
Political Economy at the University of Per etical
ugia,
and he held the position of Profess 1
or of 09
Economics at Cagliari University in
PIERO SRAFFA By the 1920s, supply and demand
analysis
work on the theory of value that Sr had come to dominate economic thi
affa made nking in
his mark. Europe. Sraffa was dissatisfied with t
his mode t each
of thinking. His contributions to val different price, we get the industry s
ue theory upply of
were twofold—one destructive an coffee mugs.
d one Sraffa argued that the condition
constructive. First, he pointed out t s of
he logical production, and thus the supply curve,
flaws in the Marshallian analysis o for any
f supply. one firm had to affect the conditio
Second, he developed a more adequ ns of
ate theory production for all its competitors.
of supply that relied on the classical For
notion of example, when one firm expands
a surplus. its
In 1925 Sraffa published an arti production of coffee mugs it will incr
cle in the ease its
Annali di Economia of Bocconi demand for the materials (e.g. clay) t
University hat are
attacking the foundations of orthodox Ma needed to produce coffee mugs and
rshallian so the
economics. Edgeworth read this paper price of these materials will increase
in Italian . But if
and told Keynes about it. He also ask the cost of making coffee mugs rises
ed Keynes because
to have Sraffa write a shorter version of the of higher material costs, all firms m
paper ake less
for the Economic Journal (Sraffa 1
926). Both 110
articles pointed out logical problems
with the
supply curve analysis of Marshall.
According to Marshall, the sup
ply curve
of any firm was independent of th
e supply
curves for all other firms in the ind
ustry. An
industry supply curve was derived b
y simply
adding up the supply curves of ever
y firm in
the industry. If there were 100 fir
ms in the
industry, and 50 wanted to produc
e 1,000
coffee mugs if they could be sold for
$1 while
the other 50 firms wanted to produ
ce 2,000
coffee mugs if the price was $1, tot
al output
in the industry would be 150,000 cof
fee mugs
if the price was set at $1 in the market. Si
milar
calculations could be made for di
fferent
prices. Adding up the quantities a
monopolistic competition by Joan Ro
binson
profit by producing coffee mugs. As a and others (see Harcourt 1986).
Sraffa was responsible for other cr
result, iticisms
other firms will want to produce few of orthodox microeconomics. The Ca
er mugs mbridge
at each price. Because of Controversy (see also ROBINSON), sugg
such ested
interdependence, Sraffa contended, i by Sraffa to Robinson, involved the ar
t was gument
illegitimate to draw Marshallian supply (being made in Cambridge, England) t
curves hat the
for any industry. orthodox theory of value was circular. Ano
Sraffa’s second criticism was an atther
tack on approach to value theory was thus n
the assumption of diminishing retur eeded.
ns in Sraffa went back to the economics of
production. He argued that most pro Ricardo
duction, and the classical notion of a surplus to find t
especially manufactured consumer his
goods, approach.
occurs under conditions of increasing r According to Sraffa, a logicall
eturns. y
He also showed that diminishing re consistent theory of value and distrib
turns ution
cannot apply to a particular industry had to return to the classical conceptio
or good n of
in isolation, since changes in the c the circular nature of production—
ost of goods
production in a particular industry wil getting used to produce goods, and a s
l affect urplus
the cost of production in all other in getting created if you wind up produ
dustries cing
that require this good in the produ more goods than you started off with.
ction Sraffa
process. For this reason, Sraffa held t (1960) then went on to show the consi
hat the stency
economic model of perfect competiti of this model. He showed how such a
on had model
to be abandoned, and it had to replac can be used to explain value or rela
ed with tive
a model recognizing firm interdependen prices, as well as the principles tha
ce and t
the existence of monopoly and oligopoly. determined the distribution of incom
This e
critique led to the development of mo between wages and profits.
dels of
ned by
subsistence needs of workers) or profit rat
Beginning with a given technol e (and
assuming that competition would re
ogy that sult in a
details what is necessary to produce goo uniform rate of profit throughout the econ
ds, and omy),
given either a real wage (determi Sraffa demonstrated that relative pric
es would recognize that the cost of inputs must
be determined. The distribution of equal
income the value of the output produced i
between wages and profits wou n each
ld be sector. Thus we can think of A as th
determined outside the model by s e price
ome other of agricultural goods and M as the p
forces. The main point of this analy rice of
sis is that manufactured goods. To find the pri
current technology, or the costs of p ces of
roduction, these two commodities we need to so
determines relative prices. lve the
Let us take a simple case, one above two equations for A and fo
with no r M.
surplus, to demonstrate the main p Unfortunately, there is no unique
oint of mathematical solution here; but we d
Sraffa. Suppose that the economy o know
produces that the mathematics of producti
only two types of goods— on
manufactured goods
(M) and agricultural goods (A). Techn
ological
requirements for producing these go
ods are as
follows:
2A+2M=6A
4A+1M=3M
Two units of agricultural goods
and two
units of manufactured goods are req
uired to
produce six units of agricultural
goods,
while four units of agricultural go
ods and
one unit of manufactured goods yiel
d three
units of manufactured goods. Starti
ng with
six units of agricultural goods and
three
units of manufactured goods, and e
ngaging
in the production of these goods, w
e wind
up with six units of agricultural go
ods and
three units of manufactured goods
. Our
economy reproduces itself from y
ear to
year, but creates no surplus or fails
to grow
during the year.
If we think about prices in term
s of this
model or set of equations, we s
hould
PIERO tries.
SRAFFA Next, Sraffa assumed that the rate of p
rofit
technology will require A to equal 2 depended on the rate of interest (Ronc
M, or aglia
the price of agricultural goods must b 1993). With these two assumptions, Sr
e twice affa
the price of manufactured goods. was able to again demonstrate that it
The was
technology of production thus deter technology or the cost of production
mines that
values or relative prices, although it determined relative prices. Values or
does relative prices could thus be explain
not tell us what the price of each goo ed
d will without having to resort to the circula
be. rity
Sraffa was able to extend this mo of marginalist analysis. Likewise, we
del to do
a world of many goods and again sho not have a circular theory of incom
w that e
the technology of production stil distribution that depends on the noti
l on
determines relative prices. He was als marginal productivity. Instead, the
o able distribution of income between wages
to extend the model to cases wher and
e a profits gets determined by monetar
surplus gets produced. Here things ge y
t even policy, by competition, and by other f
more complicated, and Sraffa had to orces
make that affect interest rates.
a few simplifying assumptions. Firs Sraffa’s place in the history of eco
t, he nomics
assumed that capital mobility would is rather difficult to pinpoint. He made
lead several
to a uniform rate of profit. This is a telling criticisms of standard economic th
fairly eory,
reasonable assumption, since capit and he began to develop a new and di
al fferent
should flow to those industries or se theory of value. Yet few economists, ev
ctors en the
yielding greater returns and should lmajority of economists who are critic
eave al of
those industries or sectors with lo traditional economic theory, have followe
wer d the
returns. This should reduce profit rat path pioneered by Sraffa.
es in
the former set of industries and inc 1
rease 11
profit rates in the latter set of indus
GUNNAR MYRDAL “The Current Situation of the Italian
Banks”
Works by Sraffa Manchester Guardian Commercial:
The
“The Bank Crisis in Italy,” Economic Jou Reconstruction in Europe, Supplement
rnal, 32 No. XI,
(June 1922a), pp. 178–97 (7 December 1922b), pp. 675–6
“The Laws of Return under Comp Rocaglia, Alessandro, “Towards a Post-
etitive Sraffian
Conditions,” Economic Journal, 1 ( Theory of Income Distribution,” Jo
December urnal of
1926), pp. 535–50 Income Distribution, 3, 1 (Summer
“General Preface” and “Introduction,” in 1993),
On the pp. 3–27
Principles of Political Economy
and
Taxation, 1 of The 112
Works and
Correspondence of David Ricardo
, 10 vols.,
ed. Piero Sraffa, Cambridge Uni
versity
Press, 1951–5
Production of Commodities by Mea
ns of
Commodities: Prelude to a Criti
que of
Economic Theory, Cambridge, C
ambridge
Works about Sraffa
Kaldor, Nicholas, “Piero Sraffa 189
8–1983,”
Proceedings of the British Academy,
71 (1985),
pp. 615–40
Mongiovi, Gary, “Piero Sraffa,”
in A
Biographical Dictionary of Dissen
ting
Economists, ed. Philip Arestis and
Malcolm
Sawyer, Hants, Edward Elgar, 19
92, pp.
536–45
Potier, Jean-Pierre, Piero Sraffa: U
northodox
Economist (1898–1983), London
and New
York, Routledge, 1991
Roncaglia, Alessandro, Sraffa and th
e Theory of
Prices, Wiley, 1978
Roncaglia, Alessandro, “Piero Sraf
fa’s
Contribution to Political Econom
y,” in
Twelve Contemporary Economists,
ed.
J.R.Shakleton and G. Locksley, N
ew York,
Wiley, 1981, pp. 240–56
llage of
Solvarbo, a rural, farming area in ce
Other references ntral
Sweden. His father was a wealthy land
Harcourt, G.C., “On the Influence of Piero Sowner,
raffa who was able to provide Myrdal wit
on the Contributions of Joan Robi h an
nson to excellent education. Myrdal stu
Economic Theory,” Economic Jou died
rnal, 95 mathematics at the Royal Gymnasium and
(1986), pp. 96–108 then
enrolled at Stockholm University to stu
dy law.
He chose this course of study because he want
GUNNAR MYRDAL (1898– ed
to understand how society worked. Al
1987) though
Myrdal received a law degree in 192
3, the
The economics of Gunnar grueling course of study killed his inte
rest in
Myrdal
the law. His wife Alva then convinced
(pronounced mirr-DALL) has him to
two study economics, a discipline that co
distinguishing characteristics—a focus mbined
on real science and mathematics with an atte
world economic issues and an effort mpt to
to bring understand the workings of society (Angre
the insights from other disciplines sano
into 1997, pp. 146f.). After studying unde
economic analysis. Myrdal spent muc r Knut
h of his Wicksell, Myrdal received a Ph.D. in Econo
life studying the problems of race r mics
elations, from Stockholm University in 1927 a
unemployment and poverty. He also s nd then
ought to began teaching there.
understand how economies change o In 1932 Myrdal was appointed by the So
ver time, cial
and he looked towards psycholog Democratic government to a new housi
ical, ng and
historical, sociological, and cultural fapopulation commission, and was thus
ctors as able to
the cause of these changes. influence Swedish housing policy. Fro
Myrdal was born in 1898 in the vi m 1934
h Post-
War Planning Commission and Min
to 1936, and again from 1942 to ister for
Trade and Commerce.
1946, he Because of his economic ideas and his
served in the Swedish Parliament, a many
nd in the positions of political influence Myrdal
late 1930s he served on the Boar became
d of the one of the main architects of the S
National Bank of Sweden. In the wedish
mid-1940s, welfare state. Furthermore, Myrdal
Myrdal became chairman of the Swedis was a
strong advocate of using Keynesia these matters with his distinction b
n fiscal etween
policy in Sweden. Kindleberger (1 expected outcomes and final outco
987, pp. mes, or
394f.) credits Myrdal with convincing between ex ante and ex post eco
Finance nomic
Minister Ernst Wigters to spend m variables. Expected or ex ante ec
oney for onomic
public works and run budget deficit variables are measured at the begin
s in order ning of
to reduce unemployment. In 1974, some process; final or ex post varia
Myrdal bles are
shared the Nobel Prize in Econo measured at the end of the process.
mics with
Friedrich Hayek.
Myrdal had wide and diverse i
nterests,
and he made important contribution
s to both
economic theory and policy analysi
s. At the
theoretical level, he introduced the
ex ante-
ex post distinction to help cla
rify
macroeconomic analysis, and he d
eveloped
the notion of cumulative causatio
n as an
alternative to equilibrium analysis.
At the
policy level, Myrdal explained
the
persistence of poverty throughout
the
developing world and among blac
ks in the
US, and he suggested numerous p
olicies to
deal with the problem of poverty.
The lack of a distinction bet
ween
expectations and actual outcomes
created
much confusion in economics dur
ing the
1920s. Businesses, for example, i
nvest to
make a profit; yet they sometime
s lose
money. Businesses even invest at ti
mes when
there is no additional savings; bu
t all
economists know that savings mu
st equal
investment. Myrdal (1939) helped
clarify
GUNNAR principle of cumulative causation was
MYRDAL first
applied in economic analysis by Wic
With this distinction Myrdal was ksell,
able to when he examined what happens when real
explain how an increase in investment and
over ex natural interest rates diverge. It was
ante saving would lead to additional Myrdal,
savings however, who first described this principle
(through increases in profits and otand
her recognized its importance.
incomes), so that ex post, savings A cumulative economic process c
will equal an be
investment. By the same token, greater sa contrasted with a unidirectional caus
vings, al
ex ante, would cause a recession and schema, where A causes changes in B
lead to , but
lay-offs and lower profits for busin B has no further effects on A. Wi
esses. th
Unable to sell what they already pr unidirectional causation, changes in A
oduce, lead
businesses would scale back investment. to changes in B and things end there;
Again, the
when measured ex post, saving wil system reaches a new stable equilibr
l equal ium
investment. with higher (or lower) values for t
Although the ex ante-ex post di he
stinction variables A and B.
helps to explain how economies will With cumulative causation, the vari
move ables A
towards an equilibrium where saving and B impact each other. Changes in
s equals A will
investment, for the most part Myrda affect B, which will further affect A,
l was again
opposed to equilibrium analysis and impact B, etc. There is no equilibrium or
proposed point
an alternative means of understanding of rest for the system. When A and
the way B both
economies work. Cumulative causat increase, we have a virtuous cycle or
ion positive
involves a positive or negative fee feedback loop; and when A and B both decli
dback ne,
mechanism involving two or more v we have a vicious cycle or negative fe
ariables. edback
Since changes in any one variable l loop. Myrdal used the idea of cumul
ead to ative
similar changes in other variables, th
e entire 1
system moves along in one directio 13
n. The
GUNNAR MYRDAL d, Myrdal
was approached by the Carnegie Cor
causation to explain economic prob poration
lems like to study racial problems in the US. He acc
poverty and race relations. epted
In 1938 while lecturing at Harvar the invitation and spent the next fiv
e years umulative
working on the pathbreaking An causation to help explain the socioe
American conomic
Dilemma (Myrdal 1944). This book arg condition of black Americans. Prej
ued that udice
there was a moral conflict in Americ against blacks led to lower living standar
a. On the ds for
one hand, Americans believed in the blacks. Seeing that blacks do indeed have l
ideals of ower
justice and equal opportunity, and did no living standards, white prejudices
t think were
blacks were less able than whites. On the reinforced. This led to further declines in
other black
hand, in practice blacks and whites living standards relative to whites. A
were not s Myrdal
treated equally and America did not l (1944, p. 381) succinctly put
ive up to it,
its high ideals. Much of An American “Discrimination breeds discriminat
Dilemma ion.”
attempted to trace the discriminatio Myrdal went on to document the many
n existing ways
in America against blacks. It docum black Americans were kept down d
ented the ue to a
political and socioeconomic condi cumulative process of discriminati
tion of on.
blacks and whites, and marshaled consi
derable 114
evidence to show that blacks were
treated
differently from whites.
In his typical fashion, Myrdal
employed
sociological, historical, psychologi
cal, and
political insights into his analysis.
He also
showed the damage that stemmed fr
om racial
segregation and discrimination. He arg
ued that
the entire American society suffered by
denying
blacks a decent education, by not
providing
them with job training, and by disc
riminating
against them in employment and
housing.
Myrdal also made the case that A
merica’s
treatment of blacks was inconsistent
with the
needs of a technologically advance
d society.
Thus, as a result of discrimination,
the US
economy performed poorly.
Myrdal also used the notion of c
merica
results from a negative feedback process has
Discrimination in education, for exa one
important policy implication —this situatio
mple, n can
meant that blacks were less likely tha be remedied in any one of a number of
n whites ways.
to become doctors. Discrimination in edu Improvement in any one area will lead t
cation o gains
also meant that blacks would be in other areas through a cumulative pro
less cess of
knowledgeable about health and sanit improvement. But where to start?
ation. In Myrdal looked to American institut
addition, blacks had less money tha ions to
n whites break into the vicious cycle of discrim
for medical care. For all these reasons ination
, blacks against black Americans. Organizations su
receive less adequate medical treatment a ch as
nd are churches, schools, trade unions, and
in poorer health than whites. Conseqthe
uently, government were repositories of the A
blacks find it harder than whites to ob merican
tain and creed of justice and equality. Moreover
keep a job; and with lower incomes, , many
black of these institutions could immediately imp
education will suffer (Myrdal 1944, p. rove
172). the socioeconomic condition of black
Myrdal (1944, p. 956) also note s, thus
d that reducing prejudice against blacks and begin
segregation leads to white stereotypes of b ning
lacks a positive or virtuous cycle. Myrdal
and causes whites to focus on the dif thus
ferences proposed expanding the role of the f
between blacks and themselves. This, ederal
in turn, government in the areas of education, h
affects how whites regard blacks. When ousing,
whites and income security. Laws making it eas
have less regard for blacks, they are le ier for
ss likely blacks to vote was another easy way to
to associate or interact with blacks, an break
d blacks the cycle of discrimination and preju
will be less likely to work or live wit dice.
h whites Myrdal (1944, pp. 198ff.) also advoc
who have little regard for them. Seg ated
regation migration from the rural South to the in
and racial stereotypes are thus furt dustrial
her North and West, where discrimination
reinforced. was not
The view that the condition of black A
movement would help both American lab
or and
so prevalent and high-paying jobs black Americans. Finally, Myrdal ad
vocated
were more using fiscal policy to achieve full-
plentiful. Incorporating blacks into employment,
the labor so that blacks migrating to Northern and W
estern While most economists have clai
cities could get jobs and become integrat med that
ed into a trade-off exists between equality an
the post-war industrial economy. d growth
Myrdal (1957) later applied the p (see also KUZNETS and PIGOU), Myrda
rinciple of l held
cumulative causation to the study of that there is no such trade-off, and tha
economic t greater
development, and used it to explain equality would lead to more rapid
persistent growth.
poverty in South Asia (Myrdal 19 Myrdal (1970, p. 51) argued that in
68). He equality
contrasted “spread effects,” which leads to slower growth because of the
create a physical
positive cumulative cycle with “b and psychological consequences of
ackwash poverty,
effects,” which create a negative c and because the poor are unable to utilize
umulative their
cycle. Once a region begins to d talents. Because it raises productivity
evelop growth,
economically it will attract capital greater consumption is really gre
and labor ater
from other regions. These new reso investment in developing countries.
urces will Also, a
assist in the development process. On
the other
hand, persistent poverty normally lea
ds to high
fertility rates, poor nutrition, and l
ow labor
productivity, all of which contribut
e to even
greater poverty.
Following along the lines of hi
s policy
recommendations for reducing black po
verty in
the US, Myrdal (1970) stressed the n
eed to end
the vicious cycle of poverty and begin a vi
rtuous
cycle of growth and development.
First and
foremost, developing nations must sp
end more
money on education. Second, efforts
had to be
concentrated on improving sanitation, p
roviding
clean water and developing other
public
amenities. Third, income support progr
ams had
to address the problem of income inequal
ity and
the lack of adequate income receive
d by most
citizens in these countries.
GUNNAR field like economics. He often quipped that
MYRDAL the
only reason he accepted the prize was t
welfare state that redistributes income wil hat the
l lead award committee called him very early
to higher levels of demand and mor in the
e rapid morning, before he was fully awake.
growth. Myrdal is the rare economist who has m
Throughout his entire life Myrdaade
l was significant contributions to both econ
highly critical of the methods empl omic
oyed in theory and economic policy. His theo
orthodox economic analysis. We have seen ry of
how cumulative causation provides a theo
he rejected equilibrium analysis in f retic
avor of alternative to traditional equilibrium a
cumulative causation. Myrdal (1969 nalysis.
) also And the proposals to help reduce pove
criticized social scientists in general rty and
, and unemployment that follow from this
economists in specific, because they c theory
ould not provide an alternative to traditional laissez
write and speak so that ordinary peop -faire
le could policy prescriptions.
understand them. Instead, profession
als write
and speak to each another. This redu Works by Myrdal
ces the
importance of social science scholar The Political Element in the Develop
ship. ment of
Myrdal (1929) also criticized the att Economic Theory (1929), Cambridge, H
empt by arvard
economists to hide their normative o University Press, 1965
r value Monetary Equilibrium, London, Hodge,
assumptions behind the façade of sc 1939
ientific An American Dilemma, New York, Har
objectivity. He was not against econ per &
omists Brothers, 1944
making value judgments; he was only op Rich Lands and Poor The Road to
posed World
to their refusal to acknowledge them. Even Prosperity, New York, Harper & Br
after others,
winning the Nobel Prize, Myrdal clai 1957
med that
the prize was inappropriate for an un 1
scientific
15
FRIEDRICH HAYEK The Challenge of World Poverty: A

World
Asian Drama: An Inquiry into the AntiPoverty Program in Outline,
Poverty of New York,
Nations, New York, Pantheon Book Pantheon Books, 1970
s, 1968 Against the Stream: Critical Essays
Objectivity in Social Research, New on
York, Economics, New York, Pantheon Boo
Random House, 1969 ks, 1972
YACK)
Works about Myrdal achieved worldwide recognition as a cha
mpion
Angresano, James, The Political E of the free market and an oppone
conomy of nt of
Gunnar Myrdal, Cheltenham, U
K, Edward 116
Elgar, 1997
Dostaler, Gilles, Ethier, Diane and
Lepage,
Laurent, (eds.) Gunnar Myrdal a
nd his Work,
Montreal, Harvest House, 1992
Jackson, Walter A., Gunnar Myrda
l and
America’s Conscience: Social E
ngineering
and Radical Liberalism, Chapel
Hill, North
Carolina, University of North Caro
lina Press,
1990
Kindleberger, C.F., “Gunnar Myrdal 1898
–1987,”
Scandinavian Journal of Econom
ics, 89
(1987), pp. 393–403
Lundberg, E., “Gunnar Myrdal’s Contrib
utions to
Economic Theory,” Swedish Jou
rnal of
Economics, 76 (1974), pp. 472–8
Pressman, Steven, “An American Dilem
ma: Fifty
Years Later,” Journal of Economic Is
sues, 28,
2 (June 1994), pp. 577–85
Reynolds, Lloyd G., “Gunnar My
rdal’s
Contributions to Economic Theor
y, 1940–
1970,” Swedish Journal of Eco
nomics, 76
(1974), pp. 479–97
Streeten, Paul, “Gunnar Myrdal,”
World
Development, 18, 7 (1990), pp. 1,0
31–7
FRIEDRICH HAYEK (1899–
1992)
Friedrich Hayek (pronounced HI-
School of Economics in order to brin
g the
government interference with the ri economic ideas from continental Eur
ope to
ght of England.
individuals to engage in free exchange thr Following publication of the Roa
ough d to
the market. His work makes a strong Serfdom in 1944 Hayek became a w
case that orld-
individual choice, rather than gover renowned social theorist. Receiving
nment many
decision-making, yields both econo teaching offers, Hayek accepted an appoint
mic ment
benefits (greater efficiency) and non- at the University of Chicago in 1950. He reti
economic red
benefits (greater liberty and freedom) in 1962 and returned to Europe, acce
. pting a
Hayek was born in Vienna in 18 position at the University of Freiburg. I
99. His n 1974
grandfather was a friend of Austrian econ Hayek shared the Nobel Prize in Eco
omist nomics
Böhm-Bawerk; his father was traine with Gunnar Myrdal. The committee single
d as a d out
physician and then became a Profes Hayek’s original way of advocating p
sor of olitical
Botany at the University of Vienna. ideas in announcing the award.
During Early in his career (in the 1930s)
World War I, Hayek served in the A Hayek
ustrian made contributions to monetary theory and
Army on the Italian front. Returning the
from the theory of business cycles. Then he be
war he enrolled at the University of Vienna gan to
and focus on the problems of inflation
earned two doctorates—one in law (19and
21) and unemployment. By the 1940s Hayek
one in political science (1923). became
Ludwig von Mises, head of the a strong critic of socialism, of gover
Austrian nment
Institute of Economic Research, the planning, and of all government inter
n hired vention
Hayek. In 1927, he appointed Haye in the economy. He blamed governme
k to be nts for
Director of the Institute. Four years later L creating economic problems and for
ionel making
Robbins hired Hayek as Tooke Prof economic problems worse by meddlin
essor of g with
Economic Science and Statistics at the Lo the market economy.
ndon
ons. This
work attempted to develop and expl
In his first major book, Hayek ain the
dynamics of Wicksell’s (1898) Inte
(1933) rest and
examined the role that money pla Prices. Hayek argued that monetary
yed in factors
economic expansions and contracti were a necessary condition for the
business cannot absorb the labor no longer ne
cycle, but that changing the money supp eded to
ly was produce consumer goods.
not enough to cause fluctuations in This analysis of the
output. causes of
Changes in relative prices were also unemployment was quite different fr
necessary om that
to explain the business cycle. of Keynes. For Hayek it is not a lack of dem
Following Böhm-Bawerk, Haye and
k believed that creates unemployment;
that capitalist economies produce goods rather,
in ever unemployment stems from the compo
more roundabout ways. The length sition of
of time it demand, or demand for the wrong t
takes to bring goods to market co ypes of
nstantly goods (consumer goods rather than inve
increases because machinery and to stment
ols had to goods). It can only be remedied by
be developed before they could be reducing
employed consumer demand so that extra sa
in the production of goods and servi vings
ces. becomes available for businesses to
When money is created by bank use for
s, but no
additional savings takes place, the
re is
immediately a greater demand for c
onsumer
goods. This pushes up the prices of
consumer
goods relative to other goods. Busin
esses, in
an attempt to meet this demand, a
dopt less
roundabout means of production. B
ut soon
after prices begin to rise, interest ra
tes must
rise so that banks do not incur gre
at losses
when the loans they made in the past
get paid
back with money that can buy much
less than
the money they lent. Higher intere
st rates,
in turn, will slow down consumer s
pending.
Industries that produce consumer go
ods will
go idle and lay off workers. No
w past
excesses begin to take their toll. Th
e failure
to produce more investment goods
means
that firms producing investment
goods
FRIEDRICH way to
HAYEK produce those goods. As a result, inf
lation
additional investment, enabling them distorts the economy by moving resou
to adopt rces to
longer production processes. where they should not be employed (ineffi
For this reason, Hayek opposed attem cient
pts to and unwanted activities). This reduc
employ Keynesian expansionary polies
cies to economic efficiency and thus the stan
deal with unemployment during the dard of
Great living for the nation. Second, by causing gre
Depression. He was against stimula ater
ting spending in order to beat the price in
consumer demand, expanding public crease,
works more consumer goods get produced a
projects, or propping up prices. And he nd less
argued roundabout means of production get empl
that these Keynesian policies helped oyed
convert by businesses. This too reduces futu
what might have been a mild recessio re
n into a economic growth.
prolonged depression. In addition, by While opposed to inflation, Hayek was
creating even
inflation, Keynesian policies ultimately h more opposed to using incomes polic
urt the ies as a
economy. tool to combat inflation. He saw this as
Hayek pointed out several har a step
mful down the road to a totalitarian state. In additi
consequences of inflation. First, for on,
Hayek incomes policies, like inflation, destr
(1945) one of the most important oy the
characteristics of the market system i informational function of prices. Fin
s that it ally,
provides information. Prices tell con Hayek saw incomes policies as ignori
sumers ng the
which goods require less effort and real cause of inflation—too much money. S
fewer ince
resources to produce; prices also tell busin inflation stemmed from too much m
esses oney,
which inputs and means of production are money creation had to be slowed do
least wn to
costly. Inflation distorts this signaling fu eradicate inflation. And excessive m
nction oney
of prices. When all prices are continually ri creation, Hayek (1976a) argued, was the re
sing, sult
it is hard to know which goods are les
s costly 1
to produce and what is the cheapest 17
FRIEDRICH HAYEK rnment
leads to inflation for two reasons, accordi
of government monopolization ov ng to
er the Hayek. First, the government is always te
printing and circulation of money. mpted
Monopoly to print more money in order to pay
control over money creation by the gove its bills.
Second, governments are tempted limits to
to print human reason. Men and women
money and create inflation in order could
to repay understand general economic relatio
borrowed money with money that ns, but
is worth could never understand the exact rela
much less because it can purchase fewer tionships
goods. operating at any time. Hayek (1955,
To keep governments from deli pp. 53–
berately 63) also stressed that the social scien
creating inflation, Hayek (1976a) ces were
proposed fundamentally different from the n
allowing private businesses to issue atural
their own sciences. People do not obey psychol
currency. Thus large firms, or more likel ogical or
y large economic laws the way that matter o
banks, would each print up their ow beys the
n money. laws of physics, and so all attempts t
People and firms would choose to o control
hold those society in the way that science cont
currencies they expect to be most ac rols the
cepted by environment are misplaced. Both o
others and least likely to decline i f these
n value. beliefs have implications for econom
Privately issued money, Hayek felt, woul ics, and
d keep
inflation in check because it would 118
keep the
inflationary tendencies of government i
n check.
Also, private money issuers would h
ave to be
concerned about their reputation and
the value
of the money they created. As a resu
lt, Hayek
thought that they would not tend to
issue too
much money.
The argument that economic pro
blems that
arise due to government interventio
n became
a dominate theme in the economics
of Hayek
starting in the 1940s. He increasingly rel
ied on
philosophical and psychological insig
hts when
making his case against govern
ment
involvement in economic affairs. H
e stressed
that there were finite limits to the a
mount of
knowledge that any one individu
al or
institution can acquire, as well as
d since
policy makers cannot understand all
each supports Hayek’s case against the
government involvement in economic intricacies and subtleties of the market syst
affairs. em.
One argument for economic planning Instead of improving economic perfor
in the mance,
1930s and 1940s was that central p government policy would only stifle
lanners the
could figure out the supply and deman economic system that is responsible
d for all for
goods in the economy and manipulat improving our living standards.
e prices Hayek also turned on its head the ca
accordingly. Going even further (se se that
e also government power had to be used to c
LANGE), some economists argued ounter
that monopoly power. He held that mono
because the economy was so complex, pla poly
nners power is usually the result of govern
with a good mathematical model co ment
uld do actions. For example, domestic prod
better than the market in setting prices ucers
. Others lobby the government to keep out impo
(see also GALBRAITH) argued that rts and
as firms restrict entry into an industry or prof
became larger and more monopoli ession
stic, through licensing requirements. Haye
government planning was neede k also
d to thought that even if large firms bec
countervail this power. ome
Hayek turned these arguments on their powerful, potential competition (or the
head. threat
For Hayek, the complexity of the ec of new rivals starting up) would force fi
onomy rms to
means that any one person could operate efficiently and produce the g
not oods
understand the workings of the w demanded by their customers at the l
hole owest
economy. As a result, supply and d possible cost.
emand But Hayek went even further than t
equations could not be known by planners his. He
, and argued that government policy has li
planning would only lead to ineffici mited
encies. individual liberties and taken us dow
Similarly, Keynesian macroecon The
nomic Road to Serfdom. This applies to so
management (fine-tuning) was flawe cialist
government policies that attempt to redis
tribute
economies as well as capitalist econom income in the name of economic justice.
Hayek
ies that (1976b) contends that it is illegitim
undertake planning for the future or ate to
attempt to describe the outcome of the market p
reduce unemployment. Similarly, it rocess as
is true of either just or unjust. Income distribut
ion is a her sense,
fact about the world, the result of i however. He thought that all men a
mpersonal nd all
market forces. The notion of justice women should be treated as equals b
does not efore the
apply to such situations. In addition law. Equality of the law, or equal ru
, attempts les that
on the part of government to redi apply to all citizens, would preserve
stribute liberty
income will do more harm than good. Th against the coercive power of gove
e poor rnment
are hurt because redistribution re (Hayek 1976b).
duces Hayek’s main contribution as an eco
economic incentives and therefore nomist
decreases has been his arguments about the be
the economic pie. This leaves less for eve nefits of
ryone, free markets and the information pro
wealthy and poor alike. The poor are vided by
also hurt prices. These arguments lead to the concl
because the wealthy perform imp usion
ortant
economic functions like taking r
isks,
supporting arts and education, and testi
ng new
and expensive products that, if succ
essful, get
mass produced at lower prices.
Going even further, Hayek (1944
; also see
Butler 1983, Ch. 4) argued against gove
rnment
attempts to provide equal econ
omic
opportunity to all individuals in order to
obtain
equality of results. He contends that the
notion
of equal opportunity is illusory. I
f the
government attempted to give all c
hildren an
equal starting point, this would
mean
redistributing the wealth of their parents
so that
no child starts out ahead of others.
It would
also mean keeping the income of a
ll parents
equal so that some children do not
gain any
advantages. Again, in seeking to provid
e equal
opportunity, governments by neces
sity must
become more totalitarian.
Hayek did support equity in anot
FRIEDRICH Individualism and Economic Order, C
HAYEK hicago,
University of Chicago Press, 1948
that attempts to alter or control markets s The Counter-Revolution of Science: Studies
hould on the
be opposed because they inevitably Abuse of Reason (1955), Chicago,
limit Liberty
individual freedom, reduce econo Press, 1979
mic The Constitution of Liberty, Chicago,
efficiency and lower living standards. MaUniversity
rkets, of Chicago Press, 1960
for Hayek, were self-regulating devi The Denationalization of Money, London, I
ces that nstitute
promote prosperity. Government poli of Economic Affairs, 1976a
cy and Law, Legislation and Liberty,Vol. 2, C
other attempts to hinder the workin hicago,
gs of University of Chicago Press, 1976b
markets make us worse off economic New Studies in Philosophy, Politics,
ally and Economics
reduce individual liberty. and the History of Ideas, London,
Routledge
Works by Hayek & Kegan Paul, 1978
The Fatal Conceit: The Errors of So
cialism,
Prices and Production (1931) 2nd edn. Chicago, University of Chicago Press
, London,
, 1988
Macmillan, 1934
The CollectedWorks of F.A.Hayek, 10 vols., C
Monetary Theory and the Trade Cy
hicago,
cle (1933),
University of Chicago Press, 1989–94
Fairfield, New Jersey, Augustus M.Kell
y, 1975
The Pure Theory of Capital, London, Works about Hayek
Routledge
& Kegan Paul, 1941 Barry, Norman P., Hayek’s Social and
The Road to Serfdom (1944), Chicago, Uni Economic
versity Philosophy, London, Macmillan, 197
of Chicago Press, 1956 9
“The Use of Knowledge in Society,”
American
Economic Review, 35, 4 (Septemb 1
er, 1945), 19
pp. 519–30
SIMON KUZNETS Our Time,
New York, Universe Books, 1983
Barry, Norman P., “Restating the Libe Machlup, Fritz, “Hayek’s Contributio
ral Order: n to
Hayek’s Philosophical Economics,” i Economics” in Essays on Hayek,
n Twelve ed. Fritz
Contemporary Economists, ed. J.R. Machlup, Hillsdale, Michigan, Hil
Shakleton lsdale
and G.Locksley, New York, Wiley, College Press, 1976, pp. 13–59
1981, pp. Nishiyama, Chiaki, and Leybe, Kurt
87–107 R., The
Butler, Eamon, Hayek: His Contrib Essence of Hayek, Stanford, Hoover In
ution to the stitution
Political and Economic Thought of Press, 1984
Other references There he began to study economics and bec
Wicksell, Knut, Interest and Prices ame
(1898), exposed to Joseph Schumpeter’s theo
London, Macmillan, 1936 ry of
innovation and the business cycle. W
hen the
Russian Revolution closed the universi
SIMON KUZNETS (1901–85) ty and
led to civil war in Russia, the Kuznets
family
Simon Kuznets is best known for dfled Russia, going first to Turkey and eventu
eveloping ally
to the United States (Kapuria-
the system of national income acc
Forman and
ounts that
Perlman 1995).
all countries employ to measure e
Kuznets taught himself English ov
conomic
er one
activity. He also measured income distr
summer and then enrolled at Colum
ibution,
bia
and examined how the distribution
University. At Columbia, Kuznets st
of income
udied
in the US changed during the twentieth c
under Wesley Clair Mitchell, who tra
entury.
ined
But the work of Kuznets went b
Kuznets in empirical economic metho
eyond
ds and
measuring economic phenomena.
sparked his interest in business cycle
He also
s. He
sought to determine the causes of
received a BA from Columbia in 1923
economic
and a
growth and changing income ineq
Ph.D. in 1926. His dissertation (on fluctuat
uality,
ions
studied the cycles of growth that e
in wholesale and retail trade) involv
conomies
ed
go through, and attempted to under
questions of both economic measureme
stand the
nt and
consequences of economic growth
cyclical variations in economic activ
on income
ity
distribution.
(Kuznets 1926).
Kuznets was born in Pinsk (then
After receiving his doctorate, Kuz
part of the
nets
Soviet Union, now part of Belarus)
worked at the National Bureau of Eco
in 1901.
nomic
His father was a skilled furrier, who mov
Research (NBER) for around three y
ed the
ears.
family to Kharkov, a city noted f
Then in 1931 he accepted a position
or its
at the
intellectual life, at the beginning of Worl
University of Pennsylvania. Kuznets
d War
left
I. After graduating from the local public s
Pennsylvania for Johns Hopkins in 1
chool,
960,
Kuznets enrolled at the University of K
where he remained until his retireme
harkov.
nt in
1971. All the while, Kuznets maintain
120 ed his
connections with the NBER.
Over the course of his academic most
career important contribution of Kuznets w
Kuznets received many professional acc as
olades. probably his work developing a syste
In 1949 he was made President of the Amer m of
ican national income accounting.
Statistical Association; in 1953 he b Macroeconomics studies the overa
ecame ll
President of the American Econo performance of national economies. T
mic o test
Association; and in 1971 he was awa hypotheses about macroecono
rded the mic
Nobel Prize in Economic Science. relationships, or to find the causes of
While the Nobel Prize committee good
singled macroeconomic performance, it is ne
out his work in the area of economic cessary
growth to have some measure of overall eco
and changing social structure, the nomic
income for all the years between 19
19 and
activity. In the seventeenth-century 1938, and to provide estimates of US econ
omic
William activity going back as far as 1869 (
Petty made some rudimentary atte Kuznets
mpts at 1941, 1946a, 1946b, 1952a).
calculating economic activity in Eng Kuznets (1933) carefully described b
land, and oth the
national income estimates for the methodology that he used in comp
UK were iling
made several times subsequent t measures of economic activity as well as
o the some
pioneering work of Petty. However of the problems he encountered in making
, no one such
attempted to make such measureme estimates. As such, he set the stand
nts on an ards for
annual basis, and few estimates w measuring economic activity and develo
ere done ped the
carefully or systematically. Still, in t procedures that are still employed tod
he 1920s, ay.
England was far ahead of the US in For example, Kuznets was awar
compiling e that
national income data. Kuznets was estimates of national income exclude
primarily d goods
responsible for changing this. He and services that were not marketed a
moved the nd sold.
US from the position of laggard to When households cook their own me
being a als, mow
leader in national income statistics. their own lawns, and clean their hou
At the NBER Kuznets was respo ses, they
nsible for are producing goods and services; b
developing the first estimates of U ut these
S national goods and services do not get coun
income for the years from 1929 to ted in
1932. He government figures of economic ac
then went on to develop estimates o tivity.
f national Likewise, illegal activities like prostituti
on and SIMON K
drug trade are difficult, if not imp UZNETS
ossible, to
measure and so cannot be included in est the automobile manufacturer and also the v
imates alue
of overall economic activity. of the whole car would be to count twi
Kuznets was also careful to distingui ce the
sh final tires that are produced. In order to get
goods from intermediate goods, and a more
was able accurate measure of economic activity
to use this distinction to avoid the p it is
roblem of necessary to subtract the value of all parts fr
double counting. An automobile, a f om
inal good the final price of the car sold to the con
sold to consumers, gets assemble sumer.
d from Taking this difference, or computing th
intermediate goods such as tires, glass, e e value
ngines, added by the car manufacturer, provi
and brakes. To count the value of tir des the
es sold to foundation for measuring national in
come.
National income is simply the sum of the va
lue
added by every firm in the economy
over a
specific time period. It can be derived from t
he
periodic reports made by business firm
s about
their revenues from sales, their expen
ditures
on parts, and their quarterly profits.
Kuznets understood that national i
ncome
measures had severe limitations as indi
cators
of national well-being or national we
lfare.
Just because national income increased
it did
not mean that some country was neces
sarily
better off. Income could have beco
me
distributed more unequally; so despite
higher
incomes overall, a large majority
of
households might be worse off. Kuznet
s also
noted that the growth process itself
might
lead to undesirable outcomes like
urbanization, traffic congestion, an
d
pollution. Finally, national income acc
ounts
do not take into account how much
output Germany
goes to the government, and gets paid (plus data on the production of iron, co
for by al, and
compulsory taxation. other products, throughout the worl
Kuznets’ work on measuring na d),
tional Kondratieff noticed that there were regular
income led naturally to a study of b 20–
usiness 30 year periods during which prices ro
cycles, or the periodic expansion se and
and then 20–30 year periods during which
contraction of economic activity. Prio prices
r to the declined. These long-run economic c
work of Kuznets, Nikolai Kondratieff hanges
(1925), have since been called “Kondratieff
a Russian economist, noted the exist waves.”
ence of Shorter cycles, of around ten years, hav
long-run economic cycles lasting bet e been
ween 45
and 60 years. Examining several hundred 1
years 21
of price data for the US, France, and
SIMON KUZNETS This, plus the ability to take advan
tage of
associated with changes in business inv economies of scale, contribute to mo
estment re rapid
(see also SCHUMPETER). productivity growth. As a result, li
In his study of economic fluct ving
uations, standards rise as the population gro
Kuznets (1930) found intermediate ws. But
cycles of soon the new citizens will become p
growth and decline lasting around 2 art of a
0 years. larger labor force, and this will lea
These cycles have come to be c d to a
alled downward pressure on wages. As wag
“Kuznets cycles” (Abramovitz 196 es fall,
1) in so too does spending and investment,
honor of their discoverer. Kuznets and the
thought downward phase of the economic
that demographic changes could e cycle
xplain begins.
these 20-year cycles. Increasing po Kuznets (1965) expanded his w
pulation ork on
can stem from waves of immigration economic cycles to study the struc
or from tural
growing birth rates due to favor economic changes that result from ec
able onomic
economic circumstances. Whateve growth and decline. Here he studied
r the how the
cause, population growth leads to a business cycle affects savings and
greater consumption rates, productivity, in
demand for consumer goods, espe come
cially distribution and other factors (like
larger and more housing. Additional the
demand international flow of capital, goods
encourages additional business inv , and
estment. people).
Kuznets (1953, 1955) also exa
mined the
impact of economic growth on inpopulation received 15 percent of all n
come
distribution, and pioneered the measational
urement income and the top 5 percent of the
of income distribution. Using bot US
h IRS population received between 25 perce
income tax data and US Census nt and
Bureau 30 percent of all income. He also fo
survey data, he examined the fractio und a
n of total decline in income inequality in the US
income received by each of ten i during
ncome and after World War II, with the top 1 pe
groups (the top 10 percent of incom rcent
e earners, of the population getting only 8.5 perce
the next 10 percent, the third 10 perc nt of
ent, etc.) all income and the top 5 percent rece
for virtually every year between 1 iving
913 and 18 percent of all income. The business
1948. Kuznets (1953) found that cycle,
in the Kuznets argued, could explain these ch
interwar years the top 1 percent of anges.
the US Low unemployment during and after
World
122
War II increased the fraction of total in
come
going to lower income groups. At the
same
time, lower interest rates and higher in
come
taxes reduced the fraction of income
going
to the most affluent. Looking at data
over
longer time horizons and for many dif
ferent
nations, Kuznets (1955) found that in
come
equality followed a U-shaped patter
n—it
declined during the early stages of eco
nomic
development making the poor relativ
ely
worse off, but it rose at later stages
of
development thus benefiting those w
ith
lower incomes.
Another important empirical findi
ng by
Kuznets involved savings rates in the
US, or
its converse, the ratio of consumptio
n to
national income. Kuznets (1946b, 19
52b)
found that saving rates in the US people would save more as their inc
were omes
remarkably constant, and did not change a increased. The fact, discovered by Kuznets,
s the that
US economy grew. This contradicte savings rates were constant led Milt
d the on
prediction of the simple Keynesian Friedman to develop the permanent
consumption function, C=a+bY, wherincome
e C is hypothesis and Franco Modigliani to d
consumption and Y is current income evelop
. If this the life-cycle hypothesis as a means
hypothesis were true, then spending of
rates explaining constant savings rates.
should fall as incomes increase. Fa Finally, Kuznets devoted substant
lling ial
spending rates means rising savings attention during his lifetime to the fa
rates. ctors
Essentially, the simple Keynesian view wa affecting productivity growth. This w
s that as a
o-fifths
was due to redistributing labor fro
natural extension of his focus on e m less
productive sectors (i.e. agriculture)
conomic to more
growth, since growth is due to the productive sectors (i.e. manufacturin
combined g). Since
effects of greater productivity and technology was the more important
a larger factor
population. Of the two factors, pr historically, and since redistributing
oductivity labor
growth is certainly the more import becomes less important over time a
ant, for as s fewer
Adam Smith pointed out it is pro Americans work in agriculture, he tho
ductivity ught that
growth that will lead to improvements in the effort to improve productivity mu
living st focus
standards. Studying productivity g on technological breakthroughs and a
rowth dvances.
allowed Kuznets to incorporate his At the end of the twentieth centur
diverse y, most
interests in population changes, in work in economics was highly abstra
making ct and
precise empirical estimates, and in i theoretical. Economists even looked
mproving down
living standards. upon empirical studies seeking to m
Kuznets placed heavy empha easure
sis on economic variables and examine ho
technological change and innovatio w these
n as the variables change over time. Kuznets
means to improve productivity gro stands
wth. He firmly within the empirical traditio
estimated (Kuznets 1946) that over n in
a 50-year economics that began with Petty’s p
period three-fifths of the gain in US produ olitical
ctivity arithmetic. The work of Kuznets
was due to technological advances and tw has
allowed a substantial body of knowl SIMON K
edge to UZNETS
be developed about economic gro
wth and Works by Kuznets
development. It has also yielded
an Cyclical Fluctuations: Retail and Who
enormous amount of data that lets e lesale
conomic Trade, United States, 1919–1925, N
theories be tested. And it has all ew York,
owed Adelphi, 1926
governments to compile and re Secular Movements in Production an
port d Prices,
macroeconomic data on a regular Boston, Massachusetts, Houghton
basis. If Mifflin,
economics is to be regarded as a s 1930
tudy of “National Income,” Encyclopedia of t
the behavior of real world econo he Social
mies, Sciences, Vol. 11, NewYork, Macmillan,
Kuznets must be regarded as one of 1933,
its half pp. 205–24
dozen most important figures. National Income and Its Composition,
1919–
1938, 2 vols., New York, National Bur
eau of
Economic Research, 1941
National Income: A Summary of Find
ings, New
York, National Bureau of Econo
mics
Research, 1946a
National Product Since 1869, NewYork, N
ational
Bureau of Economic Research, 1946b
Income and Wealth of the U.S.: Tren
ds and
Structure, Cambridge, Bowes & Bo
wes,
1952a, with Raymond Goldsmith
“Proportion of Capital Formation to Na
tional
Product,” American Economic Revi
ew, 42, 2
(1952b), pp. 507–26
Shares of Upper Income Groups in I
ncome and
Savings, New York: National Burea
u of
Economic Research, 1953
“Economic Growth and Income Inequa
lity,”
American Economic Review, 45, 1
(March
1955), pp. 1–28
Economic Growth and Structure: Selected
Essays,
New York, Norton, 1965
Economic Growth of Nations, Cambrid
ge,
Massachusetts, Harvard University Pres
s, 1971 Abramovitz, Moses, “The Nature a
Population, Capital, and Growth, Ne nd
w York: Significance of the Kuznets Cycle,” Eco
Norton, 1973 nomic
Growth, Population, and Income Di Development and Cultural Change,
stribution: 9 (April
Selected Essays, New York, Norton, 1961), pp. 349–67
1979
1
Works about Kuznets
23
JOHN VON NEUMANN
Hinck, Harriet, “Simon Kuznets 1971, John von Neumann (pronounced N
” in Nobel OY-mon)
Laureates in Economic Science was trained as a mathematician, and is reg
s: A arded
Biographical Dictionary, ed. Bernar as one of the most brilliant mathe
d S.Katz, matical
New York, Garland, 1989, pp. 143– geniuses of the twentieth century. Nevert
59 heless,
Kapuria-Foreman, Vibha and Perlman, M he made several contributions to ec
ark, “An onomics.
Economic Historian’s As might be expected, these contri
Economics: butions
Remembering Simon Kuznets,” involved applying mathematics to e
Economic conomic
Journal, 105 (November 1995), pp decision making. But unlike other
. 1524–47 major
Lundberg, Erik, “Simon Kuznets’ Contri figures who brought mathematical te
bution to chniques
Economics,” Swedish Journal of
to economics, von Neumann did not
Economics, employ
73 (December 1971), pp. 444–61 the calculus to explain economic relatio
Ben-Porath,Yoram, “Simon Kuznets in Per nships.
son and Rather, he brought to economics the
Writing,” Economic Development a insights
nd Cultural from games of strategy. By so doing,
Change, 36, 3 (April 1988), pp. 435– he shed
47 new light on the human interactions t
hat form
Other references the basis of economic life.
Von Neumann was born in Bud
apest,
Kondratieff, Nikolai, The Long Wave Cy
Hungary in 1903. His father wa
cle (1925),
s a
New York, Richardson and Synder, 19
successful and wealthy Jewish banker
84
. Early
in life von Neumann’s mathematical
talents
became obvious. By the age of six h
JOHN VON NEUMANN (1903– e could
divide two eight-digit numbers in his
57) head;
by eight he mastered calculus (H
almos
1973, p. 383). At school he was exc
124 used
from regular math classes to receive pr
ivate
tutoring from college mathematics
professors. By the end of his senior ye
ar of
high school he was regarded as a
professional mathematician and ha
d
published his first mathematical paper.
Although registered as a student a
t the
University of Budapest, von Neumann
did not
attend classes. Instead, he studied at
the
University of Berlin and returned to B
udapest
only to take exams. After two years
he
transferred to the Swiss Federal Instit
ute of
Technology, where he encountered t
he
outstanding mathematicians of his ti
me. He
received a diploma in chemical engin
eering
from the Swiss Federal Institute in 1923
and a
doctorate in mathematics from the Un
iversity
of Budapest in 1926.
From 1926 to 1930 von Neumann
taught
mathematics at the University of Berl
in and
then at the University of Hamburg, whi
le also
publishing articles on set theory, algeb
ra, and
quantum physics. Fearing the consequenc
es of
remaining in Germany, he accepted a te
aching
position at Princeton University in 19
30. In
1933, he was hired by the Institute
for
Advanced Studies at Princeton, a post
that he
held for the rest of his life.
When World War II began, von
Neumann was called to serve on impo
rtant b. In
war committees and advisory group 1954 he was appointed to the Atom
s. He ic
helped develop the world’s first com Energy Commission (AEC) by Presi
puter dent
for the US military and, at the beh Eisenhower. Soon after his arrival i
est of n
J.Robert Oppenheimer, he participat Washington, von Neumann was diagn
ed in osed
the Manhattan Project, which led t as having cancer and his health rapi
o the dly
development of the first nuclear wea deteriorated. Because he attended A
pons. EC
After the war, von Neumann vigor meetings in a wheelchair, and becaus
ously e of
defended US nuclear testing and sup his strong pro-nuclear position, man
ported y
development of the hydrogen bom
pointed out that this procedure of c
ounting
people (Poundstone 1992) believe t equations and unknowns fails to ru
le out
hat von negative prices, which makes no sense an
Neumann was the model d can
for Dr never exist in the real economic w
Strangelove in the 1963 Stanley orld.
Kubrick Consequently, counting equations
film with that title. and
Fellow Hungarian Nicholas Kaldor unknowns fails to demonstrate that all m
met von arkets
Neumann while they were both on v can achieve equilibrium at the same t
acation in ime.
Budapest in the late 1920s. Von N Von Neumann also suggested th
eumann at the
expressed interest in mathematical e Walrasian supply and demand equa
conomies tions
and Kaldor suggested he read Walras ignored important interdependencies
(Macrae among
1992, p. 250). According to Walras markets, such as when low car prices
, general lead to
equilibrium can be shown to exist if an energy crisis. He (von Neumann
the set of 1928)
mathematical equations representin developed game theory to account for jus
g supply t such
and demand was equal to the nu interdependencies. He also conceived
mber of of game
unknowns (the price of each good theory as a challenge to standard ec
and the onomic
quantities of each good bought and analysis which adopted the metaph
sold). In or of
this case, the system of equations classical mechanics and the maximi
could be zation
solved for the price and the quantit assumption that followed from adop
y of each ting the
good (see also WALRAS). Von N differential calculus. Von Neumann
eumann thought
that social phenomena required di JOHN VON NE
fferent UMANN
models and methods of analysis. Ga
me theory Most economic analysis does not
provided this method. concern
Game theory is about conflict itself with such interaction, and at on
situations e level
where individuals are competing ag this approach is perfectly satisfactory.
ainst one Many
another and are uncertain about w economic decisions that get made
hat their are
opponent or competitor will do; yindependent of the behavior of others
et all . For
individuals know that the outcome example, when I go to the supermark
of the et, the
conflict depends upon what each party price I pay for Grape Nuts cereal do
decides es not
to do. Essentially, then, game theory depend upon the number of boxes of cereal t
concerns hat
the interaction between two or more I buy. However, in many instances the react
people. ion
of others does play an important rol
e in
economic decision making. This is most li
kely
to be the case where the number of ec
onomic
agents or decision makers is small, suc
h as in
an oligopolistic industry. In these situations
the
decision made by one firm will likely
affect
the decisions made by other firms, an
d these
interactions will affect economic outco
mes.
When Oskar Morgenstern arrived
in
Princeton in 1939, he and von Neu
mann
quickly became close friends. Morge
nstern
read von Neumann’s (1928) paper on s
trategy
for parlor games and recognized that
the
framework von Neumann developed co
uld be
applied to many economic situations. T
he two
then became collaborators on the theo
ry of
games and the use of game theory for econo
mic
analysis.
Von Neumann and Morgenstern (
1944)
began by describing the characteristi Neumann and Morgenstern assumed th
cs of a at each
game. Each game could be described player would try to achieve the best p
by three ossible
features: (1) a number of players, (2) result, meaning that each player would em
a set of ploy
decisions that each player had to ma a strategy that would likely lead to the
ke, and largest
(3) a pay-off matrix, or a table sho gain for them.
wing the Figure 9 illustrates the pay-off matri
outcome for every combination of d x for a
ecisions game with two players, each of whom h
made by the players. as two
Once a game is defined in these terms, possible moves. This gives us four p
each ossible
player can calculate their gains or loss outcomes, each with a different pay-off for
es from the
each move they might make or each
strategy 1
they might employ in playing the ga 25
me. Von
JOHN VON NEUMANN the time because that decision is the
very best
two players. For each outcome, the the player could do. With a mixed strat
first pay- egy, the
off goes to Player 1 and the second pay- best a player could do would be to se
off goes lect each
to Player 2. Thus, if Player 1 sele alternative with some fixed probabilit
cts a and y.
Player 2 selects b, then Player 1 ga
ins 1 and
Player 2 loses 1. It is possible to thi
nk of the
pay-offs as monetary gains and los
ses (say
$1000), but strictly speaking the n
umbers in
the boxes should represent the utilit
y received
by each player.
Von Neumann (1928) demonstr
ated that Figure 9 A Game Theory Pay-off Matri
there is always a rational course of
action for x
two players in a game. The rational
course of Figure 9 is an example of a gam
action may be to use a pure strateg
y (always e where
making the same choice) or a mixe mixed strategies are required. In its
d strategy, simplest
which involves selecting each option or real world instantiation, it is the ga
choice me of
with some probability. With a pure s matching pennies. Player 1 wins the g
trategy, a ame and
player would choose the same alter wins a penny, whenever both player
native all s show
heads or both players show tails;
otherwise
Player 2 wins. If Player 1 tends to Player 1 to break even over the long ru
choose
strategy a, then Player 2 would soon rec n is to
ognize select strategy a half the time and select strate
this and could gain by choosing strat gy
egy b. On b half the time.
the other hand, if Player 1 tends t Various extensions and applications
o choose of this
strategy b, Player 2 gains by emp simple framework are possible. For ga
loying mes of
strategy a more frequently. The onl more than two people, von Neuman
y way for n and
Morgenstern (1944) studied the cond
126
itions
under which players would form coalit
ions in
order to gain at the expense of other
players
who are not in the coalition. In the real
world,
this is analogous to studying the con
ditions
under which it would make sense for two fir
ms
in an oligopolistic industry to merge,
thus
forming a very large monopoly by reducing
the
number of competitors in the industry. It is al
so
analogous to studying the conditions
under
which it makes sense for business fir
ms to
collude and raise prices, for workers
to get
together and form a union, or for gro
ups of
individuals to form a special interest group
and
lobby the government for legislation that w
ould
confer economic benefits on the mem
bers of
the group.
Perhaps the most famous extensio
n of
game theory is the prisoner’s dilem
ma,
which shows how two individuals pur
suing
their own best strategy can wind up in
a less
than optimal situation. A typical priso
ner’s
dilemma is shown overleaf in Figure 1
0. The gets rewarded (with a new identity an
following story usually goes along w d new
ith the life) while the other prisoner serves five
prisoner’s dilemma pay-off matrix. years
Two in jail.
criminals have been captured and p From the point of view of Player 1,
ut into he is
separate rooms. If neither confess t better off confessing (choosing b) rega
o their rdless
crime, (i.e., if both choose a) they boof what Player 2 does. If Player 2 refu
th get ses to
off scott free. If both criminals confe confess (choosing a), Player #1 does
ss (i.e., better
if both choose b), they each get thre by confessing than by not confessi
e years ng
in prison. But if one prisoner confess (gaining 3 rather than gaining nothi
es and ng).
the other prisoner does not, the con Likewise, if Player #2 confesses (cho
fessor osing
Prisoner’s dilemma situations
are
b), Player 1 does better by confe common in every day life and in ec
onomic
ssing, life. They are the heart of the free
because b gives him a loss of -3 rat rider
her than problem. Like the prisoner who co
a loss of -5. The same thing is true nfesses,
of Player the free rider does not pay to sup
2. No matter what Player 1 does, Pl port
ayer 2 is community services that everyone t
better off confessing. The paradox akes to
here is be desirable. The outcome of free ridi
that the outcome of the game (both ng is a
players lack of important community service
confessing and spending three years s. Free
in jail) riders will also bring down utop
ian
socialists’ schemes of the sort propo
sed by
Robert Owen.
The prisoner’s dilemma has been
used to
study a wide range of topics, some o
f which
are only tangentially related to eco
nomics.
It has been used to explain the ar
ms race
Figure 10 The Prisoner’s Dilemma (Schelling 1966; Russell 1959). Und
er this
analysis both the US and the Soviet
is worse than the outcome that resu Union
lts from had to build missiles (strategy b) beca
use had
the “irrational strategy” of not conf
they not done this they would have
essing.
been at
the mercy of their adversary. The p JOHN VON NE
risoner’s UMANN
dilemma has also been used to exp
lain the international trade to explain how t
advantages of oligopolists colluding wo
to raise nations might come to adopt protecti
prices rather than competing and onist
earning policies (strategy b), even though b
little or no profits. It has been emp oth
loyed in countries would gain from free trade. F
inally,
Schelling (1978) has used the prison
er’s
dilemma to explain why racial segre
gation
exists in neighborhoods and why ho
ckey
players do not want to wear helmets
even
though all players gain from the saf
ety
provided by helmets.
One potential drawback of game t
heory
is that it does not always provide deter
minant
solutions. For example, the prisoner
’s
dilemma does not let us predict exactly
what
each prisoner will choose to do. It can
only
help us analyze the decision facing
each
prisoner. However, the real world itself
may
not always have definite or determi
nate
results. Rather, actual results may depe
nd on
a number of different factors. Game t
heory
is a useful tool in analyzing these situa
tions,
capturing the different factors that go
into
making decisions and helping people t
o see
their best strategy in a particular situ
ation.
As Leonard (1995, p. 756) has obser
ved,
game theory was “part of a general sh
ift in
science which involved…the abando
nment
of determinism, continuity, calculus, an
d the
metaphor of the ‘machine’, to allo Annalen,
w for 100 (1928), pp. 295–320. Translate
indeterminism, probability, d and
and reprinted in Tucker and Luce (e
discontinuous changes of state.” In lar ds.)
ge part Contribributions to the Theory of G
von Neumann was responsible for th ames, Vol
is shift 4, Princeton, New Jersey, Princeton Univ
of focus and orientation on the par ersity
t of Press, 1950, pp. 1–27
economists. Theory of Games and Economic Beha
vior,
Princeton, Princeton University Pres
Works by von Neumann s, 1944
with Oskar Morgenstern
“Zur Theorie der Gesellschaftsspiele” (
“Theory
1
of Parlor Games”), Mathematische
27
JOAN ROBINSON York, Doubleday, 1992
“A Model of General Equilibrium,”
Review of Other references
Economic Studies, 13 (1945–6), p
p. 1–9 Russell, Bertrand, Common Sense a
nd Nuclear
Warfare, New York, Simon & Schust
Works about von Neumann er, 1959
Schelling, Thomas, Arms and Influe
Halmos, Paul, “The Legend of Jo nce, New
hn von Haven, Connecticut,Yale University Pre
Neumann,” American Mathematica ss, 1966
l Monthly, Schelling, Thomas, Micromotives a
80, 4 (April 1973), pp. 382–94 nd
Leonard, Robert J, “From Parlor Games to Macrobehavior, New York, Norton,
Social 1978
Science: von Neumann, Morgenstern
, and the
Creation of Game Theory 1928
–1944,” JOAN ROBINSON (1903–83)
Journal of Economic Literature,
33, 2(June
1995), pp. 130–61 Joan Robinson made major contrib
Macrae, Norman, John von Neumann, N utions in
ewYork,
two areas of economics. Early in her
Pantheon Books, 1992
career,
Morgenstern, Oskar, “The Collaboratio
she focused the attention of econo
n between
mists on
Oskar Morgenstern and John von N
market forms in between perfect co
eumann on
mpetition
the Theory of Games,” Journal
and monopoly. Later she was instrum
of Economic
ental in
Literature, 14, 3 (September 1976), pp
defending and expanding the theori
. 805–16
es of
Poundstone, William, Prisoner’s Dile
Keynes, and became one of the fou
mma, New
nders of
post-Keynesian economics.
Robinson was born Joan Maurice in
Surrey, class and put a high premium on education a
England in 1903. Her family was upper
middle nd
independent thinking. Her father was a mili
tary
128 general, an author and, later in life, head of o
ne
of the colleges making up the Univer
sity of
London. Her mother was the daughte
r of a
Cambridge University professor. Rob
inson
attended St Paul’s, a leading school in Lon
don
for girls, where she studied history; s
he then
went to Girton College, Cambridge, where
she
studied economics. She became intere
sted in
economics in order to learn why pover
ty and
unemployment existed in the world,
and
because she thought economics could
solve
these problems (Shaw 1989, p. 145).
With the exception of a few years s
pent in
India with her husband (economist A
ustin
Robinson), Robinson spent the half c
entury
following her 1925 graduation teachin
g and
lecturing in Cambridge. However, beca
use she
was a woman, she did not become a fu
ll-time
member of Cambridge University until
1948.
In the 1930s, Robinson was an a
ctive
participant in the “Cambridge Circus,”
a small
group of economists helping Keynes to dev
elop
his General Theory. She then helped
defend
Keynes from his many critics and expanded
his
ideas along several lines. In 1974 Robinson
was
made President of the American Eco
nomic
Association, becoming its first female Pre seemed incompatible with the actual
sident British
and one of its few non-American Presidents economy of the 1920s, which was plagued
. She with
is the first woman to have made the high unemployment and industries operati
list of ng at
finalists for the Nobel Prize in Econo low capacity. Robinson was also diss
mics. atisfied
As an undergraduate, Robinson with the fact that Marshall and other econom
studied ists
Marshall’s Principles of Economics focused on just two extreme types
, the of
standard textbook at the time. What s industries—perfect competition and mon
he found opoly.
especially unsatisfactory was the concl The interesting real world, she thought,
usion of fits in
this work—that producers and consumers j between these two extremes. The Econom
ointly ics of
maximized their well-being. This co Imperfect Competition (Robinson 193
nclusion 3)
Taking into account both the lower p
rice and
analyzed these real world industries falli the greater sales, firms might cut price
s to sell
ng part more but not receive any more revenue (i.e.
way between a highly competitive indust their
ry with marginal revenue from selling more
many small firms and an industry m would be
ade up of zero or negative). Conversely, firms
only one firm. might
To explain firm decision-making receive more revenue if they increas
Robinson ed their
used the concept of marginal reven prices, producing and selling less.
ue (see also By showing how raising price
COURNOT), the additional revenue a fi s and
rm gets producing less output could yield more re
when it produces and sells one more venue
thing. For for the large firm, Robinson was able to ex
competitive firms, marginal revenu plain
e would why imperfect competition was characteri
always equal price, since firms can al zed by
ways sell insufficient production and underut
more goods without having to run a sale or ilized
lower resources. Imperfect competition co
the price they charge. But under i uld thus
mperfect explain (while the theory of perfect comp
competition firms faced downward etition
sloping could not) the high rates of unempl
marginal revenue curves. To sell mo oyment
re, goods prevailing in England during 1920s an
had to be put on sale. But when firms run d during
sales, the Great Depression of the 1930s.
some consumers pay less than they w The Economics of Imperfect C
ould have ompetition
otherwise paid. The firm loses this (Robinson 1933, Ch. 25) also showed that
revenue. under
imperfect competition, workers receive JOAN RO
d wages BINSON
less than the value of what they p
roduced. at a competitive disadvantage. They are
Consequently, the marginal productivit forced
y fails to to accept the wage offered by the si
hold when imperfect competition ex ngle
ists. With employer. Robinson recognized that the
imperfect competition labor gets ex world
ploited by did not consist of monopsonistic labor
powerful businesses. To help drive markets
home this any more than it was comprised of monopoli
point, Robinson developed the not stic
ion of product markets. However, the notio
monopsony, a case in which there is only a n of
single monopsony helped focus attention on
employer in a particular geographic wage
region or determination as a bargaining process a
one employer for workers with cert nd the
ain skills. exploitation of workers due to their la
With only one potential employer, ck of
and with bargaining power against a few large fir
many individuals looking for work, ms.
people are Another important contribution
in
Economics of Imperfect Competition
was its
analysis of price discrimination. Ec
onomists
knew that large, monopolistic firms c
harged
different prices to different people, but Robi
nson
(1933, Ch. 15) was the first to explai
n its
operating principles and its conseque
nces.
Robinson (1933, p. 179) pointed out tha
t price
discrimination was possible only with mono
poly
or imperfect competition. Through p
rice
discrimination, monopolistic firms wo
uld be
able to increase their revenues and their
profits.
To engage in price discrimination,
firms
needed to segment the market for their
product
into two parts—those consumers willi
ng and
able to pay high prices and those consumers
who
were price sensitive. Then the firm needed s
ome
way to charge higher prices to the first
group. Likewise,
One way of doing this would be to the practice of pricing through haggling, as d
charge one
different prices at different times of at automobile dealerships, will lead t
the day. o price
Thus, telephone companies offer lower discrimination. Here the hagglers, unwi
rates in lling to
the evenings and on weekends. Bus pay higher prices, buy cars for less mon
iness ey than
customers, generally insensitive to price, p those who do not want to negotiate ove
ay the r price
higher day rates; and individuals pay the redfor hours and hours.
uced An economic world characterize
off-peak phone rates. Discount coup d by
ons also imperfect competition also led to a new
help to segment the market and allow theory
for price of price determination, one hinted at by Robin
discrimination. Those who are cost c son
onscious
will clip coupons and buy goods at a lower p 1
rice; 29
those who are not will pay full price.
JOAN ROBINSON saw with

microeconomic analysis. On a theoretical
and developed later by post- level,
Keynesian Robinson became aware of logical
economists (see Eichner 1976). In c problems
ompetitive with supply and demand analysis.
markets, firms were all price takers; t On a
hey had to practical level, the Great Depression a
set their prices equal to what the mar nd work
ket would of Keynes made her lose interest in th
bear and what all the other firms in th e pricing
e industry and output decisions of firms.
were doing. With imperfect comp One problem with supply and d
etition, emand
however, prices were set by producers, who analysis according to Robinson (1980
added , Vol. 5,
a mark-up to their prime costs (primarily pp. 48–58) was that it ignored tim
wages). e and
The less competitive the industry, the grea expectations; instead a timeless noti
ter the on called
mark-up. And the greater the need by “equilibrium” took center stage. Ro
the firm binson
for internal sources of funds for expa thought that the notion of stability in
nsion, the herent in
greater the mark-up. equilibrium analysis was inappropria
Despite its many advances, Robi te for a
nson grew discipline like economics which de
dissatisfied with The Economics als with
of Imperfect growing and changing economies. Cont
Competition almost as soon as she rary to
finished standard economic theory, consume
writing it. Her dissatisfaction came rs and
from the businesses do not respond to current
numerous problems she prices in
ways that move the economy tow
ards an
equilibrium price. Rather, consum orientation, one focused on how prices cha
ers and
businesses respond to prices today b nge
ased upon over time rather than on how prices
what they think prices will be in t move
he future. towards the present equilibrium price.
Moreover, changing prices can c A second problem with supply and
hange demand
expectations. Lower prices can le analysis for Robinson concerned the na
ad to ture of
expectations of even lower future capital. Robinson began the so-
prices, called
making consumers less willing to Cambridge Controversy with her critique o
buy some f the
good despite a sharp drop in its pri marginalist theory of distribution. Accordi
ce. Under ng to
such conditions no equilibrium, or this theory (see also CLARK), the rate of pro
market fit
clearing, price is possible; and supwas determined by the marginal productivit
ply and y of
demand analysis cannot illuminate capital. The question Robinson (1953–4) ra
what is ised
going on in the real world. To under was how to measure capital in order to f
stand real ind its
economies requires a new theor marginal product. This relatively simp
etical le and
innocuous question sparked a heated
130 debate
between Cambridge, England and Ca
mbridge,
Massachusetts over the possibility of meas
uring
capital when you don’t know the rate o
f profit
(see Harcourt 1972).
Robinson pointed out that the ma
rginal
productivity theory of distribution requi
res that
we know the demand for capital in o
rder to
measure marginal productivity. Constr
ucting
such a demand curve requires relating the pr
ofit
rate and the quantity of capital. The pro
blem is
that capital is not something homogeneous
(like
workers) that can easily be counted and
added
up. Capital consists of large plants and
small
plants, automated assembly lines, hammers
and
screwdrivers, computers and computer soft
ware. it cannot
These goods have nothing in common assume it knows the profitability of ca
that we pital in
can use to find “a quantity” of capital; order to measure the quantity of capita
so some l. This
other approach must be used. procedure is circular; therefore, the m
The traditional means of countin arginal
g capital productivity theory of distribution mu
is to measure its value, or future prof st be
itability. abandoned.
This works fine as a practical or acc Robinson’s critique of microecon
ounting omic
matter, but is unsatisfactory as part of theory also supported the macroecon
a theory omic
that explains what determines the rate of pr approach of Keynes. If we reject ma
ofit. rginal
As Robinson pointed out, if economi productivity as a theory of distribution
c theory , labor
is supposed to explain the profit rate,
Countries
running trade deficits would experi
supply and labor demand do not d ence the
reverse set of changes —their goods
etermine would be
wages and employment. We no long less expensive abroad and they woul
er have a d export
good reason to believe that unemploym more goods. Price changes thus bring trad
ent will e into
disappear by waiting for wages t balance according to standard economic t
o fall. heory.
Similarly, if the notion of equilibrium is Contrary to this conventional
useless view,
for studying real economies there is Robinson (1980, Vol. 1, pp. 182–205;
no reason Vol. 4,
to assume that the labor market wil pp. 212–40) argued that there is a K
l clear at eynesian
full employment equilibrium. adjustment mechanism. Trade probl
Robinson was also instrumen ems get
tal in resolved through income changes rat
extending the economics of Keyne her than
s into the through relative price changes. Cou
international realm. Traditionally, e ntries
conomists running a trade deficit fail to sell enough g
held that changes in exchange rates oods
or money throughout the world. Conseque
flows (see also HUME) would correct an ntly,
y trade production declines and unemployme
imbalances. Countries with trade s nt rises.
urpluses As a result, people in this country b
would experience either an influx of uy fewer
money or goods and services from abroad and their
an appreciating currency. This wo trade
uld make deficit moves to a position of balance.
their goods more expensive to citizens o But this
f other affects surplus countries, which
countries and reduce their exports. now
experience reduced demand for the goo JOAN RO
ds they BINSON
produce. Their trade surplus gets re
duced, but surpluses, especially when achieved
their unemployment rate also goes u by
p. specializing in manufacturing industries,
Robinson next extended Keynwould
es by raise the domestic rate of profit and l
examining international trade in d ead to
ynamic greater investment and technologic
terms, or how trade balances change ove al
r time. improvements. This, in turn, would create
Rather than perceiving internationa more
l trade as domestic employment and greater in
an issue of the best way for countries come.
to divide Trade surpluses could thus lead to lon
up the task of producing different g g-term
oods (see improvements in productivity and li
also RICARDO), Robinson (1980, Vving
ol. 4, pp. standards. By attempting to generate
14–24; Vol. 5, pp. 130–45) saw for trade
eign trade surpluses, trade policy became part o
as part of a national growth strateg f the
y. Trade arsenal of tools that governments might
use to
spark economic growth (see also KAL
DOR).
The economics of Joan Robinson
was
always focused on the real world. But i
t was
also critical of accepted economic th
eories
that were not realistic or plausible.
Her
analysis of imperfect competition look
ed at
how large firms actually make decis
ions
about price, production, and employ
ment.
Her contributions to post-
Keynesian
macroeconomics and the theory
of
international trade were also importa
nt in
helping economists understand how
real
economies worked.
Economics has always been a m
ale-
dominated profession. Somew
hat
surprisingly, it seems that the mathem
atical
nature of the discipline is not responsib
le for
this. Economics has smaller fractio Economics of Imperfect Competition,
ns of London,
female undergraduate majors and s Macmillan, 1933
maller Introduction to the Theory of Employ
fractions of female Ph.D.s than in ment,
either London, Macmillan, 1937a
mathematics or the natural sciences Essays in the Theory of Employment,
(Kahn London,
1995). Within this male bastion, Jo Macmillan, 1937b
an An Essay on Marxian Economics, Lon
Robinson stands out as the don,
most Macmillan, 1942
distinguished female economist.
Works by Robinson 1
31
JAN TINBERGEN Shaw, G.K., “Joan Robinson 1903–83,” P
ioneers
“The Production Function and the T of Modern Economics in Britain,
heory of Vol. 2, ed.
Capital,” Review of Economic St David Greenaway and John R.Presl
udies, 21, 2 ey, New
(1953–4). Reprinted in Robinson (19 York, St Martin’s Press, 1989, pp.
80), Vol. 144–69
2, pp. 114–31 Skouras, Thanos, “The Economics of
The Accumulation of Capital, Lon Joan
don, Robinson,” in Twelve Contemp
Macmillan, 1956 orary
Economic Heresies: Some Old- Economists, ed. J.R.Shackleton a
Fashioned nd
Questions in Economic Theory, G.Locksley, New York, Wiley, 1981, p
New York, p. 199–
Basic Books, 1971 218
An Introduction to Modern Econo Turner, Marjorie, Joan Robinson and
mics, New the
York, McGraw Hill, 1973, with John Americans, Armonk, NY, M.E.Sharp
Eatwell e, 1989
Collected Economic Papers, 5 vols., Ca
mbridge,
Massachusetts, MIT Press, 1980 Other references
Eichner, Alfred S., The Megacorp and Oli

Works about Robinson gopoly:
Micro Foundations of Macro Dynami
Gram, Harvey, and Walsh, Vivian, cs, New
“Joan York, Cambridge University Press,
Robinson’s Economics in Retrospect, 1976
” Journal Harcourt, Geoff, Some Cambridge Contr
of Economic Literature, 21, 2 (June 19 oversies
83), pp. in the Theory of Capital, Cambri
518–50 dge,
Rima, Ingrid (ed.) The Joan Robins Cambridge University Press, 1972
on Legacy, Kahn, Shulamit, “Women in the Eco
Armonk, New York, M.E.Sharpe, 1 nomics
991 Profession,” Journal of
Economic
Perspectives, 9, 4 (Fall 1995), pp.
193–205 JAN TINBERGEN (1903–94)
Jan Tinbergen was a pioneer in econo
132
metrics
and economic modeling. He construct
ed the
first statistical economic models, and then
used
these models to study business cycles
and the
effect of economic policy on natio
nal
economies. But Tinbergen was not j
ust a
number-cruncher. Rather, as Baum (1
989, p.
305) points out, all his statistical wor
k was
driven by a “deep-seated concern for
human
welfare and a conviction that scienti
fic,
mathematical analysis can be combine
d with
a broader humanistic approach.”
Tinbergen was born in 1903 in The
Hague,
which borders on the North Sea in
the
Netherlands. His father was a language tea
cher
who stressed the need to express com
plicated
ideas in simple language. Despite the influ
ence
of his father, Tinbergen gravitated to
wards
science and mathematics in high schoo
l rather
than to language courses.
After graduating from high scho
ol,
Tinbergen enrolled at the University of Lei
den
to study physics. During this time (th
e mid-
1920s), Einstein gave annual lectures at Le
iden
and stayed with Paul Ehrenfest, the pr
ofessor
under whom Tinbergen was studyi
ng.
Tinbergen even got to meet Einstein on sev
eral
occasions. Nonetheless, Tinbergen lost int
erest onomics
in physics and shifted his course of was the logical means towards this
study— end.
first to mathematics and statistics, t Tinbergen also developed personal concern
hen to s for
economics. One reason for this change wa peace, justice and the welfare of human
s that ity. He
the economic conditions in Leiden du became an active member of the Dutch
ring the Social
1920s were among the worst in Ho Democrat Labor Party and a conscie
lland. ntious
Unemployment and poverty were hi objector. Rather than serve in the ar
gh and my, he
there was virtually no public assist agreed to perform alternative service
ance. to his
Tinbergen felt a responsibility to help im country in the Rotterdam prison administra
prove tion.
the lives of the Dutch people and ec
contributions to economics. Most of
these
After completing a dissertati were statistical in nature. He is resp
onsible
on on for developing the first economic m
minimization problems in economi odel of
cs and an entire economy, and he used this
physics in 1929, Tinbergen joined t model
he Dutch to study and explain the fluctuations
Central Bureau of Statistics. He spen of the
t most of Dutch economy. He was also instru
the next 16 years there studying business mental
cycles, in creating and developing econom
except for a short stint working for t etrics.
he League Econometrics is a set of mathematic
of Nations. From 1945 to 1955, Ti al
nbergen techniques that economists use to e
served as director of the Central Planning stimate
Bureau the quantitative relationship between
of the Dutch government. During thi two or
s time he more variables. For example, by st
devoted his energies to economic planni udying
ng. After historical relationships between intere
a one-year teaching position at Ha st rates
rvard, he and savings, economists can estimat
became a professor at the Netherlan e how
ds School much more people are likely to sav
of Economics (now Erasmus Univ e when
ersity). In interest rates rise. Putting interest ra
1969, Tinbergen shared the first Nobe tes on
l Prize in
Economics with Ragnar Frisch. The
prize was
awarded for their contributions t
o the
development of econometrics.
Tinbergen made several impo
rtant
JAN TINB
ERGEN
the x-axis and savings rates on the y
-axis,
we can construct a two-dimensional
Figure 11 Interest rates & savings graph
of the relationship between these vari
ables
(see Figure 11).
Each point on the graph represent
s the
savings rate (the amount of savings rel
ative to
household disposable income) and the
interest
rate in one particular year. Regression anal
ysis
is a statistical technique that enabl
es
economists to find the best line depicti
ng the
relationship between interest rates and sav
ings
rates, where “best” means the line t
hat
minimizes the difference between ind
ividual
data points and the line, so that the set of poin
ts
lie as close to the line as possible.
Mathematically, regression analysis e
nables
economists to find this line in the form
of an
equation such as y=a+bx, where a is
the y-
intercept and b is slope of the line, o
r the
regression coefficient. The regression
coefficient b measures how much y change
s for
each unit change in x, or how much
more
households save when interest rates rise by
one
percentage point.
Macroeconomic models are just lar
ge sets
of regression equations. Each equation
relates
one part of the economy to other parts
of the
economy.
In 1936 Tinbergen developed
a
macroeconometric model of the D ely
utch whenever income rose; rather consu
economy containing twenty-four eq mption
uations (and other variables) changed slowly
(see Tinbergen 1959, pp. 37–84). T as
hese income changed, and would adjust to
equations described the key macroec higher
onomic income levels only after several yea
relationships of the Dutch economy rs.
—what Mathematically, this was shown by h
determined consumer spending, bus aving
iness consumption depend on a weighted a
investment, exports, and so on. In verage
many of present and past income (rather tha
cases, lags were introduced so t n on
hat just present income).
consumption (and other macroecon
omic 1
variables) did not change immediat 33
JAN TINBERGEN sing his
macroeconomic models to study ec
Shortly after building his macro onomic
economic fluctuations and develop theories ab
model of the Dutch economy, Tinbergen out the
(1939) business cycle.
developed a model of the US econo In the 1930s, macroeconomists st
my for the udied the
1919–32 period that contained for different phases of the business cyc
ty-eight le and
equations. During World War II he built a s provided different explanations for ea
imilar ch of the
model for the UK economy (Tinberg different phases. Moreover, they mai
en 1951). nly paid
This statistical work led to a heat attention to how economies moved
ed debate towards
between Tinbergen and Keynes ab equilibrium (static analysis), but they g
out the ave little
nature and usefulness of econom attention to how economies grow and
etrics. oscillate
Critically reviewing a book by Ti over time. Tinbergen provided a singl
nbergen e, unified
(1939), Keynes (1939) claimed explanation of the business cycle. He also sh
that owed
econometrics merely gave quanti how and why economies change over t
tative ime. His
precision to what is already known t inspiration for this came from the
o be true cobweb
qualitatively about economic relati theorem, which Tinbergen discovered i
onships. n 1930.
Tinbergen (1940) replied that regr Traditional economic theory assu
ession mes that
coefficients can help test theories and th prices and markets move in a straight
at they forward
might also suggest new economic th manner towards an equilibrium or p
eories. To oint of
prove his point, Tinbergen began u rest (see also MARSHALL). Thus if
price is
too high, there will be excess good
s in the Tinbergen provided an explanation
market. This will push down pric
es and for this
reduce the supply of goods brough phenomenon. His explanation was that
t to the output
market. Conversely, if price is too in agricultural markets responded to prices
low, a with
shortage will lead to higher prices a lag. Farmers needed time to react to c
and a hanges
greater supply of goods brought t in the market and some types of prod
o the uction,
market. The problem, however, wa for example raising pigs, required consider
s that in able
many agricultural markets it was time. If too many pigs were brought to mark
not et,
uncommon to see prices and quantit this would reduce the price of pigs. But becau
ies move se
in opposite directions—prices would of the lower price, farmers would raise
fall and fewer
more goods would be produced for pigs for sale in the following year. At the
sale. same
time, the low price would lead to a
134
large
demand for pigs as consumers became
used to
consuming pork, bacon, and other pig prod
ucts.
This combination of low supply and
high
demand would create a shortage of pi
gs and
push up prices. In response, farmers p
roduce
too many pigs the following year, lea
ding to
another surplus.
The cobweb theorem provided
the
foundation for Tinbergen’s (1937) anal
ysis of
the business cycle. He developed twe
nty-two
statistical equations, each of which s
howed
how supply and demand respond over t
ime to
shortages and to excess supply. Each e
quation
also modeled the change taking plac
e in
different economic sectors. From the
se
equations Tinbergen was able to sho
w how
economies oscillated over time, just li
ke the
production of pigs. erent
After developing his macroeconoeconomic policies were studied in is
metric olation
model of the workings of an econ from each other and no method exist
omy, ed for
Tinbergen diverted his attention to dealing with multiple policy targets. Tinbe
policy rgen
issues. He showed how policy maker(1952, Chs 4, 5) saw that multiple t
s could argets
use macroeconomic models to meas required multiple policies. Thus if one
ure the wanted
effects of any proposed policy. Then he sh to lower unemployment and strengthe
owed n the
how his statistical model could help politi national currency, two different policie
cians s were
make policy decisions when facing needed to achieve these two aims. In
contradictory or conflicting economi general,
c goals. if policy makers had a certain numb
Prior to the work of Tinbergen, differ of
hanges
affecting the structure of the econo
quantitative targets, they must have my (such
as changes in the laws governing monopol
at their y and
disposal at least an equal number competition and new forms of taxat
of policy ion) or
instruments. quantitative changes, which invol
Tinbergen also explained how ve
economic manipulating policy instruments suc
analysis could be used to help na h as the
tional money supply, exchange rate or am
governments develop plans to im ount of
prove government spending (Tinbergen 1952; v
economic outcomes. First, policy an der
makers Linden 1988).
needed to determine the collective pref In the 1970s, Tinbergen shifted his att
erences ention
of its citizens regarding economic target from economic planning to incom
s. Then e
they needed to manipulate policy in distribution. Several factors are pro
struments bably
in order to best satisfy the colle responsible for this change. First, in
ctive terest in
preferences of its citizens. The prefer economic planning was waning through
ences led out the
to policy targets that could either be world (see also LEONTIEF). Second,
fixed or income
flexible. The means to this end could disparities were large and growing i
be either n most
far reaching reforms in the way e countries as well as between countri
conomies es. This
operate (for example the introduction o conflicted with Tinbergen’s desire to
f social increase
security legislation, guaranteed em social justice and economic welfare.
ployment, Like his other work, Tinbergen ap
or incomes policies), qualitative c proached
income distribution from a dynamic pers JAN TINB
pective. ERGEN
Rather than seeking the causes of t
he present hypothesis (see Piore and Doeringer 1
distribution of income, Tinbergen (1975 971),
) sought which sees two different labor markets opera
to find the root causes of change ting
s in the in developed countries rather than on
distribution of income over time. e large
He located labor market. According to the dual labor m
these in the factors affecting both the arket
supply of theory, one labor market exists for highly-
labor and the demand for labor. The skilled
two most workers while a separate market exists for th
important factors affecting labor su ose
pply and lacking skills and adequate education.
labor demand, according to Tinber Workers
gen, were cannot easily cross over from one market to t
education and technological develop he
ment. His other, and employers demand workers
analysis also relied upon the dual la from
bor market either labor pool.
From this perspective, expanded educ
ation
tends to reduce income inequality bec
ause it
tends to equalize the abilities of indiv
iduals
in a country. In addition, education
will
equalize the wages received by these
two
groups of workers. A greater supply
of
educated workers will reduce their (h
igher)
wages. At the same time, more educ
ation
reduces the supply of less-educated w
orkers.
This means that the remaining low-
skill
workers receive higher wages.
On the other hand, technological a
dvances
tend to increase income inequality. Technol
ogy
requires skilled and educated manpow
er, thus
increasing the demand for skilled work
ers and
hence their earnings. Technology also displ
aces
those who do not meet the higher
qualifications. This reduces the dema
nd for
unskilled workers and their earnings.
Tinbergen (1975, p. 2) saw chan
ging development. Second, policies should
income inequality as the outcome of direct
a race technological innovation so that it re
between education and technologi quires
cal more low-skill labor. Increasing the d
development. If education improves emand
more for low-skill labor would push up the
rapidly than technology, income ine wages
quality of those at the bottom of the distributi
declines; if technology has the uppe on and
r hand, would mitigate the tendency for technol
income inequality becomes greater. ogy to
Three policy implications follow f increase income inequality. Finally, Tinbe
rom this rgen
analysis. First, government support suggested using tax policy as a mea
for ns of
education needs to be increased so
that 1
education expands faster than techn 35
ological
JOHN HICKS pments in
General Economic Theory,” Econo
reducing inequality. He thus advocat metrica,
ed higher 2, 1 (January 1934), pp. 26–8
taxes on wealth, capital gains, and inheri An Econometric Approach to Busines
tances. s Cycle
Today, virtually every developed Problems, Paris, Hermann, 1937
country Statistical Testing of Business Cycle
in the world has constructed a l Theories,
arge 2 vols., Geneva, League of Nations,
macroeconometric model of nearly 1939
1,000 “On a Method of Statistical Business
equations. These models are used t Cycle
o study Research: A Reply,” Economic Jour
economic activity and to predict th nal, 50
e future (1940), pp. 141–54
course of the economy. They are a Business Cycles in the United Kingdo
lso used m, 1870–
by governments and by central bank 1914, Amsterdam, North-Holland,
s to help 1951
formulate economic policies. The e On The Theory of Economic Polic
xistence y,
of these macroeconometric models i Amsterdam, North-Holland, 1952
s due to Centralization and Decentralization in
the pioneering work of Tinbergen. T Economic Policy, Amsterdam, Nor
his work th-
makes Tinbergen one of the half do Holland, 1954
zen most Economic Policy: Principles and Desi
important economists of the twen gn,
tieth Amsterdam, North-Holland, 1956
century. Selected Papers, Amsterdam, North-
Holland,
1959
Works by Tinbergen Shaping the World Economy: Suggesti
ons for
“Annual Survey of Significant Develo an International Economic Policy,
New
York, Twentieth Century Fund, 19
62 Works about Tinbergen
Lessons from the Past, Amsterdam,
North- Baum, Sandra R., “Jan Tinbergen 1969” in N
Holland, 1963 obel
Income Distribution: Analysis and Laureates in Economic Science, ed.
Policies, Bernard
Amsterdam, North-Holland, 1975 S. Katz, New York and London, G
arland
Publishing, 1989, pp. 304–17
136 Bos, Henk C., “Jan Tinbergen: A Profile,” Jou
rnal
of Policy Modeling, 6, 2 (1984), pp.
151–8
Hansen, Bent, “Jan Tinbergen: An Appr
aisal of
His Contributions to Economics,”
Swedish
Journal of Economics, 71, 4 (1969),
pp. 25–
36
Keynes, John Maynard, “Professor Tinb
ergen’s
Method,” Economic Journal, 39 (S
eptember
1939). Reprinted in The Collected Writi
ngs of
John Maynard Keynes, XIV, Lond
on,
Kol, J. and Wolff, P. de, “Tinbergen’s
Work:
Change and Continuity,” De Econo
mist, 141,
1 (1993), pp. 1–28
Van Der Linden, J.T.J.M. “Economic Thou
ght in
the Netherlands: The Contribution of Prof
essor
Jan Tinbergen,” Review of Social Econo
my, 46,
3 (December 1988), pp. 270–82
Other references
Piore, Michael and Doeringer, Peter In
ternal
Labor Markets and Manpower Ana
lysis,
Lexington, Massachusetts, D.C.Heath
, 1971
JOHN HICKS (1904–89)
taught to undergraduate students.
John Hicks is best known for deve
Hicks was born in Warwick, Engl
loping and in
several pictorial diagrams used to demon 1904 into a middle-class family. His father
strate was
economic principles and techniques a journalist and an editor. Hicks received a go
of od
analysis. These now form the basi high school education at private Brit
s of ish
contemporary economics, especially schools, and then earned a scholarsh
as it is ip to
Jevons Professorship at Manchester Uni
versity.
Balliol College, Oxford. Hicks began s Eight years later he returned to Oxfor
d, where
tudying he taught until his retirement in 196
mathematics at Oxford, but soon change 5. Hicks
d fields was knighted in 1964, thus becoming
and concentrated on economics. He Sir John
received Hicks. In 1972 he shared the Nobel
his degree in philosophy, politics, Prize in
and Economics with Kenneth Arrow.
economics in 1926. Hicks has made important contrib
After graduating, Hicks taught at the utions to
London both macroeconomics and microecon
School of Economics, at Cambridge Uni omics—
versity, a rare feat in the twentieth century,
and briefly in South Africa. He w when
as not macroeconomics and microeconomi
enamored with Cambridge, disliking cs have
both the
physical climate and the intellectual
climate (a
great tendency to quarrel), but he f
ound the
London School a congenial place to work
. Hugh
Dalton of the London School got Hic
ks to read
Pareto’s Manual, an event of great i
mportance
in his life. When he got to the mat
hematical
appendices, Hicks realized Pareto did no
t finish
what he set out to do—make economic a Figure 12 IS-LM diagram
nalysis
clearer and more precise by translati
ng it into
mathematics. At that moment Hicks d
ecided to
devote his career to completing w
hat Pareto
started (Klamer 1989, p. 169).
In 1938 Hicks was appointed to the
Stanley
JOH this would lower interest rates in the
N HICKS money
market. But with lower interest rat
remained separate and distinct fields and es,
when investment would rise and the total demand
specialization prevails in all acade for
mic goods and services would increase in the go
disciplines. As a macroeconomist, Hicks i ods
s best market. Of course, with more goods
known for formalizing the macroec and
onomic services being produced, people woul
theories of Keynes. In one of the m d need
ost cited more money so that they can buy more
economic papers of all time, Hicks things.
(1937) But a greater demand for money woul
condensed Keynes’ General Theory d push
into a set up interest rates, reduce investment and out
of two curves (see Figure 12). put,
Standard Keynesian theory never ma and thereby lower the demand for mon
de the ey.
relationship between the goods market an Interactions between the goods mar
d the ket and
money market clear. In the goods the money market could conceivably g
market, o back
businesses produce things and sell these t and forth forever, yielding no final and
hings stable
to consumers, government, other bu outcome. The IS-LM model demonstr
sinesses ated that
and other countries. Equilibrium in th the goods market and the money market wo
e goods uld
markets requires that the supply of achieve equilibrium simultaneously.
goods This
brought to market equals the demand f diagram now serves as the basis for
or these most
goods. In the money market, peopl undergraduate education in macroecon
e and omics,
businesses demand a fixed stock of money and has made IS-LM and Keynesian
that ism
is set by the nation’s central bank. Equilibrsynonymous in the minds of most eco
ium nomics
in the money market requires that the students.
demand The IS curve in Figure 12 repres
for money equals the supply of moneyents
. equilibrium positions in the goods ma
These two markets, however, ar rket of
e the economy. IS stands for the fact that
interrelated rather than independent in the
of each
other. If the supply of money were in 1
creased, 37
JOHN HICKS interest rates fall, economic output
must
goods market investment (I) equals savi expand to keep the goods mark
ngs (S). et in
The downward sloping IS curve sho equilibrium. This is because lower interes
ws that as t rates
will increase business investment, nomists
but it will and classical economists arose fro
also reduce savings. To get savings m
up, and different assumptions about the two
ensure that savings and investment curves.
are equal, If the LM curve was flat rather than
the economy must produce more go steeply
ods, more sloped, fiscal policy (or a shift in
jobs, and greater incomes. the IS
The LM curve shows curve) would be needed to exp
possible and
equilibrium positions in the money employment and we are in the w
market. orld
LM stands for the fact that money described by Keynesian economists.
demand On the
(L) must equal money supply (M) other hand, if the IS curve were
in the flat,
money market. Figure 12 shows t monetary policy (or a shift in the LM
hat as curve)
interest rates rise it is necessary f would be needed to expand output
or the and
economy to expand if the money m employment, and we are in the
arket is world
to remain in equilibrium. This is described by the classical economist
because s.
higher interest rates reduce the dem
and for 138
money, since by holding money peo
ple lose
the interest they could be earning by
holding
some interest-bearing asset. Howeve
r, if the
economy grows, people will want
to hold
more money because they will be
buying
more goods. With more goods pr
oduced,
money demand will increase and wi
ll come
to equal the money supply.
Simultaneous equilibrium is ac
hieved at
the point of intersection between th
e IS and
LM curves. Since the goods marke
t moves
towards points on the IS curve and t
he money
market moves to points on the LM c
urve, the
whole economy must move towards th
e single
point at which the two curves meet.
Hicks then went on to show h
ow the
differences between Keynesian eco
be. More interest is required to comp
ensate
A second macroeconomic contributi
on due
to Hicks involves the term structure of int
erest
rates. Economists frequently talk abo
ut “the
rate of interest” as if there were only
one rate
of interest existing in the economy.
But as
everyone knows, there are many different
rates
of interest at any given time. Rates o
n credit
cards are higher than rates for h
ome
mortgages, and rates are higher for fix
ed rate Figure 13 The yield curve
mortgages than for variable rate mor
tgages.
Interest rate theory attempts to expl the lender for the greater probability th
ain the
relationship among all these different at the
rates. loan will not be repaid.
Economists have devised two w The yield curve is a graphic device for loo
ays to king
make sense of the vast array of interesat the rate of interest on loans made for differe
t rates. nt
One focuses on the risk of lending mo lengths of time. These loans take the f
ney and orm of
the other on the length of time for people and businesses purchasing governme
which nt (or
money is lent. The greater the risk corporate) bonds. A yield curve might show
to the that
lender, the higher the rate of interest n a three-month loan to the US governme
eeds to nt pays
s 11–13)
answered this question with a reso
4.4 percent, a two-year loan pays 5.5 unding
“yes,” and developed the expectati
percent, a ons
10-year loan pays 7 percent, and a 30 hypothesis to explain the relationship
-year loan among
pays 8 percent (see Figure 13). assets with different maturity lengths
One question that arises conce .
rning the Hicks reasoned that if a 6-
yield curve is whether there is any month bond
linkage paid 5 percent now and a-year bon
among interest rates for assets with d paid
different 5.5 percent now, then investors must
maturities—say 6-month and 1- expect
year that six months from right now the r
government bonds. Hicks (1939, Ch ate on
a 6-month bond will be 6 percent. I d. Since
nvestors bond prices are inversely related to i
earn 5.5 percent either way. They c nterest
an earn rates, the interest rate on the 6-
5.5 percent over the whole year month bond
by
purchasing a 1-year bond now; alter
natively,
they can earn 5 percent for the fi
rst six
months of the year, and 6 percent
for the
second six months of the year. This
averages
out to the same 5.5 percent that c
ould be
earned from a 1-year bond. In gene
ral, the
expectations hypothesis holds that
returns
on assets of longer maturities will e
qual the
average of the current return on sho
rter-term
assets and the expected return on
shorter-
term assets in the future.
Hicks then went on to explain
why the
expectations hypothesis had to be tr
ue. This
explanation essentially relies on the
process
of arbitrage (see also COURNOT).
If a 1-
year bond paid 5.5 percent when a
6-month
bond paid 5 percent and was expe
cted to
pay 5.5 percent at 6 months in the
future,
no one would want to own 6-
month bonds
and no one would buy them. Over
a 1-year
time period, two 6-month bonds
are
expected to earn only 5.25 percent.
People
would prefer to have 1-year bonds
paying
5.5 percent; so they will sell their
6-month
bonds and buy 1-year bonds. This
drives
down the price of the 6-month bo
nd and
drives up the price of the 1-year bon
JOH change
N HICKS from the substitution effect of a price
change.
will rise and the interest rate on the
1-year
bond will fall. This process will co
ntinue
until the equilibrium condition identif
ied by
the expectations hypothesis is final
ly
achieved—the rate on a 1-year bond
will be
equal to the average of the rate on a 6
-month
bond and the rate expected on a 6-
month
bond a half year from now.
While Hicks made many contribu
tions as
a macroeconomist, it is as a microec
onomist
that Hicks first achieved fame. Alth
ough Figure 14 Indifference curve and bud
Edgeworth drew the first indifferenc get
e curve constraint
diagrams, it was Hicks (1934)
who
incorporated indifference curve analy The key to this analysis is the intro
sis into
duction
standard microeconomic theory. He
of a budget line. This line represents
showed
how
how indifference curves could be u
much of each good a consumer could purch
sed to
ase
construct a downward sloping deman
given their current income and the c
d curve
urrent
for any good. He then used indifference cu
rves
1
to separate the income effect of a price
39
JOHN HICKS consumer can buy 10 beers and no
pretzels.
prices of goods. For example, with
$10 and
with pretzels and beer each costin
g $1, a
consumer can buy any combination of
pretzels
and beer that adds up to 10. This is
shown by
the negatively sloped line in Figure 14.
At one
extreme, the consumer can buy 10
bags of
pretzels and no beer. At the other ext
reme the
more, consumer income can buy les
Figure 15 Income and substitution ef s of

fects everything. Spending on both beer and pret
zels
In between these will fall due to the income effect. Together, t
he
extremes many
two effects together change spending
combinations are possible. All of
from 5
these
beers and 5 pretzels to 1.5 beers and 7 pretze
possibilities are show by the budget
ls.
line.
These effects are shown by the rotation
Hicks next added indifference
of the
curves (see
budget line. Due to this rotation, point C is no
also EDGEWORTH) to this diagra
w
m in order
where our consumer gets the greatest u
to explain consumer behavior. Co
tility.
nsumers
Hicks then figured out an ingeneo
would choose the combination of pr
us way
etzels and
to separate the income and substitution effe
beer that yielded the highest utility,
cts.
or which
The slope of the budget line represen
was the highest on the diagram (poi
ts the
nt A).
relative prices of the two goods. If ther
Hicks then looked at the effects of a c e were
a substitution effect, but no income eff
hange ect, we
should be on our original indifference
in price. Suppose that the price of a
curve,
beer were
but choosing different combinations of pre
to increase to $2. With the price
tzels
of beer
and beer based on the new $2 price of
relatively higher, people will want to
beer or
purchase
the new budget line. Hicks suggested t
more pretzels and less beer. This
hat we
is the
show the income effect by taking the old bud
substitution effect, whereby an incre
get
ase in the
line and moving it up the graph until it
price of a good reduces demand for
is just
that good
tanget to the original indifference curv
and increases demand for most other goo
e. This
ds (all
is shown as the dashed line on Figure
goods that are not complementary
15. At
goods). Yet,
point B the relative prices of beer and
there is also an income effect. When
pretzels
beer costs
are the same. It thus shows the chan
ge in
140 consumer spending habits must theref
ore be
due to the income effect alone.
Because the income effect and
the
substitution effect each reduce the consum
ption
of beer, it follows that when the price
of beer
rises, people buy less beer. The dema supply, and studied how much more consu
nd curve mers
for beer must therefore slope down would buy and how much more pro
ward—as ducers
the price of beer rises, the quantity c would sell given some change in price.
onsumed Hicks
falls and conversely as the price of be took this elasticity notion and applied it
er falls, to the
the quantity consumed will increase. decisions businesses had to make ab
Finally, Hicks (1932) is responsi out
ble for production.
introducing the notion of the elastic From a firm’s point of view, goods
ity of can be
substitution, a natural extension of M produced in several different ways, eac
arshall’s h using
notion of elasticity. Marshall applied the different combinations of labor and cap
notion ital. A
of elasticity to consumer demand and pro more labor-intensive production process
ducer would
to substitute capital for labor. With
more
employ less capital and more labor, and a capital, workers will be more produc
tive and
more thus will be paid more.
capital-intensive production process w Hicks has justly been called (Ha
ould use mouda
less labor and more capital. In gene 1993) “the economist’s economist.”
ral, firms Writing
face a trade-off in production—each ad exclusively for his professional collea
ditional gues, he
worker employed requires less machin developed numerous tools and diagr
ery, and ams that
each additional machine used in p have enabled economists to depic
roduction t the
requires fewer workers. The elasti principles of economic analysis mor
city of e clearly
substitution measures how much and concisely. Hicks showed how to
machinery combine
could be dispensed with if one mor an analysis of the money market w
e worker ith an
were used in producing goods, or alt analysis of the goods market, ho
ernatively w to
how many workers could be dispe understand the relationships between
nsed with interest
by purchasing and using one more rates of different maturities, and ho
machine. w to
Hicks pointed out that workers s combine utility theory and the theo
hould not ry of
necessarily oppose labor-saving te demand. For his many advances and
chnical for the
change since it could lead to higher wages many areas in which he made imp
. This ortant
would arise if the elasticity of sub contributions, Hicks must be regarde
stitution d as one
between labor and capital is large, and it i of the half dozen most important t
s easy wentieth-
century economists. OSKAR
LANGE
Works by Hicks “Mr. Keynes and the ‘Classics’: A Sug
gested
The Theory of Wages, London, Macm Interpretation,” Econometrica, 5 (April
illan, 1932 1937),
“A Reconsideration of the Theory of pp. 147–59. Reprinted in Hicks (1967
Value,” )
Economica, 1 (February and May Value and Capital: An Inquiry into S
1934), pp. ome
52–76, 196–219, with R.D.G.Allen Fundamental Principles of Economic
“A Suggestion for Simplifying the Theory,
Theory of Oxford, Clarendon Press, 1939
Money,” Economica, 2 (February Capital and Growth, Oxford, Clarendo
1935), pp. n Press,
1–19. Reprinted in Hicks (1967) 1965
Critical Essays in Monetary Theory,
Oxford,
Oxford University Press, 1967
Collected Essays on Economic Theory
, 3 vols.,
Oxford, Basil Blackwell, 1981–3
Works about Hicks
Baumol, William, “John R.Hicks’ Contr
ibution
to Economics,” Swedish Journal
of
Economics, 74 (1972), pp. 503–72
Hagemann, Harold and Hamouda, Omar
F., The
Legacy of Hicks: His Contributions
to
Economic Analysis, London and Ne
w York,
Routledge, 1994
Hamouda, Omar F., John R.Hicks:
The
Economist’s Economist, Oxford, Bl
ackwell,
1993
Klamer, Arjo, “An Accountant Amo
ng
Economists: Conversations with Sir
John
R.Hicks,” Journal of Economic Pe
rspectives,
3, 4 (Fall 1989), pp. 167–80
Morgan, Brian, “Sir John Hick Contribu
tion to
Economic Theory,” in J.R.Shackleton
and G.
Locksley (eds.) Twelve Contempora
ry
Economists, London, Macmillan, 198
1, pp.
could
allocate resources efficiently despite t
he fact
OSKAR LANGE (1904–65) that prices were set by bureaucrats rath
er than
by the market. It also explained how
Oskar Lange (pronounced LANG- less
ga) is best developed countries could use the to
ols of
known for his work on economic planning
and
the economics of socialism. This w 1
ork 41
explained how socialist economies
OSKAR LANGE sciences. After much anguish Lange o
pted for
economic planning to grow more q the latter, and enrolled at the Unive
uickly and rsity of
efficiently. Less well-known is the Krakow to study mathematics, statist
work that ics, law,
Lange did on capitalist economies. and economics. He received his doc
This work torate in
explained why market economies went 1928 for a study of business cycles in
through Poland,
regular business cycles, and why th and then obtained a position as lect
e standard urer in
policies to deal with high unemployme statistics at the University.
nt were During the 1930s and early 1940
inadequate. s Lange
Lange was born in the town of visited England and then the US
Tomaszów as a
Mazowiecki, in western Poland, in Rockefeller Foundation Fellow. Dur
1904. His ing this
father was a German textile manufac time he studied with Joseph Schum
turer who peter at
produced goods for sale in eastern Harvard; then he held teaching positions
Europe. at the
Proceeds from the business allowed the University of Michigan, Stanford U
Langes niversity,
to live a middle-class lifestyle unti and the University of Chicago. In the l
l shortly ater war
before World War I; at that time the years Lange worked to set up a ne
business w Polish
went bankrupt and the family eco government. After World War II he se
nomic rved the
circumstances became difficult. Polish government as ambassador to the
Lange developed interests in b United
iology, States, Polish delegate to the UN S
mathematics and the social sciences ecurity
while he Council, member of Parliament, and
was growing up. When the time came to c member
hoose of the Central Committee of the P
a path of study, he had difficulty olish
deciding Worker’s Party. In 1948 Lange retur
between the biological sciences and ned to
the social academic life, teaching at the Centra
l School
of Planning and Statistics in Warsaw
and then economy. He studied questions such as whe
at the University of Warsaw.
The economic work of Lang ther
e was centrally planned economies could be
concerned primarily with the theor run as
etical and efficiently as market economies, ho
practical problems of a planned or w to
socialist provide adequate incentives to managers u
nder
142 socialism, and how to find the proper
balance
between centralization and decentralizati
on. In
all his work, Lange tried to bring math
ematics
and statistical analysis to bear on the p
lanning
problem.
One of the major problems facing
any
socialist economy is how to allocate re
sources
efficiently. In a capitalist economy this funct
ion
gets performed by markets. Those go
ods in
greater demand by consumers fetch h
igher
prices, thus signaling to producers of
these
goods that they need to expand product
ion. In
contrast, goods that consumers do not want
pile
up on store shelves and in warehou
ses.
Businesses stop producing these item
s and
instead make those goods in greater d
emand.
Lange was instrumental in showing th
at just
because there was no market it did not
mean
that socialism led to an inefficient all
ocation
of goods—producing too many thi
ngs
consumers did not want and not enough of w
hat
consumers greatly desired.
In 1908 the Italian economist Enrico Bar
one
attempted to show that markets were
not
necessary for economic efficiency (tra
nslated would exactly equal each other. By setti
as Barone 1935). He started with a ng the
set of price of each good equal to its market c
mathematical equations, each represe learing
nting the price, planners would make sure that
supply or the demand for some particular g the
ood. economy produced the goods consu
Barone used this set of equations to s mers
how that wanted.
socialist economies could set prices In the 1930s, Friedrich Hayek and
correctly Lionel
and efficiently allocate goods. All e Robbins, two economists teaching at
conomic the
planners had to do was solve these e London School of Economics, raised a
quations rather
and find the market clearing price f obvious objection against this scheme
or each . They
good, or the price where supply and argued that the procedure envisioned by Ba
demand rone
have changed again, and the prices s
et by an
was possible in theory, but impos economic planning board would agai
n be out
sible in of date.
practice; before making any decis In 1938 Lange (1964) responded
ion, a to these
socialist government or ministry of objections and demonstrated that an
economic efficient
planning would have to gather an socialism was possible. He showed th
immense at it was
amount of information, and derive not necessary for economic planners
hundreds to know
of thousands (Hayek 1935), or ma thousands upon thousands of mathe
ybe even matical
millions (Robbins 1934) of equatio equations; nor was it necessary for
ns. They them to
would then have to solve all these eq solve all these equations in order to g
uations in et prices
order to find the set of market cleari right. All that was needed, Lange co
ng prices. ntended,
Moreover, as Robbins (1934, p. 151 was for planners to follow a simple
) pointed trial and
out, by the time this set of equations was s error method. Whenever shortages e
olved xisted in
mathematically the economy woul an economy, economic planners sho
d have uld raise
changed, and the information upon prices; and when surpluses existed,
which the planners
solution was based would be obsolete. P should lower prices. By imposing the
lanners se rules,
would thus have to re-estimate all the eq socialist planners would function just
uations like the
and solve this new set of equations. market in a capitalist economy, and the soc
Of course, ialist
by the time this was done, the econo economy would be able to efficiently
my would allocate
resources. Making their job even OSKAR
easier, LANGE
planners would not have to start their tri
al-and- system. Many years later Lange realiz
error process from scratch. Rather, t ed that
hey would with the aid of a computer it would be possib
begin with the set of efficient prices deter le
mined to solve thousands of equations and
by the market. find
Lange (1964) also argued tha market-clearing prices for all goods in
t this just a
procedure would result in an economic few seconds (Feiwel 1972, p. 614)—much
system less
far superior to capitalism. The economy time than the market itself would nee
would d. By
reach equilibrium prices more quic moving to equilibrium prices more qu
kly, since ickly,
economic planning boards would ha business cycles would be shorter and
ve greater milder;
knowledge of the whole economy therefore socialist economies would experi
than any ence
individual entrepreneur under a ca less unemployment than capitalist eco
pitalist nomies.
According to Lange, a socialist ec
onomy
had other advantages. It was superior
to a
capitalist economy because it had a more eq
ual
distribution of income. In addition, s
ocialist
economies were plagued less by the pr
oblems
of monopoly power. Under socialism
firms
could not make excessive profits by restric
ting
output, and thus they could not wield
great
political power.
Although Lange devoted much eff
ort to
showing how socialism could be as ef
ficient
as capitalism, socialism was not a utopi
an end
state for Lange. He (1964, p. 109) saw that “t
he
real danger of socialism is that o
f a
bureaucratization of economic life.”
And he
worried that economic planners might
act in
their own interests rather than in the i
nterests
of the nation. But Lange also noted t
hat the
same problems existed under mono because monopolies had destroyed the
poly market
capitalism—corporate managers be and free competition. These monopoli
came es were
bureaucrats and did not respond to th able to control prices, keep out comp
e needs etitors,
of consumers. Lange thought that decentr and influence both consumers and poli
alized ticians.
decision-making and better-educated Lange thus saw socialism as a way to
planners restore
would help to mitigate these problem the efficiency of market pricing a
s. nd
Lange’s analyses of the economic pro competition, as well as a means to
blems make
that exist under capitalism constitute his s economic decision-making more dem
econd ocratic.
contribution to economics. Accordi Economic management would be und
ng to ertaken
Lange, in capitalist economies the ma
rket did 1
not play the role that economic theory 43
gave it
OSKAR LANGE s and
equipment. Flexible prices would thus he
by public functionaries, who were lp the
subject to economy move to full employment. This
democratic control, rather than by is the
the heads traditional analysis of how econo
of large and powerful enterprises t mies
hat were responded in times of high unemploy
subject to no controls at all. ment.
A second problem with capit But Lange argued it was also pos
alism sible for
according to Lange (1944a) is that the money supply to fall by more t
capitalist han the
economics tend to remain stuck at h decline in prices. To understand why this
igh levels might
of unemployment. This work paralle occur requires knowing that in m
ls that of ature
John Maynard Keynes. Lange noted economies money gets created whe
that two n banks
outcomes were possible during a r make loans. In a recession, banks will fear
ecession, that
only one which would lead to a g they may not get repaid when they l
rowth in end out
employment. First, the recession co money. If they call in loans and refuse
uld cause to lend,
prices to drop but have little effect this will reduce the money supply and
on the push up
amount of money in circulation. W interest rates. In this case we get ev
ith lower en less
prices, the existing money supply woul investment and greater unemployme
d allow nt.
consumers to buy more goods and servi Either of these two scenarios is po
ces and ssible in
businesses to purchase more plant practice. A monetary economy thus p
ossesses
no automatic mechanisms, like flexibl
e prices, demand for goods to create more jobs. The o
to guarantee that it will head tow
ards full nly
employment equilibrium. Moreove solution to unemployment becomes curbin
r, Lange g the
argued that rising monopolistic elementpower of monopolies by having the sta
s under te take
capitalism make flexible prices less them over. In the interests of econo
likely and mic
the second scenario more likely. performance, the state must assert de
Going even further, Lange dou mocratic
bted that control over the economy. Monop
macroeconomic policies of the sort oly
advocated capitalism thus becomes a roadway
by Keynes could solve the unemp to
loyment democratic socialism for Lange.
problem. Here too monopolies got in Lange saw socialism not as the nega
the way. tion of
Monopolies were more likely to re capitalism but as its extension. He believed t
spond to hat
greater demand by raising prices t the growth of monopolies and oligopol
han by ies had
expanding output and hiring more already destroyed the market and f
workers. ree
This, obviously, limits the ability ocompetition. Market socialism was a
f greater way to
restore competition and maintain dem
144 ocracy.
Lange was critical not only of capi
talism;
he was also highly critical of the So
viet
economy. Refusing to describe it as a socia
list
economy, Lange (1944b) thought the
Soviet
Union was “an authoritarian economy
guided
by political objectives.” Its political obje
ctives
were to be one of the world’s leadi
ng
industrial countries and to provide ade
quately
for the national defense. The Soviet
Union
therefore did not develop a democratic ma
rket
socialism. Rather the government div
erted
resources to defense spending and inve
stment
in large-scale manufacturing. It did t
his by
reducing the quantity of goods availa
ble to
other sectors. Consumers were starv possible. Because goods were always in
ed for short
goods and had to spend hours waiting supply, no matter how shoddy the goods we
in line re,
to buy them. Agriculture was hindered in they would be bought by someone.
order The work of Lange should be viewe
to develop a manufacturing sector. d as an
And attempt to combine the best aspects
materials were always in short sup of
ply. socialism (democracy in economic de
Likewise, the emphasis on quantity cision-
(rather making) with the best aspects of capi
than market-clearing prices) by So talism
viet (efficiency). He advocated governme
economic planners hurt quality. In o nt
rder to ownership of large, monopolistic firms and
meet the quantity goals imposed by p also
lanners, advocated using the price mechanism to in
firms would make the cheapest go sure
ods
Econometrics-in Memory of Henr
y Schultz,
that the economic system produce Chicago, University of Chicago Pre
ss, 1942,
goods that pp. 49–68
satisfy consumer needs. He sought to c “The Theory of the Multiplier,” Econometr
ombine ica, 11
central planning with (July-October 1943), pp. 227–45
decentralized Price Flexibility and Employment, Bloo
management, and he sought to mak mington,
e planners Indiana, Principia Press, 1944a
more efficient through better education Working Principles of the Soviet Ec
and by onomy, New
providing them with the modern t York, Research Bureau for Pos
ools of twar
analysis and forecasting. If the cou Economics, 1944b
ntries of “Economic Controls After the War,”
Central and Eastern Europe begin t Political
o look for Science Quarterly, 60 (1945), pp. 1
some middle ground between survi –13
val-of-the- Some Problems Relating to the Poli
fittest capitalism and total governme sh Road to
nt control Socialism, Warsaw, Polonia Publishing
over all economic activity, it is certai House,
n that the 1957
economic thought of Lange will t Economic Development, Planning a
ake on nd
increasing importance. International Cooperation, New Yor
k,
Works by Lange Monthly Review Press, 1963
On The Economic Theory of Socialism, N
ewYork,
“Say’s Law: A Restatement and Crit
McGraw Hill, 1964, with Fred M.T
icism,” in
aylor
Studies in Mathematical Econom
Economic Theory and Market Socialism:
ics and
Selected
Essays of Oskar Lange, ed. Tadeusz WASSILY LEO
Kowalik, NTIEF
Hants, Edward Elgar, 1994
Contributions,” Kyklos 25, 3 (1972), pp.
601–
Works about Lange 18
Fisher, Walter D., “Oskar Ryszard Lange,
Feiwel, George R., “On the Economic 1904–
Theory of 1965,” Econometrica 34, 4 (Octobe
Socialism: Some Reflection on r 1966),
Lange’s pp. 733–8
Rider, Christine, “Oskar Lange’s Dissen
t from
Market Capitalism and State Sociali
sm,” in
Economics and its Discontents, ed.
Richard
P.F. Holt and Steven Pressman, Chelt
enham,
UK & Northampton, Massachusetts,
Edward
Elgar, 1998, pp. 165–82
Kowalik, Tadeusz, “Oskar Lange’s Ma
rket
Socialism,” Dissent, 38, 1 (Winter 19
91), pp.
86–95
Other references
Barone, Enrico, “The Ministry of Produ
ction in
the Collectivist State,” in Collectivi
st
Economic Planning, ed. F.A.Hayek,
London:
Routledge, 1935, pp. 245–90
Robbins, Lionel, The Great Depression, Lo
ndon:
Macmillan, 1934
Hayek, Friedrich A., “The Nature and Hist
ory of
the Problem,” in Collectivist Econo
mic
Planning, ed. F.A.Hayek, London, Routl
edge,
1935, pp.
WASSILY LEONTIEF (1906–99)
Wassily Leontief (pronounced LAY-yon-
TEE-
F) is best known for developing inpu
t-output
analysis. This technique, which descr economies expand, and how the inflat
ibes the ionary
interrelationships among the different process gets distributed and diffus
sectors ed
or industries of an economy, has a nu throughout the economy (Leontief 194
mber of 6). The
important applications and provides technique was also used by socialist econo
broad mies
insights into how economies work. and by developing economies after Worl
Input- d War
output analysis has been used to un
derstand 1
how production bottlenecks might ari
se when 45
WASSILY LEONTIEF Ph.D. A chance encounter in a Berlin cafe
with
II for constructing five-year econom Chinese visitors led to a job as consul
ic plans. tant and
Leontief was born into an educ advisor to the Minister of Railways i
ated and n China.
wealthy family in St Petersburg, In this capacity Leontief spent a year trav
Russia in eling
1906. His father taught labor econom through China collecting data to help
ics at the plan the
University of St Petersburg, and his moth Chinese railway network. This work
er was provided
an art historian. Somewhat of a chil the insights about
d prodigy, economic
Leontief entered the university whe interrelationships, and the opportunity
n only 15 to map
years old. There he studied philo out these relationships using real wor
sophy, ld data.
sociology, and then economics. L In 1931, Leontief came to the
eontief United
frequently got into trouble for criti States. He worked first as a research
cizing the associate
new Communist government, and at the National Bureau of Economic
was jailed Research
several times while attending the un in New York, then for many years at
iversity. Harvard
In 1925, at the age of 18, Leontief re University. It was at Harvard in the 19
ceived 30s that
an MA in Social Science with th Leontief began developing his input
e title -output
“Learned Economist.” The Leontie model for the US economy. In the
f family decades
then left Russia because of their di since, he further refined and expand
fferences ed this
with the Communist government a model, and found many ways to use the m
nd settled odel
in Germany. Leontief enrolled at for studying real world economic pr
the oblems.
University of Berlin to continue hi Leontief left Harvard in 1975 to ass
s studies ume a
in economics, and in 1928 he rece position at the Institute of Economic Res
ived his earch
at New York University.
Over the years, Leontief receiv
ed many cited his work in input-output analysis
accolades and awards. In 1970, he
served as . This
President of the American Econ undoubtedly constitutes Leontief’s m
omic ajor
Association. In 1973 he was awar contribution to economics.
ded the Although the vision of the econom
Nobel Prize in economics. In seley as a
cting set of interrelated sectors, with one s
Leontief for this prize, the Nobel C ector
ommittee buying goods from other sectors, and
with
146
money flowing from sector to sector an
d back
again, was originally set forth by Ca
ntillon
and Quesnay, it was Leontief who put
these
relationships into mathematical terms
and
gathered the data necessary to constru
ct real
world input-output tables. It was also Leon
tief
who drew out the policy implications
of the
mathematical representation of the ec
onomy
that he developed. This tool allows an
analyst
to work out how the changes in any one
sector
or industry of the economy will affect
every
other sector or industry. Moreover, i
nput-
output analysis allows for comprehen
sive
government planning, something Leo
ntief
regarded as the next stage of capital
ist
development.
The major insight behind input-
output
analysis is that if an economy is to pr
oduce
more of one good, say automobiles, i
t will
need to be sure to have all of the inp
uts or
parts that are needed to build another car. Th
us
more tires, more hubcaps, more axles,
more
glass windows, more engines etc. wi
ll be car production.
required. In turn, producing each pa Labor inputs are easily handled in
rt will this
require other parts. Tires will requir framework. The workers who assem
e more ble
rubber, more machinery etc. Making automobiles are viewed as an input
things that
even more complicated, to produce requires other inputs. Workers will thus
more need
engines or hubcaps or axles the econo food, clothing, shelter, and yes, cars t
my will o get
need to produce more cars, since vehi them to and from work, if they are t
cles are o help
needed to transport parts and raw m produce cars. And what is true of th
aterials. ese
To produce the additional cars, of cour assembly workers is true of all other w
se, will orkers
require more of all the inputs necess in the economy.
ary for
window glass, and the extra car coul
d not be
Through extensive study of prod made. On the other hand, if all the inp
uts were
uction and produced in the required amounts, there
the technological needs of numero would
us US be just enough parts and materials av
industries, Leontief (1941) was a ailable to
ble to get one more car.
represent the technical production relat Input-output models are not m
ionships erely
for major industries in mathematical for technological relationships. They als
m. This o allow
accounting-like framework specified policy makers to determine the cons
all other equences
goods in the economy that were n of changing economic policy. For e
eeded to xample,
produce any particular good. This reduced government spending on d
gave efense
Leontief a large set of mathematical equ inevitably hurts the armament indust
ations, ry, their
one for each good produced in the suppliers, and all their suppliers’ sup
economy. pliers. In
With aid of a computer, Leontief w contrast, greater spending on infras
as able to tructure
solve this set of equations. His sol (such as roads, bridges, and railways)
ution told aids the
him how much more of all other goo construction industry, their suppliers, an
ds had to d their
be produced in order to get one mo suppliers’ suppliers. Putting these tw
re car. If o sets of
these other goods were not produced as changes together would allow the go
needed, vernment
production bottlenecks would arise to calculate the total impact of mil
; there itary
would be shortages of engines, or reconversion on different geographic
tires, or areas in
the country and on different indus WASSILY LEO
tries or NTIEF
sectors of the economy (see Leonti
ef 1961; intensive goods and import labor-
1965; 1986, Chs 9 and 10). intensive
Leontief (1986, Ch. 5, 6) demonstrat goods. The result has come to be known
ed how as the
input-output techniques could be us Leontief Paradox. Leontief’s finding
ed to test has led
economic theories when he studied to numerous efforts to revise trade the
US trade ory in
relations with other nations. Surpri order to account for these real world fi
singly, he ndings.
found that American exports used l Another real world application of
ess capital input-
and more labor in their productio output analysis stems from work Le
n than ontief
American imports. This contradicted tr (1977; 1986, Ch. 11, 12) did for the
aditional United
trade theory, which held that a cap Nations beginning in 1973. This wor
ital-rich k has
country (like the US) should expor attempted to develop a world input-
t capital- output
model that incorporates the environment
as an
“economic sector.” One can think of econo
mic
sectors producing not only their normal out
put,
such as cars, but also a number of pol
lutants.
Likewise, one can think of a polluti
on-
abatement sector, whose inputs are t
he
pollutants produced by other sectors.
This
sector destroys these pollutants and returns
the
environment to its original state or q
uality.
Leontief has used this model to stud
y the
environmental impact of expanding produ
ction
as well as the costs of economic growt
h with
limited additional environmental pollutio
n (i.e.
the inputs needed for the pollution-
abatement
sector).
From the 1940s to the 1960s there
was a
great deal of interest in input-output a
nalysis
worldwide. The development of the co
mputer
meant that increasingly complex and nning
realistic agencies and bureaucracies arose in
input-output models could be develo both
ped for developed countries and developing coun
every country. During World War tries,
II, and input-output models provided a simple
governments used input-output anal and
ysis to useful tool to assist in this endeavor.
determine which sectors of the econo However, during the 1970s interest in in
my were put-
likely to experience shortages, and to output analysis began to wane. First, the m
develop ood
policies that would expand production by at the time was shifting away from pl
these anning
sectors. Furthermore, after World War II na and back towards allowing the mark
tions et to
became interested in taking charge of their determine the pace and direction
own of
economic future rather than leaving i
t to the 1
whimsical forces of the market. Pla 47
WASSILY LEONTIEF changing. Input-output analysis, howeve
r, takes
development. Second, some limita these relationships as fixed.
tions of Besides input-output analysis, Leont
input-output analysis became app ief has
arent. also been concerned with the method
Because it is both difficult and ex ology of
pensive to economic science and the everyday
estimate all the actual input- practices
output of contemporary economists. Here Leont
relationships for a large, complex ief has
economy, shifted from being a model builder, i
national governments infrequently nterested
revise the in establishing empirical relationships, to
national input-output model. Cons being
equently, a sharp critic of professional practices. Hi
policy analysis using input-output tool s first
s would critique of the methodology of eco
rely on considerably out of date data (M nomics
arshall (Leontief 1937) attacked Keynes an
1989, p. 162). d his
Third and most important, in the real followers for constructing abstract, th
world, eoretical
growth and development has been models whose conclusion was alrea
associated dy built
with changes in technology and the into the premise of the model. Leontief felt
means of that
production. Technological improve without good empirical estimates of
ment has the way
meant that production can take place with an economy actually worked, such
fewer model
inputs (especially labor requiremen building, could shed no light on the
ts). That problems
means input— output relationships a facing real economies. The nature
re always of this
criticism is essentially that econo
mics has
ceased to be an empirical science a without bothering to ask whether or n
nd instead
has become too theoretical. ot the
In his Presidential address to the assumptions of these models were realistic.
American The
Economic Association, Leontief ( conclusions of these mathematical deri
1971) vations
continued his criticism of how his cwere irrelevant, Leontief asserted, because
olleagues they
actually did economics. This tim began with assumptions that are not tr
e his ue (see
complaint was about the mathemalso SAMUELSON).
atical Leontief also criticized his fell
formalism dominating the econo ow
mics economists for performing sophistica
profession. He argued that econom ted
ists have statistical analysis on data of questio
become intrigued with developing nable
formal meaning and validity. More positively
models and then logically deduci , he
ng the recommended that economists devote
characteristics or properties of tha more
t model time and attention to gathering data and
spend
148
less time developing sophisticated te
sting
techniques. Finally, Leontief argued
that
economic relationships, unlike relationshi
ps in
the physical sciences, change over time bec
ause
the individual behaviors on which t
hese
relationships depend, also chan
ge.
Econometric testing, which assumes
that
economic relationships always stay the
same,
is therefore misplaced, and helps disgu
ise the
weaknesses in the data sets and the fa
ct that
economic relationships do change ove
r time.
This argument anticipates the Lucas
Critique
of macroeconomic model building (se
e also
LUCAS).
In an even more positive vein, Leont
ief has
urged economists to engage in the so
rt of
“systematic fact-finding, traditionally im
posed disciplines can therefore teach econo
on and accepted by their colleagues mists a
in the great deal about the use and importance of d
natural and historical sciences” (1983, ata
p. viii). collection and theory testing.
He has also called for economists to While similar criticisms have been mad
be more e by
interdisciplinary—by studying and others about the everyday practices
working of
with sociologists, engineers, and man economists (see Mayer 1993), none of
agement these
scientists. These areas give more va critics has the prestige of Leontief or the bro
lue to ad
empirical and practical work, and t experience that comes from years of
heir doing
practitioners are knowledgeable and s empirical economics. Unfortunately, t
killed in hese
data gathering and analysis. These criticisms have fallen on deaf ears wit
other hin the
Quarterly
Journal of Economics 51, 1 (1937), pp.
economics profession. Even worse, 337–
51
much of The Structure of the American Econ
the profession remains unaware of t omy, 1919–
his line of 1929: An Empirical Application
criticism coming from such a pres of
tigious Equilibrium Analysis, Cambridge,
figure. Harvard
The one unifying theme in all of University Press, 1941
Leontief’s “Wages, Profits, and Prices,” Quarterly
work is that economics should be an Journal
empirical of Economics 61, 1 (1946), pp. 26–
and practical science, devoted to gatheri 39
ng data Studies in the Structure of the Ameri
and solving problems through the a can
pplication Economy, New York, Oxford Uni
of analytical tools to real world da versity
ta. Input- Press, 1953
output analysis is about seeing h “The Economic Effects of Disarma
ow the ment,”
economy really works, and usin Scientific American, 204, 4 (1961),
g that pp. 47–
knowledge to improve economic perfo 55 with M. Hoffenberg
rmance. “The Economic Impact-Industrial
Leontief’s methodological complai and
nt is that Regional— of an Arms Cut,” Re
economists are not doing this any m view of
ore. Economics and Statistics, 47, 3 (1
965), pp.
Works by Leontief 217–41, with others
“Theoretical Assumptions and Nonob
servable
“Implicit Theorizing: A Methodological Facts,” American Economic Revie
Criticism
w, 61
of the Neo-Cambridge School,”
(March 1971), pp. 1–7
The Future of the World Economy, NICHOLAS K
New York, ALDOR
Oxford University Press, 1977
“Foreword” in Why Economics Is Works about Leontief
Not Yet A
Science, ed. Alfred Eichner, Arm Cave, Martin, “Wassily Leontief: Input-
onk, M.E. Output
Sharpe, 1983, pp.vi–xi and Economic Planning” in Tw
Input-Output Economics (1966), 2nd elve
edn., New Contemporary Economists, ed. J.R.Sha
York, Oxford University Press, 19 kleton
86 and G. Locksley, New York, Wiley 19
81, pp.
160–82
Dorfman, Robert, “Wassily Leontie
f’s
Contributions to Economics,” Swedish
Journal
of Economics, 79 (1977), pp. 430–49
Marshall, James N., “Wassily Leontief 19
73,” in
Nobel Laureates in Economic Scie
nces: A
Biographical Dictionary, ed. Bernard S
.Katz,
New York and London, Garland Pub
lishing,
1989, pp. 160–73
Other references
Mayer, Thomas, Truth versus Precisio

n in
Economics, Hants, Edward Elgar, 199
3
NICHOLAS KALDOR (1908–86)
Nicholas Kaldor spent most of his c
areer
devising policies to improve econo
mic
performance. He argued for taxing spe
nding
rather than income, and taxes that w
ould
favor and spur production in the
manufacturing sector of develope
d
economies. Kaldor also opposed tig
ht
money policy as a means of control
ling
inflation; instead, he advocated polici
es to airly
control the wage-price spiral that c affluent surroundings and received a
aused n
inflationary pressures. excellent education. He attended a m
Kaldor was born in Budapest, H odel
ungary high school in Budapest that was fa
in 1908. His father was a criminal l mous
awyer for using the Socratic method of teac
and legal consultant; his mother camehing.
from
a wealthy family of businessmen
and 1
bankers. Kaldor thus grew up in f 49
NICHOLAS KALDOR Chancellor of the Exchequer from 1964–
8 and
Although his father wanted him again from 1974–6.
to study When he began teaching at Ca
law, Kaldor became interested in e mbridge,
conomics. Kaldor shifted from his early focu
In part, this stemmed from his int s on
erest in economic theory to a focus on economic p
politics; but he was also fascinated olicy.
by the He also rejected his earlier views
German hyperinflation of 1923, whi that
ch he had economies work best when left alon
witnessed first-hand while on vacati e by the
on in the government and adopted a more activist
Bavarian Alps. policy
In 1925 Kaldor enrolled at the orientation. In particular, he develope
University d several
of Berlin. Two years later he wen tax policies to improve overall eco
t to the nomic
London School of Economics (LS performance. Also, in the 1970s an
E), where d early
he studied under Friedrich Hayek. Gra 1980s Kaldor advocated active gov
duating ernment
in 1930, Kaldor accepted a teaching j intervention to control price inflation
ob at the .
LSE but left in 1947 to become Di In 1951 Kaldor was appointed to
rector of a Royal
the Research and Planning Divisio Commission on the Taxation of Pro
n for the fits and
European Economic Commission. Income. This committee was charge
Kaldor d with
returned to academia in 1949, acc examining the British tax system and
epting a making
position at King’s College in Cam recommendations for improving it.
bridge, Kaldor
home to the followers of Keynes. Th found himself in the opposition dur
roughout ing the
the 1950s and 1960s, Kaldor serv Commission hearings. He was also oppo
ed as an sed to
advisor to both British and for the main Commission recommendat
eign ions and
governments. He was a special advis wrote a lengthy minority report. This
or to the
was then
expanded into a book (Kaldor 19
55) that developing countries (advising
advanced a radical plan to tax spend
ing rather the
than income. Throughout the 1950 governments of India, Sri Lanka, Gu
s Kaldor yana,
(1960–80, Vols. 1 (Part 3), 7, 8) Turkey, Iran, Venezuela, and Ghana).
pushed Kaldor (1955) was opposed to the
expenditure taxation on both devel income
oped and tax for several reasons. First, income d
oes not
150
adequately measure the ability of an indivi
dual
to pay taxes. To cite just one glaring pr
oblem,
capital gains are taxed only when ass
ets get
sold; unrealized gains remain untaxed
with an
income tax. As a result, income from pr
operty
escapes taxation and the income tax
treats
wealthy individuals too leniently. Mor
eover,
the very wealthy have inherited most
of their
wealth and do not earn much additi
onal
income. Taxing income allows the
se
individuals to virtually escape taxation
.
Second, Kaldor noted serious eco
nomic
defects with the income tax. Because
interest
and profits are subject to taxation, the i
ncome
tax discourages the savings and investment
that
are required to receive such income.
In
addition, because returns to successfu
l risk-
taking get taxed at very high rates, i
ncome
taxation discourages this important eng
ine for
economic growth.
To remedy these problems, Kald
or
proposed converting the income tax int
o an
expenditure tax. One should think of
the
expenditure or consumption tax as a
n nd so
income tax that allows all new savi only spending gets taxed. Of course,
ngs to a tax
be deducted from taxable income. deduction for savings will cause ta
New x
savings can easily be measured as ad collections to fall unless higher tax rate
ditions s are
to stock portfolios and bank balance imposed. Also, to keep the income t
s. If a ax a
household dissaves, or uses its wea progressive tax despite large deduction
lth to s for
finance current spending, that hous savings by wealthy families, very hig
ehold h tax
would be taxed on its negative savin rates will have to be imposed for high
gs for levels
the year (which gets used for consum of consumption. Kaldor himself (195
ption). 5, p.
A “new savings” tax deduction all 241) suggested that the highest tax rat
ows e on
annual savings to escape taxation, a
ing
countries were reluctant to embrac
expenditures would have to be set e this
proposal. The two nations that Kald
above or did
100 percent, and possibly as high convince to follow his advice exper
as 300 ienced
percent. popular uprisings against the expen
The major benefit of moving diture
from tax. As a result, both countries (Indi
income to expenditure taxation is a and
that Sri Lanka) abandoned the expendit
savings would be encouraged. Peopl ure tax
e would soon after it was implemented (s
save more because spending wou ee
ld be Pressman 1995).
highly penalized by high taxes whil Following these failures, Kaldor
e saving took a
escapes taxation. More savings, in t new approach to tax policy. He sug
urn, will gested
lead to technological improveme that taxation should be structured t
nts, o help
productivity growth, greater incom particular industries or economic se
es, and ctors.
even more savings and investment. Kaldor wanted to develop Engl
Although Kaldor served as an e and’s
conomic more productive economic sectors,
advisor to two British Labour gover an
nments, idea that harkens back to Quesna
and as an advisor to several deve y’s
loping d i s t i n c t i o n b e t w e e n p r o d
countries, few countries followed u c t ive a n d
his tax unproductive economic sectors. Ka
policy prescription. Britain never ldor
adopted (1981) placed great emphasis on
an expenditure tax, and develop increasing returns to scale as a fact
or NICHOLAS K
c o n t r i bu t i n g t o e c o n o m i ALDOR
c g r ow t h .
Increasing returns means that as growth experiences of various devel
firms oped
produce more of some good, each countries (see Thirlwall 1983). First,
worker Kaldor
becomes more productive. Impro found a high correlation between eco
ved nomic
p r o d u c t iv i t y s p u r s b o t h growth and the growth of manufacturing ou
d o m e s t i c tput
expansion and greater competitiven for twelve industrial countries during the 19
ess in 50s
a global economy (Kaldor 1981). and 1960s. He argued that aggregate
Kaldor (1967) was convince growth
d that rates were dependent upon manufact
increasing returns ruled in the man uring
ufacturing growth rates (rather than vice versa), a
sector. His belief stemmed from three e nd that
mpirical this could be explained by increasing
regularities that he found when lookireturns
ng at the to scale in industrial activities.
Second, Kaldor found a high corr
elation
between productivity growth in the
manufacturing sector and the growth
of
manufacturing output. Here, he argue
d that
productivity growth in manufacturing
was
dependent on the growth of manufact
uring
output. When people want more manufact
ured
goods, the firms producing those goo
ds will
expand production. Due to economies of
scale,
productivity growth accelerates and co
sts fall
because of the greater demand for
manufactured goods.
Third, Kaldor found that the growth
of a
country’s manufacturing output wa
s
correlated with the growth of productiv
ity in
other economic sectors. He argued that
as the
manufacturing sector grows, it is abl
e to
absorb surplus agricultural labo
r.
Consequently, productivity and livin
g
standards rise in the agricultural secto
r. In and thriving manufacturing sector means r
addition, “industrialization tends t apid
o economic growth and rising standards of liv
accelerate the rate of change of tech ing.
nology, The policy conclusion that Kaldor dre
not just in one sector, but in the econ w from
omy as this analysis is that governments must
a whole” (Kaldor 1967, p. 23). He support
nce, domestic manufacturing industri
productivity rises in all economic s es.
ectors, Governments can do this through the
and living standards improve through direct
out the purchase of manufactured goods, or
nation. by
From these facts Kaldor conclud supporting manufacturing industries w
ed that ith tax
economic growth depends first and f
oremost 1
on the growth of an industrial sector. A hea 51
lthy
NICHOLAS KALDOR holds that changes in the supply of m
oney are
breaks, regulatory relief, and other the cause of higher prices. The way t
incentives o control
or assistance. inflation was to make sure the mone
A particular policy proposal that y supply
followed grows at a constant and slow rate, 3–5
from this analysis was the sele percent
ctive per year, which monetarists took to be
employment tax. Kaldor (1960–80, V the rate
ol. 7, pp. at which the economic output grows from
200–29; 1966, Ch. 7) proposed that year
firms in to year.
the service sector should be taxed b Kaldor (1982) raised several obj
ased upon ections
the number of workers they emplo against monetarism. First, he noted
yed. This that
would encourage according to the equation of excha
employment in nge,
manufacturing industries experie MV=PQ (see also FISHER), more money
ncing leads
increasing returns to scale and dis to greater inflation only if the velocity of m
courage oney
employment outside manufacturing (V) is stable. Kaldor denied that the
. velocity
During the 1970s, as inflation b of money was constant, and prod
ecame the uced
main economic problem in the world ec substantial empirical evidence to show ho
onomy, w the
Kaldor changed the focus of his att velocity of money changed over ti
ention and me and
policy efforts. But first he had to con differed from country to country.
tend with Second, Kaldor held that the dire
the rising tide of monetarism. ction of
Modern monetarism (see also FRIE causation was actually the reverse
DMAN) of that
claimed by the monetarists. For Kal
dor, a rise
in economic activity or a rise in pri Finally, Kaldor felt that slow money gro
ces causes
a rise in the money supply. In m wth
odern would create too much unemploymen
economies money is created when bank t. He
s make objected to the constant harping about infla
loans. When economic activity expa tion
nds, firms by monetarists. He noted that even fo
and individuals want to borrow mo r the
ney. It is monetarists themselves there are relatively
this borrowing that causes the mon few
ey supply costs to inflation, since inflation was
to rise. In contrast, when economi by
c activity definition a general rise in the price level. W
slows down, there is less demand for borhen
rowed all prices and all incomes go up by r
funds. As banks stop making new l oughly
oans, the the same proportion, there are only trivial c
money supply stops growing. osts
to the economy, essentially the time
152 and
expense of having to increase prices
(these
costs are sometimes called “menu ch
ange
costs”). Creating unemployment, on th
e other
hand, creates severe hardship for those
thrown
out of work. Advocating joblessness i
n order
to avoid the trivial costs of inflation,
as
monetarists did, was clearly a bad p
olicy
prescription.
Rejecting tight monetary policy to
control
inflation, Kaldor (1982, pp. 61–5) arg
ued for
an incomes policy to replace the curre
nt wage
bargaining system. According to Kal
dor,
inflation was not caused by too much
money,
but rather was caused by costs and
prices
pushing each other up in an endless
spiral.
Workers would demand pay increases t
o keep
their wages up in the face of higher prices. B
ut
higher wages means higher costs
for
businesses, which get passed on to co wage increases in line with producti
nsumers vity
in the form of higher prices, starting improvements (and thus not contribute to ri
another sing
cycle. costs); business, in turn, would agree
Kaldor suggested that government not to
get into raise prices.
the wage bargaining process in order Kaldor developed a name and reputatio
to stop n for
this inflationary spiral. It could do th himself by developing policy propos
is either als to
by freezing all wages and prices, or improve the market system by using econo
it could mic
get labor and business to sit down together incentives. If saving was good for the econo
and my
co-operate on keeping inflation under and spending was bad for the econom
control. y, then
Labor, for example, would agree to spending should be penalized through
keep its higher
JOHN K
ENNETH GALBRAITH
taxes. Likewise, if manufacturing p Industrial
roduction and Labor Relations, 1967
was good and a large service sect “The Irrelevance of Equilibrium Econ
or led to omics,”
slower growth, the government shou Economic Journal, 82 (December
ld tax the 1972), pp.
latter sector and provide tax break 1,237–55
s for the “The Role of Increasing Returns, Tec
former sector. This focus on deve hnical
loping Progress and Cumulative Causatio
economic policies to improve eco n in the
nomic Theory of International Trade and
outcomes makes Kaldor (along wi Economic
th Joan Growth,” Economie Appliqué, 34,
Robinson) one of the founders of t 4 (1981),
he Post pp. 593–617
Keynesian School of Economics. The Scourge of Monetarism, Oxford,
Oxford
Works by Kaldor
Economics without Equilibrium, Arm
onk, New-
An Expenditure Tax, London, Allen York, M.E.Sharpe, 1985
& Unwin, “The Economics of the Selective Em
1955 ployment
Causes of the Slow Rate of Econo Tax,” in Collected Economic Essa
mic Growth of ys, Vol. 7,
the United Kingdom, Cambridge, pp. 200–29
Cambridge Collected Economic Essays, 8 vols.,
University Press, 1966. Reprinted New York,
in Kaldor Holmes & Meier, 1960–80
1960–80 , Vol. 5, pp. 100–38
Strategic Factors in Economic Dev
elopment, Works about Kaldor
Ithaca, New York State School of
Blaug, Mark, “Nicholas Kaldor 190 Pressman, Steven, “The Feasibility of
8–86,” in An
Pioneers of Modern Economics Expenditure Tax,” International Jo
in Britain, urnal of
Vol. 2, ed. David Greenway an Social Economics, 22, 8 (1995), pp. 3
d John –15
R.Presley, New York, St. Martin’ Thirlwall, Anthony P., “A Plain Man’s G
s Press, uide to
1989, pp. 68–95 Kaldor’s Growth Laws,” Journal o
f Post
Keynesian Economics, 5, 3 (Spring 1983
), pp.
345–58
Thirlwall, Anthony P., Nicholas Kaldor
, New
York, New York University Press, 1987
Turner, Marjorie S. Nicholas Kaldor and the
Real
World, Armonk, NewYork, M.E.Sharpe,
1993
JOHN KENNETH GALBRAITH
(1908–)
The economics of John Kenneth Galbraith
has
had both a negative side and a positiv
e side.
On the negative side Galbraith has b
een a
gadfly, highly critical of traditional ec
onomic
theory. He has criticized economic the
ory for
assuming perfect competition and ignorin
g the
economic power accumulated by lar
ge
corporations. He has criticized politici
ans for
caving in to the power of large corpo
rations
rather than acting in the public interes
t. And
he has criticized his fellow economists as i
diot
savants, who can do sophisti
cated
mathematical analysis but fail to understan
d the
real economic world. On the positive
side,
Galbraith has emphasized the importa
nce of
bringing power and power relationshi
ps into ord was
economic analysis if we are goin undistinguished.
g to In 1926, Galbraith enrolled at On
understand how economies actually tario
work. Agricultural College to study agricult
Galbraith was born in Iona Station, ural
a small economics. He then did graduate wor
town on the northern shore of Lake k in
Erie, in agricultural economics at Berkeley. His
1908; and he grew up in Southern Ontario, Ph.D.
part thesis on the expenditures of California cou
of Scotch Canada. Galbraith (1981) regret nties
s that
his schooling was interrupted freque 1
ntly by 53
farm work and that his academic rec
“was without distinction…. The purpose Presidential campaign of Senator G
was to eorge
get the degree” (Galbraith 1981, p. 2 McGovern.
2). The economic work of Galbraith h
After receiving his degree Gal as been
braith concerned primarily with the questi
accepted a teaching job at Harvard on of
University. economic power. Galbraith has writte
He spent the rest of his academic n about
life at the tendency for firms to acquire ec
Harvard, although taking much ti onomic
me off to power, the consequences of this, and t
pursue his political interests. In 1 he need
941 he for government intervention to cou
became deputy administrator of the nter the
Office of power of business interests and ass
Price Administration, which gave hi ert the
m control public interest.
over the prices of most US goods u Galbraith (1967) argues that the i
ntil 1943. ndustrial
During the 1950s and 1960s Galbr sector of the US economy is not at all
aith was as it is
especially active in politics. He was an a portrayed in economics textbooks. W
dviser e do not
and speechwriter in the Presidential ca have competitive markets with a large
mpaigns number
of Adlai Stevenson and John Kennedy. I of firms subject to the will of the
n 1961 people.
Galbraith was made Ambassador t Rather, we have non-competitive mar
o India, a kets and
position he held until 1963 (see G large firms that control the market.
albraith Large,
1969). During 1968 he worked i monopolistic firms do not attempt to max
n the imize
Presidential campaign of Senator the profits of shareholders; rather, they at
Eugene tempt
McCarthy and during 1972 he work to make the market more reliable
ed in the and
predictable. market forces wherever they arise; t
Large firms plan because they m hey
ust plan. must attempt to control the market r
The market and the forces of com ather
petition than be controlled by it.
contain too much uncertainty for t The large corporation frees itself fr
he firm. om the
Investment in new technology is market in several ways. Through ver
very tical
costly; hence the firm cannot risk th integration it takes over suppliers and
at, after outlet
undertaking expensive investment, sources. By developing many diverse prod
there ucts,
will be no demand for the goods the firm can absorb the consequences
they of a
produce. To thrive, firms must eli drastic change in consumer tastes or
minate the
aversion of consumers to a particular p
154 roduct.
By spending money on advertising th
e firm
controls consumer tastes. Finally, lon
g-term
contracts between producers and sup
pliers
attempt to eliminate the uncertainty of
short-
term market fluctuations.
Traditional economic theory assum
es that
the firm is run by the owner. Galbraith
thinks
this view is severely antiquated. The firms t
hat
produce most of the goods and servic
es we
buy are run by professional managers.
Those
managers are the decision-makers for the f
irm,
whom Galbraith calls “the technostruc
ture.”
It is here that corporate power lie
s.
Professional managers have usurped
power
from the entrepreneurial owner becau
se the
important decisions of the large moder
n firm
require the technical and scientific knowle
dge
of many individuals. One person can
not be
familiar with all the aspects of engine
ering,
procurement, quality control, labor rel
ations,
and marketing necessary for doing b survival, growth, and technical virtuo
usiness. sity.
As group decision-making and tech Survival means a minimum amount of earni
nical ngs
expertise become more important, so that the independence of the deci
power sion-
passes from the individual owner to th makers can be maintained. Growth pr
e group events
that runs the firm. firing members of the technostructure as a c
But unlike owners, who have a ost-
vested saving measure. Growth also serves
interest in maximizing profits, profe the
ssional psychological needs of the technostru
managers gain little from profit maximiz cture—
ation. prestige comes from working for a larg
Rather, members of the technostructure well-
e desire known firm. Finally, technical virtuosity m
eans
JOHN K
ENNETH GALBRAITH
more jobs and promotions for memb re is no
ers of the primacy for goods produced by the
technostructure. business
Galbraith (1958) has also exam sector of the economy. Public goods
ined the may be
power held by large corporations equally important. Moreover, many
over of the
consumers. He has attacked the do goods produced by businesses are
ctrine of quite
consumer sovereignty, which holds frivolous and not of paramount imp
that ortance.
consumers know what they want Even the economic principle of di
and that minishing
businesses produce goods to meet marginal utility recognizes that as we co
consumer nsume
needs. This, Galbraith argues, runs more and more of the goods produce
counter to d by the
common sense and counter to what private sector we receive less and
we know less
occurs all the time in the real world satisfaction from each additional goo
. Demand d.
does not originate with the consu Years of favoring private product
mer; it is ion and
contrived for the consumer by the firm t neglecting the provision of public go
hrough ods have
advertising. Large firms have thus created a situation of private affluen
developed ce and
power over consumer spending. public squalor. A much-quoted pas
If consumers decide on their own sage
that they (Galbraith 1958, pp. 98f.) describe
want certain goods this would indi s this
cate some contrast:
primacy for the goods that businesses p The family which takes its mau
roduce. ve and
But since demand is contrived the cerise, air-conditioned, power-
steered and vaguely on the curious unevenness of
power-braked automobile out for a t their
our passes blessings.
through cities that are badly pave To redress this imbalance the state
d, made must
hideous by litter, blighted buildings, bill provide more public goods. Of necessi
boards, ty, this
and posts for wires that should long sinc will mean higher taxes. Funds must be diver
e have ted
been put underground. …They pic from private hands, where they will p
nic on urchase
exquisitely packaged food from a less needed commodities, to the public treas
portable ury,
icebox by a polluted stream and go on to where they will satisfy public needs.
spend Galbraith’s Presidential address to
the night at a park which is a menace the
to public American Economic Association (in
health and morals. Just before dozi Sharpe
ng off on 1973) criticized economists for ignoring p
an air mattress, beneath a nylon tent, ower
amid the relationships. Economic thinking rem
stench of decaying refuse, they ma oves
y reflect power from the realm of discourse by d
enying
its existence and by assuming that the
market
will mitigate the power of the firm. Y
et, the
most serious problems of modern soc
iety—
war, inequality, and environmental de
cay—
stem from power struggles betwe
en
corporations wanting growth and profi
ts, and
public concerns about economic securi
ty, the
environment, and the arms race. By i
gnoring
these power struggles, Galbraith clai
ms,
economics has become increasingly irrele
vant.
When important economic and social is
sues
are viewed as conflicts between two compe
ting
powers, the state comes to acquire an additi
onal
function. The state must side with the
public
purpose in order to counter the power
of the
large corporation. This theme gets de
veloped
further in Economics and the Public
Purpose
(Galbraith 1973), which argues that mage is
the US imaginary, benign or being eliminated. Fin
economy has become bifurcated. Larg ally,
e firms, large firms can influence the political
part of what Galbraith calls the “pl process
anning to their advantage.
system,” have acquired enormous ec In contrast, small firms are subject
onomic to the
power. They have the power to contro dictates of the market. They have li
l prices, ttle
and they have the resources to mold economic power and little ability to
public sway
opinion. Advertising by the large firm public opinion or the political process
equates . They
happiness with goods produced by theare thus at a competitive disadvantage r
private elative
sector of the economy. Advertising c
an also 1
urge the public that environmental da 55
to the planning system. The result i practical
s unequal solution is for the government to pre
economic development—the planni vent the
ng system market power of labor unions and th
produces too many goods and the e market
market power of large businesses from gen
system produces an inadequate su erating
pply of inflation.
goods. Most economists hold that the most ef
Power between the planning and the ficient
market way to allocate goods and services is t
systems must be made more equal o let the
according free market set prices and wages. On this v
to Galbraith. Income must be redistribut iew,
ed from government-administered pricing
the planning system to the market syste and
m. Price government interference in the labor
controls, minimum wage legisla market
tion, misallocates resources. Most econom
guaranteed minimum incomes, pr ists also
otective contend that controls create a need
tariffs, and support for small busin less
esses are bureaucracy to monitor compliance,
among the policies required. and that
For a long time Galbraith (195 they would require rationing of goo
2b) has ds. In
supported controls on wages and prices i contrast, A Theory of Price Control argu
n order es that
to control inflation. Controls are r oligopolistic firms do not take prices
equired that are
because inflation is caused primaril set in the market. Firms in the olig
y by the opolistic
pressures of higher incomes on pric sector of the economy are price make
es and of rs rather
higher prices on incomes. The only than price takers, and “it is relatively
easy to controlled only in the oligopolistic se
fix prices that are already fixed” ( ctor of
Galbraith the economy, since market power exis
1952b, p. 17). ts only
In imperfect markets there is a in this sector. Consequently, only a th
strong ousand
element of convention, with prices or so firms need to be monitored.
habitually And
set by a mark-up on costs of prodenforcement is assisted by the fact tha
uction. t large
Moreover, the mark-up itself is con oligopolistic firms are all in the public
ventional. eye.
Government controls on prices att Several themes stand out in the wo
empt to rk of
change conventions, thereby leading to Galbraith. First, large firms have subst
a more antial
desirable outcome—less inflation. M economic power, which they use t
onitoring o
price controls is made easier, acco dominate modern economies. Second,
rding to this
Galbraith, by the fact that prices n power encourages technologic
eed to be al
development and contributes important
156 ly to
economic well-being; hence, it is bett
er to
counter the power of the large firm th
an to
eliminate that power by breaking up
large
firms. Governments must therefore hel
p to
develop countervailing power in the p
rivate
sector of the economy through suppo
rting
labor unions and smaller competitiv
e
businesses. Finally, the government
must
itself counter the power of the larg
e
corporation by providing an adequat
e
supply of public goods, protecting t
he
environment, resisting the arms rac
e,
assuring employment and decent inc
omes
to all workers, and controlling prices.
Galbraith is certainly not an econo
mist’s
economist. In fact, many economists p
robably
would claim that Galbraith is not real
ly an
economist at all. Nonetheless, his wo
rk is dge,
important for its focus on economic power Massachusetts, Harvard University
and Press,
on the role of government policy as a mean 1952b
s to The Great Crash 1929, Boston, Massa
control that power. chusetts,
The Affluent Society, Boston, Massachu
Works by Galbraith setts,
American Capitalism, Boston, Massac The New Industrial State, New York,
husetts, New
Houghton Mifflin, 1952a American Library, 1967
A Theory of Price Control, Cambri
are that money matters and that fr
eedom
Ambassador’s Journal, NewYork, New matters. Money matters because only
changes
American in the money supply can affect eco
Library, 1969 nomic
Economics and the Public Purpose, activity. Money also matters because
New York, inflation
New American Library, 1973 results from too much money in the e
A Life in Our Times, Boston, Houg conomy.
hton Mifflin, Freedom matters because economies run
1981 better
when governments do not attempt t
Works about Galbraith o control
prices, exchange rates or entry into profes
sions.
Hession, Charles, John Kenneth Galbrait
And freedom is also important as a
h and His
n end in
Critics, New York, New America
itself.
n Library,
Friedman was born to poor Je
1972
wish
Reisman, David, Galbraith and
immigrants in Brooklyn, New York i
Market
n 1912.
Capitalism, New York, New York
His parents were immigrants from the
University
Austro-
Press, 1980
Hungarian Empire. Shortly after he
Sharpe, M.E., John Kenneth Galbr
was born,
aith and the
his parents moved to Rahway, New
Lower Economics, White Plains, Int
Jersey,
ernational
which is where Friedman grew up. At
Arts and Sciences Press, 1973
Rahway
Stanfield, James R., John Kenneth Galbr
High School, Friedman developed a
aith, New
love for
York, St Martin’s Press, 1996
mathematics and planned to be an i
nsurance
actuary. But while attending Rutgers
College
MILTON FRIEDMAN (1912–) (then a small private school and now
a large
The two main themes in the work of Frie
dman
MILTON FRI impose high entry barriers and reduc
EDMAN e the
supply of doctors—was regarded as
State University in New Jersey), he d highly
eveloped controversial and delayed the publica
an interest in economics, and decided to tion
major Friedman’s book.
in both economics and mathematics. After teaching briefly at the Unive
After receiving his bachelor’s de rsity of
gree in Minnesota, Friedman returned to the Unive
1933, Friedman went to the Univers rsity
ity of of Chicago in 1946, where, with Ge
Chicago to pursue graduate work in econo orge
mics. Stigler, he developed the Chicago Sch
However, a generous fellowship led ool of
him to Economics (Reder 1980). Regular Ne
transfer to Columbia University the f wsweek
ollowing columns from 1966 to 1984 (some of
year. When Friedman completed all his which
course are collected in Friedman 1975), a best
work at Columbia, he returned to the Unive selling
rsity economics book (Friedman 1962a), and
of Chicago, where he worked as a r a ten-
esearch part TV series (Friedman 1980), have
assistant to Henry Schultz. He then helped
went to make “Milton Friedman” a household name
work in Washington, first provid for
ing over thirty years
consumption statistics as part of Ro In 1967 Friedman became President
osevelt’s of the
New Deal administration and then workin American Economic Association, and i
g for n 1976
the National Bureau of Economic Resear he received the Nobel Prize in Economics.
ch. At The
the National Bureau, Friedman teamed up award committee singled out three asp
with ects of
Simon Kuznets to study the market Friedman’s work for special mention
for —his
independent professionals such as l study of the consumption function,
awyers, his
doctors and accountants. This study evenarguments about the difficulties and pr
tually oblems
became his Ph.D. dissertation from with employing stabilization policy, a
Columbia nd his
and a book (Friedman 1946). One fi contributions to monetary theory and
nding of history.
this work—that physicians earn high
salaries 1
because the medical profession was 57
able to
MILTON FRIEDMAN in California.
Among economists Friedman is
Friedman retired from Chicago in best
1977 to known for his crusade against the Ke
become a senior scholar at the Hoover I ynesian
nstitute revolution. This involved arguing a
gainst should fall, and the fraction saved
the use of stabilization policies to should
control rise, as incomes increased. Studies
either inflation or unemployment. of
For a income, consumption, and savings f
number of reasons, Friedman held th or the
at fiscal US done by Kuznets found this not
policy would not work and active to be
monetary true. The fraction of income saved
policy would worsen the business c has
ycle and stayed the same in the US over
lead to greater inflation. Friedman’ many
s work decades, despite large increases in in
on the consumption function, the come.
role of Recognizing that spending depe
money in the economy, and the nat nds on
ural rate expected future income helps explain thi
of unemployment all had the effe s fact.
ct of Whenever my income rises, I am li
countering the interventionist visi kely to
on of expect more pay increases in the futu
Keynes and his followers. It also su re. As a
pported result, I need to save less money now for fu
his own vision of an economy that f ture
unctions consumption.
best without outside interference
by 158
economic policy makers.
The simple theory of consump
tion,
outlined by Keynes, held that con
sumer
spending was mainly influenced by
current
income. Friedman’s alternative, kn
own as
the permanent income hypothesis, h
eld that
consumers geared spending to t
heir
expectations about income over a
longer
time period. Friedman (1957) pro
vided
substantial empirical support for
this
hypothesis. The hypothesis itself
also
allowed Friedman to solve a num
ber of
puzzles that stemmed from the si
mple
Keynesian consumption function.
One
implication of the simple Keynesian
theory
was that the fraction of income co
nsumed
activity. His argument for the importa
nce of
The permanent income hypothesi money stems from the quantity theory of m
oney
s also (MV=PQ), which holds that the amo
explains why some groups, such as unt of
small money in the economy (M) times the
business owners, sometimes save l number
arge of times each dollar is used in a year
fractions of their income and at othe to buy
r times goods (V) must equal economic outp
reduce their savings balances. This w ut sold
ould not during the year (PQ).
occur if savings depends on current In contrast to classical monetary th
income, eorists,
but is quite plausible if actual spending dep who took the velocity of money (V)
ends as
on average income over a number of institutionally determined (see also FI
years. SHER),
Furthermore, the permanent inc Friedman acknowledged that velocity
ome could
hypothesis has important policy impl depend on economic factors such as i
ications nterest
that contradict the policy prescriptiorates and expected inflation. In addit
ns of ion,
Keynes. Keynes advocated fiscal po Friedman recognized that people migh
licy to t want
generate additional spending and em to hold money for reasons other than
ployment buying
during a recession. But if attempts goods, namely for security or because
by the they
government to generate additional i thought that stock prices and other asset pri
ncomes ces
lead to little additional spending (b were likely to fall. However, empirical
ecause studies
people view their additional incom by Friedman (1963) found that these econo
e as mic
temporary rather than permanent), fiscal factors had only a small impact on velocity a
policy nd
will have little economic impact. that their impact tended to decline ove
In contrast to the emphasis on fisc r time.
al policy Since the velocity of money was rel
by Keynesian economists, Friedman atively
(1962, stable, it was the quantity of money
1963) argued that money and monetar that
y policy primarily affected the level of econo
play the major role in determining e mic
conomic activity.
un money
must be neutral and can have no ec
Going even further, Friedman h onomic
impact. More money would affect the
eld that level of
while money might be able to affect output with a lag of around 6 to 9 mo
economic nths. But
activity in the short run, in the long r 6 to 9 months after that, the impact o
f money epositors
would be only on prices. Thus, 12 to 18 m came running to banks to withdra
onths w their
after any increase in the money sup money, and finally raised interest rate
ply, prices s when
would start to rise and inflation would b Britain left the gold standard in Sep
ecome tember
a problem. While economists have tradi 1931. All these actions led to a shar
tionally p drop
distinguished cost-push from dema in the US money supply, reduced sp
nd-pull ending,
inflation, Friedman has argued that all in and created a Depression. Because
flation the
stems from too much demand for g central bank cannot be trusted to put t
oods, and he right
that there is too much demand when policy into effect, Friedman argues,
too much central
money gets created. banks should be forced to follow a m
Since inflation for Friedman is onetary
solely a rule rather than being allowed to con
monetary phenomenon, the only solutio tinually
n to the mismanage the money supply.
inflation problem must be to restrain the
growth
of the money supply. Towards thi
s end,
Friedman has proposed that the ce
ntral bank
be required to increase the supply
of money
by around 3 to 5 percent every year, the n
ormal
growth rate of the US economy. Th
is would
provide the needed money to pur
chase
additional goods, but not so much m
oney that
it would cause inflation.
Friedman (1963, 1992) showe
d that
monetary authorities have produ
ced
depressions, inflation, and other un
desirable
economic results through their mi
sguided
attempts to manage the money su
pply. He
blames the Great Depression on the
Federal
Reserve, showing how they first ti
ghtened
the money supply because of thei
r fears
about stock market speculation, th
en did
nothing from 1930 to 1931 when d
MILTON FRI pressure. Again, the solution is to tie the han
EDMAN ds
of central bankers and force them to i
Monetary policy frequently goes ncrease
wrong, the money supply by 3 to 5 percent ever
Friedman says, because of the long and var y year.
iable The natural rate of unemployme
lags between current economic probl nt was an
ems and idea that Friedman (1968) introduced
when any change in the money sup in his
ply will Presidential address to the American Econ
affect the economy. Friedman (1953, p omic
p. 144– Association. He held that there was
8) identifies three such lags. It will taan
ke time equilibrium rate of unemployment in
for the central bank to recognize th the
at an economy. Everyone will not always have a j
economic problem exists. It will take ob.
time to There will always be some people in b
actually change the money supply. An etween
d it will jobs, and new labor force entrants wi
take time for any change in the mone ll not
y supply immediately find work. The equilibri
to impact the economy. As a result of these l um or
ags, natural rate of unemployment, Fried
monetary policy is not likely to be of tman
he right suggested, depended upon various str
magnitude. Nor is it likely to be the riuctural
ght sort characteristics of the labor force and th
of policy, for by the time any policy e labor
starts to market that left some people without jo
affect the economy, the problem it bs. For
was example, the availability of unemplo
designed to address is no longer likely to e yment
xist. benefits and other social programs allow pe
Friedman (1962b) also claims that mo ople
netary to spend a longer period of time look
authorities are unduly influenced by ing for
fiscal work. Having a working spouse allo
authorities and the national Treasury. ws for
Central longer job searches. Any attempt to r
banks heads are appointed by the hea educe
d of the unemployment below the natural
government and approved by legislative b or
odies. equilibrium rate would soon generate
Whenever government officials want to e ever
xpand rising inflation, according to Friedma
the money supply and inflate the economy n. But
, the
central bank invariably caves in to p 1
olitical 59
MILTON FRIEDMAN o too will
production and employment. This e
with higher prices for goods, peopl ventually
e will be will lead to an economic contractio
able to buy less. As spending falls, s n and a
return to the natural rate. blames the stagflation of the 1970s o
The natural rate hypothesis also n the bad
challenged ideas about economic policy that cam
one very important idea from Key e out of
nesian Keynesian economics.
economics—the existence of a trade-off In the international realm, as well
between as in the
inflation and unemployment or the domestic realm, Friedman set his sights a
Phillips gainst
Curve (see also SAMUELSON). Fried Keynesian orthodoxy. Keynes, as we have
man held seen,
that there was no such trade-off in the favored fixed exchange rates rather
long run. than
Attempts to lower unemployment flexible exchange rates, and was res
would ponsible
generate higher inflation, yet une for helping set up a system of fixed
mployment exchange
would always return to the natural ra rates after World War II. In contrast, Fr
te. In the iedman
long run, therefore, the Phillips Curve wa (1953, pp. 157–203; 1967) argued that fl
s really exible
a vertical line at the natural r exchange rates were preferable to fix
ate of ed rates
unemployment. Policy makers could do on several grounds. First, with fixed
little or exchange
nothing to permanently lower unem rates, countries would have to use
ployment; monetary
but in a vain desire to reduce unem
ployment, 160
they would only increase inflation.
Taking this argument one step
further,
Friedman (1977) contended that h
igher
inflation would cause greater volatil
ity in the
inflation rate and thus lead to greater ec
onomic
uncertainty. This, he contended, mi
ght even
lead to a higher natural rate of unem
ployment.
Thus, not only was there no trade-
off between
inflation and unemployment, but the tw
o might
move together in the same direction. Ke
ynesian
attempts to lower the rate of unemploym
ent not
only would fail in their objective, and
not only
would contribute to inflation, but th
ey might
also have the perverse effect of in
creasing
unemployment. Friedman thus ulti
mately
ee the
value of their currency fall, and so f
policy to keep the national currency at its f oreign
goods would not become any cheaper.
ixed In addition to these many contribut
rate. Central banks would be forced t ions to
o create macroeconomics, Friedman has made
too much money in an attempt to buy several
foreign other important contributions to economic
currencies and maintain fixed exchan s. He
ge rates. was involved in one of the two m
In contrast, floating rates let mone ain
tary methodological or philosophical disputes i
authorities concentrate on monetary n the
policy history of economics (for details on th
without worrying about the value o e other
f the methodological dispute see also ME
national currency. NGER).
Second, Friedman argues that fleOne frequent criticism made about econo
xible mists
exchange rates help promote trade is that they always make unrealis
among tic
nations. With fixed rates, trade restr assumptions whenever they study the econ
ictions omy.
become a common response to trade prob And one favorite joke about econo
lems; mists
with flexible rates, the rate adjusts concerns several professionals strande
automatically in response to a trade d d on a
eficit. deserted island with many cans of fo
Finally, flexible exchange rates od, but
keep no way to open them up. After all th
inflation from being exported from one co e other
untry castaways fail to use their professional
to another. Under a system of fixed e know-
xchange how to open the cans, the economist
rates, countries experiencing inflation wi bravely
ll buy comes to the rescue: “Let’s assume we
more foreign-made goods because t have a
hey are can opener,” he proclaims.
cheaper. This will increase the spen In a controversial essay, Friedman
ding for (1953,
goods in other nations and will lead t pp. 3–43) defends this methodology and arg
o greater ues
inflation in other nations. With flexthat the realism of assumptions does not ma
ible tter
exchange rates, this would not hap in scientific analysis. According to Fri
pen. edman,
Countries experiencing inflation would s
ant thing,
according to Friedman, is whethe
all theory involves abstraction, and r the
implications of the theory are true;
so all the that is,
assumptions of a theory have to be whether the theory works and mak
, in one es good
sense, unrealistic. The only import predictions. If the theory is supporte
d by the transfer
data it does not matter whether the assu from the less well-off to the wealth
mptions y who
of the theory are completely accurat tend to live longer and therefore c
e. On the ollect
other hand, if data does not support t benefits for longer), and against gove
he theory, rnment
the theory has to be discarded even if it e support for higher education (becau
mploys se the
realistic assumptions. Although money primarily benefits those who
many are well
economists have raised objections a off). On the other hand, he has suppor
gainst this ted the
position, Boland (1979) has persuasivel all-volunteer army (Friedman 1975,
y made Ch. 8)
the case that Friedman was right in argui and has advocated that all parents b
ng that e given
theories are meant to be tools an vouchers and allowed to select the
d that school
economic assumptions can be unre where they will send their child
alistic as ren
long as they work well and help t (Friedman 1979, Ch. 4).
o predict
economic performance.
As noted earlier, Friedman’s wor
k has not
only been directed at fellow econo
mists. He
has also written extensively for a
larger
audience. This work has argued for
individual
freedom and against all forms of go
vernment
intervention in the economy. Friedman
(1962a,
1979) argues that capitalism is th
e best
economic system because it promotes
political
freedom, and because the market
can help
offset political power.
Friedman’s more popular writi
ngs have
also had a clear policy slant. He has
opposed
all government programs that are
obtrusive
to individual decision-making. Fri
edman
(1975) has argued against wage a
nd price
controls, against minimum wage
laws,
against social security (because it
breaks
down family bonds and is actually a
MILTON FRI s
EDMAN Essays in Positive Economics, Chicago
, Illinois,
Milton Friedman is the rare econ University of Chicago Press, 1953
omist Studies in the Quantity Theory of Money, Ch
who has managed to span two ver icago,
y Illinois, University of Chicago Press,
different worlds. On the one hand, 1956
he is A Theory of the Consumption Function, Prin
regarded a giant within the econo ceton,
mics New Jersey, Princeton University Press,
profession, and is one of the two or 1957
three Capitalism and Freedom, Chicago, Illi
most referenced and revered econo nois,
mic University of Chicago Press, 1962a
figures in the twentieth century. This “Should There Be an Independent Mo
work netary
has stressed the importance of mone Authority,” in In Search of A Mo
y and netary
the importance of markets to impr Constitution, ed. Leland B.Yeager, Camb
ove ridge,
economic well-being. At the same Massachusetts, Harvard University
time Press,
Friedman has written voluminously f 1962b
or the A Monetary History of the United Sta
general public. This work has stresse tes,
d the Princeton, New Jersey, Princeton Un
importance of individual decision- iversity
making Press, 1963, with Anna J.Schwartz
and freedom, and has made Friedma The Balance of Payments: Free Vers
n one us Flexible
of the two or three best known and Exchange Rates, Washington, D.C., Am
most erican
recognized economists of the late tw Enterprise Institute, 1967, with Ro
entieth bert
century. V.Roosa
“The Role of Monetary Policy,” Ameri
Works by Friedman can
Economic Review, 58 (1968), pp. 4–
17
Income from Independent Professiona
l Practice,
New York, National Bureau of Ec
onomic
Research, 1946, with Simon Kuznet 1
61
PAUL SAMUELSON Harcourt Brace Jovanovich, 1983
“Nobel Lecture: Inflation
There’s No Such Thing as a Free and
Lunch, Lasalle, Unemployment,” Journal of Polit
Illinois, Open Court, 1975. Repri ical
nted and Economy, 85 (1977), pp. 451–72
updated as Bright Promises, Perfor Free to Choose, New York, Avon, 19
mance: An 80, with
Economist’s Protest, San Diego & N Rose Friedman
ew York, Tyranny of the Status, New York, Sa
n Diego
and London, Harcourt Brace Jov
anovich, 162
1984, with Rose Friedman
Money Mischief: Episodes in Moneta
ry
History, New York, San Diego and
London,
Harcourt Brace Jovanovich, 1992
Works about Friedman
Burton, John, “Positively Milton Fri
edman,”
in J.R.Shackleton and G.Locksle
y (eds.)
Twelve Contemporary Economists
, London,
Butler, Eamonn, Milton Friedman: A
Guide to
His Economic Thought, New Y
ork,
Universe Books, 1985
Hirsch, Abraham and de Marchi, Neil,
Milton
Friedman: Economics in Theory
and
Practice, Ann Arbor, Michigan, Un
iversity
of Michigan Press, 1990
Walters, Alan, “Milton Friedman,”
The New
Palgrave: A Dictionary of Econ
omics, ed.
J. Eatwell, M.Migate and P.Newm
an, New
York, Stockton Press, 1987, pp. 4
22–7
Other references
Boland, Lawrence A., “A Critiqu
e of
Friedman’s Critics,” Journal of
Economic
Literature, 17 (June 1979), pp. 50
3–22
Reder, Melvin W., “Chicago Econo
mics:
Performance and Change,” Jour
nal of
Economics Literature, 20, 1 (Marc
h 1982),
pp. 1–38
his graduate education paid for; yet the
re was
PAUL SAMUELSON (1915–) a price to be paid. According to the fell
owship
rules he could not continue at the Uni
Paul Samuelson is a paradoxical figur
versity
e. More of Chicago. Samuelson chose to atte
than anyone else he bears responsibility fo nd
r the Harvard, which awarded him a Ph.D. i
mathematical bent of economics in t n 1941.
he late His doctoral dissertation (Samuelson
twentieth century.Yet Samuelson made a 1947b)
name is regarded by most economists as pr
for himself, and a great deal of mon oviding
ey, by the mathematical foundations
writing an immensely successful intr for
oductory contemporary economics.
economics textbook (Samuelson 194 Samuelson liked Harvard, and he
7a). Yet wanted
again, Samuelson has written on virtually the school to offer him a full-time te
every aching
area within economics. For someon position. But Harvard decided not to ke
e so ep him
mathematical, such breadth is both rema on. Determined to stay in Cambrid
rkable ge,
and unique. Samuelson accepted a position at t
Samuelson was born in 1915 in he
Gary, Massachusetts Institute of Technology
Indiana; but his parents soon move (MIT).
d to He remained at MIT for his entire professi
Chicago, so Samuelson was educate onal
d in the career, becoming a full professor at the
Chicago public school system. He then en age of
rolled 32. In 1947 Samuelson received the fir
at the University of Chicago. Intending to st John
major Bates Clark Medal from the Ameri
in mathematics, Samuelson took a c can
ourse in Economic Association, awarded annually t
economics and immediately recogni o the
zed how most promising economist under the age of
mathematics could revolutionize eco 40.
nomics. During 1951 he served as President o
As a result of winning a Social f the
Science Econometric Society, and during 196
Research Council Fellowship, Samuel 1 he
son had served as President of the American Econo
mic
derpinning
for economic ideas, believing that e
Association. In 1970 Samuelson wa conomic
theory without formalization was unsyst
s awarded ematic
the Nobel Prize in Economics. and unclear. Unlike Marshall, who f
In all his professional work, Sa elt that
muelson converting prose into mathematical e
sought to provide mathematical un quations
was a waste of time, Samuelson (19 be a virtue in science. He also showed
47b, p. 6) that the
held the reverse to be true— distinction between assumptions
converting and
mathematical equations into prose predictions is never very clear; what c
was ounts as
wasteful. Mathematical formalis an assumption and what counts a
m for s the
Samuelson clarified the nature of m consequence of some assumption is
odels and quite
arguments, and established the val arbitrary. The unrealistic assumption
idity of s praised
economic theories. Through the inf by Friedman could therefore be thou
luence of ght of as
Samuelson (1947b, 1958), econ unrealistic or false predictions derive
omic d from a
instruction at the graduate leve different set of assumptions. Fin
l has ally,
increasingly come to employ the t Samuelson pointed out that, accordin
ools and g to the
techniques of linear algebra plus d
ifferential
and integral calculus, and commu
nication
among economists has become inc
reasingly
mathematical.
Yet Samuelson has not supported
rigor for
the sake of rigor, or formalism for th
e sake of
formalism. Rather, he has look
ed at
mathematics as a tool. Mathematics illu
minates
arguments and proves economic theore
ms that
can be empirically tested.
Concern with the relevance and
testability
of economic theories underlied th
e
methodological dispute between S
amuelson
and Milton Friedman in the post-
war years.
Friedman (1953) had argued that th
e truth of
economic assumptions was unimpo
rtant; the
only thing that mattered was whet
her the
predictions made by these assumpt
ions were
correct. Samuelson (1963) responde
d that the
factual inaccuracy of assumptions co
uld never
PAUL SAM The five-volume Collected Scienti
UELSON fic
Papers of Samuelson (1966–77) cont
principles of logic, true premises ca ain
n only 388 essays written over a 50-year pe
produce true conclusions, but false priod,
remises and cover virtually every topic with
could produce both, and what one in
wants in economics. The papers in this volu
economics is true conclusions. me
Although this methodological di contain many substantive advances i
spute n
might seem abstract, important real economics. From this prolific output, t
world hree
issues were at stake. For years Fried areas stand out as being those whe
man had re
been using the model of a perfectly competSamuelson has made his mark the m
itive ost—
economy to argue that the absence consumer choice, international trade,
of any and
government intervention yields the macroeconomics.
best Samuelson’s work on consumer c
economic outcomes. In contrast, Sa hoice
muelson attempted to make the assumptions
was a proponent of Keynesian econo of
mics and microeconomics empirical and testable. It
had been advocating greater govern thus
ment followed from his methodological pre
intervention to improve economic ou cepts.
tcomes. Samuelson wanted to remove demand
The Friedman-Samuelson debate therefo theory
re was from the arena of psychological intros
not just about how to do economics, pection
but also and to get away from the untestable assumpt
about the justification for using gov ion
ernment that consumers maximized utility. He also
policy to improve economic perform saw
ance. In that the traditional theory of consumer beha
defending the assumption of per vior
fect was tautological. Consumers, by defi
competition Friedman was oppos nition,
ing bought the goods they wanted most;
government intervention; by arguing hence
that whatever consumers bought maximize
economic assumptions must be real d their
istic, utility.
Samuelson opened the door for Key
nesian 1
macroeconomic policies.
63
PAUL SAMUELSON ult can
very easily be circular, and in
Consequently, consumer behav many
ior is formulations undoubtedly is. Often
explained in terms of preferences, nothing
which are more is stated than the conclusion tha
in turn defined only by behavior. The res t people
behave as they behave, a theorem it is hard for people to migrate, and even if i
which has t is
no empirical implications, since it c hard for capital to move around the
ontains no world in
hypothesis and is consistent wit search of the highest rate of return, fr
h all ee trade
conceivable behavior, while refutabl will make the rewards going to fac
e by none tors of
(Samuelson 1947b, pp. 91–2). production in different countries mor
To escape from this circle, Sa e equal.
muelson Consider potato chips made almost entir
(1938) argued that observed con ely by
sumer hand. If wages in the US are much hi
spending could be used to reveal c gher than
onsumer wages in France, French workers will
preferences regarding the utility the be able
y received to make potato chips at lower cost. When t
from different goods. This data coul here
d then be is free trade between the US and France, Fr
used to test various assumptions ench
about potato chips will be exported and sol
consumer behavior. For example, d in the
economic US. This increased demand will incr
theory holds that consumer preferences ease the
will be
consistent and transitive. Consider a co 164
nsumer
faced with three goods costing th
e same
amount of money. If the consumer b
uys good
A rather than good B, and B rather
than good
C, then that the consumer should p
urchase A
rather than C. This is something that
could be
tested experimentally, and indeed
has been
tested. Most tests have found con
sumer
preferences to be consistent and transiti
ve, and
have thus confirmed the assum
ptions
economists make about consumer p
references
(see Caldwell 1982, pp. 150ff.).
A second area where Samuelson
has made
important contributions is internati
onal trade
theory. This work examined the e
conomic
consequences of free trade and prot
ectionism.
Samuelson (1948, 1949) showed th
at even if
showed that a tariff will increase the i
ncomes
price received by French potato chip of inputs used to a large extent in do
mestic
makers industries that compete with the foreig
and, according to the marginal pro n good
ductivity on which the tariff was placed. Howev
theory of distribution (see also CLARer, the
K), this tariff will reduce the incomes of everyone e
should raise the wages of French w lse.
orkers For example, a tariff on foreign auto
making potato chips. In contrast, A mobiles
merican will raise the price of foreign cars. This, in tu
potato chip makers, facing greater comp rn,
etition will raise the price of domestically pr
from abroad, will be forced to lower their pr oduced
ices cars, since higher prices for imports
and reduce workers’ wages. The wa spur
ges of greater demand for domestic cars. The grea
French and American workers thus t test
end to American beneficiaries of this tariff
become more equal due to free trade. will be
This result, which has come to b those factors of production or inputs used m
e known ost
as the “factor price equalization theore in automobile manufacturing. If auto
m,” has mobile
quite important policy implications production is capital intensive (i.e. if
for an it uses
increasingly global economy. relatively large amounts of machiner
One y),
consequence of the theorem is that fr business owners will gain; but everyo
ee trade ne else
arrangements between the US and will lose because of the higher car pric
Mexico es they
should tend to equalize the wages rec will have to pay. On the other hand
eived by , if
Mexican workers and by unskilled A automobile production uses a good d
merican eal of
workers. NAFTA should therefore tend to skilled labor, then skilled workers will
raise benefit
the wages of Mexican workers and l from the tariff at the expense of everyo
ower the ne else.
wages of American workers. Samuelson was also instrumental
The Samuelson-Stolper theorem in
examined bringing Keynesian economics to Am
the impact of imposing a tariff on erica.
some This was done, in part, through his p
imported good. Samuelson and Stolpe opular
r (1941)
economists and students Keynesian
notions
introductory economics textbook (S like the consumption function, the
multiplier,
amuelson and fiscal policy (see also KEYN
1947a), which introduced to Ame ES).
rican Samuelson also wrote many article
s for government programs and a sizeable
newspapers and magazines that ex tax cut.
plained Samuelson also made his own contrib
Keynes to the non-economist. And utions
he served to the development of Keynesian ec
as an economic advisor to Presidents K onomics.
ennedy Keynes showed that additional spendi
and Johnson, explaining to the ng has a
m the multiplied impact on the overall econ
importance of expansionary macro omy and
economic he held that investment was driven
policies to lower unemployment. by the
Within macroeconomic circles at expectations of businessmen. But Ke
the time ynes did
there was much debate about the not analyze the interactions betwee
relative n the
effectiveness of fiscal and monetar multiplier and business investment. Sam
y policies. uelson
Monetarists, led by Milton Friedma developed the notion of the accelerator t
n, argued o show
that only monetary policy could that as the economy expanded busi
affect nesses’
economic performance. They look decision-makers would become
ed upon more
fiscal policy as a circuitous route to have
banks
create more money. On the other si
de of the
debate, Keynesians like John Ke
nneth
Galbraith described monetary poli
cy as a
string; no matter how hard we pus
h on this
string, they argued, we could not cr
eate more
jobs. Samuelson adopted a middle
position,
insisting that both fiscal and monetary
policies
would be effective in expanding t
he US
economy and arguing that both polic
ies had to
be used for stabilization purposes.
He also
adopted a middle position regarding
the form
that expansionary fiscal policy sho
uld take.
While Galbraith pressured President
Kennedy
to increase government spending, a
nd while
conservative Keynesians urged ta
x cuts,
Samuelson argued for both an exp
ansion of
PAUL SAM increases and unemployment in Great
UELSON Britain,
found that small increases in money
optimistic and would accelerate, or i wages
ncrease, were associated with high rates of
their investment spending. unemployment and vice versa. Samuelson
Samuelson (1939a, 1939b) formal and
ized the Solow reasoned that since wages were a m
accelerator notion and derived mathema ajor
tically component of costs (60 to 70 percent fo
the combined economic impact of r most
the developed countries) and since higher cost
multiplier and accelerator processes— s get
with the reflected in higher prices, the rate of i
multiplier expanding output, and nflation
with should also be inversely related to t
expanding output leading to impro he
ved unemployment rate. The higher the r
expectations, more investment, and ate of
a new inflation, the lower the rate of unempl
multiplier process. He also demonstr oyment;
ated the and the lower the inflation rate, the hig
formal conditions under which the m her the
ultiplier- rate of unemployment would be. Loo
accelerator process would lead to ecking at
onomic US data from 1933 to 1958, Samuels
instability (either too much growth or to a s on and
harp Solow indeed found such a trade-off,
decline in economic activity as less and in
spending honor of Phillips, named it “the Phil
reduced the desire of business firms to lips
invest). Curve.”
Finally, he drew out the policy implica Samuelson regarded the Phillips Cur
tions of ve as a
the accelerator— because it made the eco tool that could identify the policy op
nomy tions
more unstable, government interventavailable to government officials. If co
ion to ncerned
stabilize the economy was needed eve about unemployment, macroeconomic
n more. policy
In another contribution to Keyn could expand the economy; but this wou
esian ld also
macroeconomics, Samuelson (1960) move the economy along its Phillips Cur
and his ve and
MIT colleague Robert Solow develo lead to a higher rate of inflation. On th
ped the e other
famous Phillips Curve relationship.
A.W. 1
Phillips (1958), in an extensive study 65
of wage
PAUL SAMUELSON at the cost of higher unemployment. Good p
olicy
hand, if policy makers were conce making thus became a job of selecting
rned with the best
inflation, they could slow down the econo point on the Phillips Curve, or making
my, but the best
of the given inflation-unemployment pp. 786–
trade-off. 97
As Linbeck (1970, p. 353) has “Protection and Real Wages,” Revie
noted, w of
Samuelson “set the style” for prof Economic Studies, 9 (November 19
essional 41), pp.
economic discourse in the last hal 58–73, with Wolfgang Stolper
f of the Economics, 1st edn., New York, McGra
twentieth century. But Samuelson al w Hill,
so made 1947a; 15th edn. with William D.N
many substantive, technical contrib ordhaus
utions as and Michael J.Mandel, New York,
well, and he made them in virtually ever McGraw
y area Hill, 1995
of economics. His most Foundations of Economic Analysis, Ca
important mbridge,
contributions have been in the ar Harvard University Press, 1947b
eas of
macroeconomics and international tra 166
de. They
have involved explaining how do
mestic
economies worked, how they were
impacted
by engaging in trade with other nati
ons, and
how economic policies could be u
sed to
improve economic performance. F
or very
many reasons, Samuelson became o
ne of the
two or three best-known and most
respected
economists during the last half o
f the
twentieth century.
Works by Samuelson
“A Note on the Pure Theory of Co
nsumer’s
Behavior,” Economica, 5 (Februa
ry 1938),
pp. 61–71
“Interactions between the Multiplier
Analysis
and the Principle of Acceleration,”
Review
of Economics and Statistics, 21 (
May
1939a), pp. 75–8
“A Synthesis of the Principle of Acc
eleration
and the Multiplier,” Journal of
Political
Economy, 47 (December 1939b),
York,
Holt, Rinehart and Winston, 1971, pp.
“International Trade and Equalisation o 111–
38
f Factor Brown, E.Cary and Solow, Robert M., eds
Prices,” Economic Journal, 58 (Jun . Paul
e 1948), Samuelson and Modern Economic
pp. 163–84 Theory,
Linear Programming and Economic New York, McGraw Hill, 1983
Analysis Feiwel, George (ed.) Samuelson an
(1958), with Robert Dorfman and d
Robert Neoclassical Economics, Boston,
Solow Massachusetts, Kluwer-Nijhoff, 198
“Analytical Aspects of Anti-Inflation P2
olicy,” Kendry, Andrian, “Paul Samuelson and
American Economic Review 50 (Ma the
y 1960), Scientific Awakening of Economics,
pp. 177–94 with Robert Solow ” in
“Problems of Methodology— Twelve Contemporary Economists, ed
Discussion,” .
American Economic Review 53 (Ma J.R.Shackleton and Gareth Locksley,
y 1963), New
pp. 231–6 York, Wiley, 1981, pp. 219–39
The Collected Scientific Papers of Pa Lindbeck, Assar, “Paul Anthony Samuel
ul son’s
A.Samuelson, 5 vols., Cambridge, Contribution to Economics,” Swedi
MIT sh
Press, 1966–77 Journal of Economics, 72, 4 (Dece
mber
Works about Samuelson 1970), pp. 342–54
Breit, William and Ransom, Roger L., Other references
“Paul A.
Samuelson—Economic Wunderkin Caldwell, Bruce, Beyond Positivism: E
d as conomic
Policy Maker,” in The Academic S Methodology in the Twentieth Cent
cribblers ury,
by W.Breit and R.L.Ransom, New London, Allen & Unwin, 1982
pp. 283–
300
Friedman, Milton, “The Methodology of
Positive
Economics” in Essays in Positive E FRANCO MODIGLIANI (1918–
conomics,
Chicago, University of Chicago Pr
)
ess, 1953,
pp. 3–43
Phillips, A.W., “The Relation Bet Franco Modigliani (pronounced m
ween
Unemployment and the Rate of o-DIG-
Change in LEE-yani) is best known for two inn
Money Wage Rates in the United ovations
Kingdom, in macroeconomics. To explain total con
1861–1957,” Economica, 25 (1958), sumer
spending, Modigliani developed the he United
life-cycle
theory of household savings and consu
mption.
To explain business investment, M
odigliani
helped formulate the famous Modiglia
ni-Miller
theorems. These theorems explain
why
corporate decisions about obtaining
funds for
investment, and about repaying in
vestors,
should not affect the market value of
a firm.
Modigliani was born in Rome, Italy i
n 1918
to Jewish parents. His father was a
doctor and
Modigliani, wanting to follow in hi
s father’s
footsteps, enrolled at the University
of Rome
to study medicine. Realizing that he
could not
stand the sight of blood, he decided
to switch
from the study of medicine to the study o
f law.
Finding the law curriculum relati
vely easy,
Modigliani earned extra money tr
anslating
economic articles from German into
Italian. A
national essay competition on pric
e control
sparked his interest because he had
previously
translated several articles on this
subject.
Modigliani entered the contest. Not
only did
the essay win first prize; the judges
were so
impressed with his essay that they tol
d him he
would make an excellent economist.
After receiving his law degree
in 1939
Modigliani decided to leave Italy,
primarily
because of the conflict between his beli
efs and
the Fascist government of Mussolin
i. After a
short stay in France, he arrived in t
FRANCO MOD as his most significant contributions.
IGLIANI Modigliani formulated the life-
cycle
States and enrolled in the social scien hypothesis with Richard Brumberg w
ce Ph.D. hile re-
program at the New School for S turning to Illinois following a confere
ocial nce on
Research. The New School was a re savings at the University of Minnes
fuge for ota.
intellectuals fleeing the tyranny of E Brumberg, a graduate student of Modiglia
urope in ni’s,
the 1930s and early 1940s, and became k died of a brain tumor shortly after their fam
nown ous
as a sort of “university in exile” (Rutkoff 19 paper (Modigliani & Brumberg 1954
86). a) was
While at the New School, Modiglia published; thus Modigliani (1963) was
ni came forced
under the influence of Jacob Marsch to develop and test the hypothesis on hi
ak, who s own.
taught him macroeconomic theory as The key assumption of the life-cycle th
well as eory
the importance of formulating testa is that rational individuals will try to keep th
ble eir
economic hypotheses. Modigliani ga level of consumption fairly constant from
ined his year
Ph.D. in 1944 and then taught econo to year. Personal income, of course, wi
mics for ll vary
several years at the New School. due to changing circumstances; in g
In 1949 Modigliani accepted a jo ood
b at the economic times people will make more mo
University of Illinois, and in 1952 he ney,
went to in bad economic times and during reti
the Carnegie Institute of Technology. rement
After people will earn much less. Even th
several visiting professorships in the late 1 ough
950s, income changes from year to year, people
Modigliani finally settled down at MI want
T, where to keep their lifestyle from changing every y
he taught from 1962 until his retire ear.
ment. In This requires that people gear th
1976 Modigliani was elected Presiden eir
t of the consumption to their expected lifetime inc
American Economic Association, and ome
in 1985 (or the expected average income over their li
he was awarded the Nobel Prize in Econo fe).
mics. They will thus save larger fractions o
The Nobel committee cited the life-f their
cycle
hypothesis and the Modigliani-Miller th 1
eorems 67
FRANCO MODIGLIANI is relatively low.
Supporting the work of Keynes,
income when they make relatively more the life-
money cycle hypothesis can explain why i
and will save little in years when the mproved
ir income expectations about future income will in
crease used to measure one part of expecte
consumption and poor expectations, or d future
worries earnings and will affect both hous
about the possibility of lay-offs, w ehold
ill reduce spending and savings behavior. Large
consumer spending. In the former case, changes
people in aggregate wealth (for example, a
spend more money now, believing they sharp
will be increase in stock prices or real estate
able to pay back any borrowing they values)
do in the will mean that people have more we
future (when their income is greater) alth and
. Also, in need to save less money for retireme
good times, people will spend more— nt.
believing The life-cycle hypothesis can also
that they do not need to save for the explain
proverbial why temporary policy changes will h
rainy day—because the future looks ave little
so good. impact on either spending or overall eco
In contrast, when people expect e nomic
conomic activity. A temporary change in taxat
problems in the future, they spend less an ion may
d save have a large impact on current incom
more now so that they have money e, but it
in reserve will have little impact on lifetime i
in case they are laid off from their jo ncome.
bs.
One important implication of the 168
life-cycle
hypothesis is that economic growth is th
e main
determinant of the national savings rate.
When
the economy is growing rapidly people
will do
not feel the need to save for the fut
ure, since
incomes will be greater in the futur
e. Savings
rates thus plummet. In contrast, when i
ncomes
and economic output grow slowly, peopl
e must
save more money out of their inc
ome and
savings rates are higher.
A second implication of the lif
e-cycle
theory is that wealth needs to be c
onsidered
when attempting to explain and p
redict
consumer spending. For any person,
the value
of wealth is nothing but the future
returns
expected from that wealth. Thus wealth
can be
theory
of finance. Finance studies the decisi
Therefore, temporary changes in taxons
made by business firms about borro
ation wing
should affect consumer spending ver money to undertake investment as w
y little. ell as
The 1968 tax surcharge in the US p decisions about repaying investors. I
rovides n
considerable support for this view ( general, the chief financial officer o
Springer f a
1975). Contrary to the expectations corporation must decide whether to fi
of many nance
economists at the time, this tax increinvestment by borrowing (debt financi
ase did ng) or
not reduce spending by much and did by printing up stock certificates and all
not help owing
reduce inflation. The life-cycle view, ho investors to own part of the company (
wever, equity
predicts that this tax surcharge shoul financing). Financial officers must al
d have so
virtually no impact on spending, pr decide whether to pay all earnings
ecisely to
because it was temporary and theref shareholders in the form of dividends,
ore had or to
little effect on lifetime incomes. retain some earnings for emergencies
The life-cycle hypothesis remains and
a useful future expansion.
theoretical tool in macroeconomic a Modigliani and Miller (1958) showe
nalysis d that
because it allows economists to take (ignoring taxes and financial mark
factors et
such as wealth and expectations abo imperfections) the cost of capital for a
ut future firm
income into consideration when attem does not depend on its capital structu
pting to re or
explain and predict the consumption dec how the firm obtains money. In the 1
isions 950s,
made by households. It is for this rea most economists thought that there w
son that as an
when economists try to understand a optimal percentage of debt financing
ggregate that
consumption and savings behavior t firms should incur. Small amounts of
hey start debt
from the life-cycle theory. provided insufficient leveraging and
The second major innovation pi large
oneered amounts of debt led to difficulties rep
by Modigliani established the modern aying
r greater
risk; but with higher interest rates, fir
that debt. High debt levels increased ms were
less able to repay their debt.
the risk Modigliani and Miller showed t
of default, leading lenders to dem hat it
and a made no difference whether a firm us
greater return to compensate them fo ed debt
financing or equity financing, and t erential
hat there tax treatment) it should not matter w
was no optimal percentage of debt f hether
inancing profits are paid out in the form of di
for a firm. All investors, they noted vidends,
, carry a or get re-invested in the firm and
large portfolio of assets with variou paid to
s degrees investors in the form of capital gai
of risk. As a result, investors shoul ns and
d not be future dividend payments.
concerned if one portion of their Modigliani’s work in corporate
portfolio finance
becomes riskier because one firm has one important implication. Inst
relies ead of
heavily on debt financing. Even if i focusing on the financial structure o
nvestors f their
do become concerned about the ad firm, management should focus
ded risk on
of lending to one firm with a high d maximizing market value for exist
ebt ratio, ing
they can always compensate for t stockholders.
his by
adding low-risk investments like
bank
deposits or government bonds to th
eir total
investment portfolio.
In a latter paper, Modigliani an
d Miller
(1961) argued that corporate divi
dend
policy should not affect the valu
e of
corporate stock. As a result, the val
ue of a
corporation should be independent
of its
choice between retained earnings
and
paying dividends to shareholders.
Two
firms, identical in all respects except
for the
percentage of profits they pay o
ut as
dividends, should have the same
market
value. This, too, contradicted the be
liefs of
most economists in the 1950s, w
ho saw
corporate dividend policy as a sign
of future
expected profits, and thus as related
to stock
prices of the firm. Modigliani and
Miller
argued that (in the absence of diff
FRANCO MOD digliani
IGLIANI (1954b) responded to those objectin
g to
Modigliani has made se macroeconomic modeling and foreca
veral sting
contributions to economics that go b because individuals would react to a
eyond ny
these two key advances in consum forecasts, thereby immediately invalid
ption ating
theory and corporate finance. In the them. He thus provided a response to
1960s, what
Modigliani and other economists b has become known as the Lucas Critiq
egan ue. His
constructing large econometric mod response was that forecasters needed t
els of o take
the US economy. These models w into account the effect of any foreca
ere st on
mathematical equations expressing economic behavior. When this is done
the , and
relationships among the many parts included in macroeconomic models,
of the good
whole economy (see also TINBER forecasting is possible. One importa
GEN). nt
They allowed economists and policy implication of this work is that if eco
makers nomic
to determine the precise effects of forecasts are poor, it is the forecaster
any that
policy change or shock to the econom should be blamed rather than the be
y, and havior
they supported the use of Keynesi of people.
an Probably no economist is more
economic policies to fine tune the n responsible for extending Keynesia
ational n
economy. Macroeconomic models l macroeconomics than Modigliani. H
et e
economists figure out the amount that developed the contemporary theories
taxes of
must be cut in order to put the unem consumption and business investment
ployed , and
to work, or the decline in interest he developed the macroeconometric m
rates odels
required to spur needed investment that assisted in implementing Keyne
and sian
employment during a recession. economic policy. Virtually every aspe
Modigliani defended these models ct of
against
some very sharp criticism that has
been 1
raised against them. In particular, Mo 69
JAMES M.BUCHANAN
Works by Modigliani
contemporary macroeconomic anal
ysis has “Liquidity Preference and the Theory o
been improved by his insights and h f Interest
is work. and Money,” Econometrica, 12, 1
(January
1944), pp. 45–88
Works about Modigliani
“Utility Analysis and the Consumption F
unction:
An Interpretation of Cross-Section Bhattacharya, Sudipto, “Corporate Fin
Data,” in ance and
Post-Keynesian Economics, ed. K.K the Legacy of Miller and Modigliani,” J
.Kurihara, ournal
New Brunswick, Rutgers Univers of Economic Perspectives, 2, 4 (Fall 198
ity Press, 8), pp.
1954a, pp. 388–436, with Richard 135–47
Brumberg
“The Predictability of Economic Events,” 170
Journal
of Political Economy, 62 (1958b), pp.
465–78
with Emile Grunberg
“The Cost of Capital, Corporation Fi
nance and
The Theory of Investment,” Am
erican
Economic Review, 48, 3 (June 1958), p
p. 261–
97, with Merton Miller
“Dividend Policy, Growth, and the Va
luation of
Shares,” Journal of Business, 34,
4 (October
1961), pp. 411–33, with Merton M
iller
“Corporate Income Taxes and the Cost of
Capital:
A Correction,” American Econo
mic Review,
53 (1963), pp. 433–43
“The ‘Life Cycle’ Hypothesis of S
aving:
Aggregate Implications and Tests,”
American
Economic Review, 53, 1 (March 1963),
pp. 55–
84, with Albert Ando
“The Monetarist Controversy or, ShouldWe
Forsake
Stabilization Policies,” American
Economic
Review, 67, 1 (March 1977), pp. 1–19
The Debate Over Stabilization Policy, C
ambridge,
Cambridge University Press, 1986
“Ruminations on My Professional Life,” in
Lives of
the Laureates: Thirteen Nobel Ec
onomists, 3rd
edn., ed. William Breit and Roger
W.Spencer,
Cambridge, MIT Press, 1995, pp. 139–
64
gure in
Samuelson, Paul A., “The 1985 Nobel economics because of his role in dev
eloping
Prize in the field of public choice, which exam
Economics,” in Macroeconomics and ines the
Finance: linkages between economics and poli
Essays in Honor of Franco Mod tics.
igliani, ed. Buchanan has employed economic anal
Rudiger Dornbusch, Stanley Fischer, an ysis to
d John study politicians and political decision-
Bossons, Cambridge, MA and Lond making.
on, MIT At the same time he has stressed t
Press, 1987, pp. 29–35 hat
Seyedian, Mojtaba, “Franco Modigliani 1understanding the political process is impo
985,” in rtant
Nobel Laureates in Economic Sci for the study of economics.
ences: A Buchanan was born into a poor rural fa
Biographical Dictionary, ed. Bernar mily
d S.Katz, New in the village of Gum, Tennessee in 19
York, Garland Publishing, 1989, pp. 203– 19. His
17 grandfather was elected Governor of Tenne
ssee
in 1891 on the populist Farmers’ All
Other references iance
ticket. Buchanan (1992) credits his m
Rutkoff, Peter M., New School: A His other, a
tory of the voracious reader, with developing his acad
New School for Social Research, emic
New York, abilities through home instruction an
Free Press, 1986 d by
Springer, W.L., “Did the 1968 Surcharg helping him with his homework assig
e Really nments.
Work?,” American Economic Rev Buchanan planned to attend Vand
iew, 65, 4 erbilt
(September 1975), pp. 644–59 University and become a lawyer, but th
e Great
Depression destroyed these dreams.
Middle
JAMES M.BUCHANAN (1919–) Tennessee State Teacher’s College, in
nearby
Murfreesboro, was the only school he
James Buchanan is an important fi could
at the University of Chicago to pursue
a Ph.D.
afford. Buchanan majored in math in Economics. Had it not been fo
r his
ematics, experiences at officer training school
English literature, and social science, a in New
nd then York, Buchanan would have probably att
pursued graduate work in Economi ended
cs at the Columbia rather than Chicago. His feelin
University of Tennessee in Knox g that
ville. “the Eastern Establishment” discrim
Following a brief stint in the Navy, he en inated
rolled against outsiders (especially poor South
erners) ks to
led him to spurn Columbia in favor of C maximize utility, the public choice
hicago school
(Buchanan 1992, p. 4). holds that politicians and governm
In 1948 Buchanan received his ent
Ph.D. and bureaucrats should be viewed in the
a teaching job at the University of T same
ennessee. light. Political exchange, like econ
Since then he has held positions at omic
a number exchange, will be made with the exp
of US and European institutions i ectation
ncluding of gain.
UCLA, the University of California
at Santa
Barbara, the London School of Ec
onomics,
and Cambridge University. But Buc
hanan has
spent most of his adult life teaching
at three
schools in Virginia. From 1958 to
1969 he
taught at the University of Virgini
a and
established the Thomas Jefferson C
enter for
Political Economy there. From 1969
to 1983,
he taught at Virginia Polytechnic Inst
itute and
founded the Center for the Study
of Public
Choice. Then Buchanan moved his
center to
George Mason University, where
it has
remained ever since. In 1986, he wa
s awarded
the Nobel Prize in Economics, prim
arily for
changing the way that economists
study
government and politicians.
Buchanan’s major contributio
n to
economics is his role in developing
the area
of public choice, a study of exchang
e in the
political realm. Public choice emer
ged out
of the field of public finance, whic
h studies
the relationship between governme
nts and
individuals. Just as economists assu
me that
economic man is rational and see
JAMES M.BUC nor can
HANAN they promote the public good throu
gh
It is perhaps easiest to understa economic policy making.
nd the Radical subjectivism entails reject
significance of his economic contribu ing
tions by modern welfare economics (see also P
starting where Buchanan began, with IGOU),
Keynes. which seeks to improve national eco
Keynes, as we saw, argued that manomic
rket welfare by contributing to a more eff
economies frequently experience pr icient
oblems, allocation of resources. More import
and that economic policy tools should antly,
be used radical subjectivism entails rejecting Keyn
to remedy these problems. Buchanan esian
did not economics. Buchanan has been highly
dispute the fact that market econom critical
ies can of Keynesian economics (Buchanan
malfunction; in fact his personal exp and
eriences Wagner 1977; Buchanan, Burton, and
during the Great Depression suppor Wagner
t this 1978), claiming that bureaucrats are un
analysis. What Buchanan disputed able to
was the make choices that maximize anythin
policy solution advanced by Keynes. He d g for
enied society since the whole notion of maxi
that government officials can improv mizing
e upon benefits for society makes no sense.
market outcomes. His case consists To the
of two contrary, by attempting to promote the
parts—one philosophical and one ec public
onomic. good, governments restrict individual fre
Philosophically, Buchanan begins edom
from a and choice, and thus reduce the welfare
position of radical subjectivism—a b of its
elief that citizens.
only individuals can know what is g But there is also an important economic
ood for case
them and what benefits them. This perspeagainst government intervention. By expla
ctive ining
denies that any outside party or bod how economic forces affect policy m
y could akers,
determine objectively what is good for peBuchanan has shown how the desire t
ople. o make
In particular, governments and gove things better will likely fail and lead t
rnment o even
bureaucrats cannot distinguish what is goo
d for 1
society from what is bad for society;
71
JAMES M.BUCHANAN against traditional economic policy
making.
worse problems. This is the essenc Buchanan (1977) contends that K
e of the eynesian
public choice argument against Ke macroeconomic policy depends o
ynes and n the
assumption that policy makers will ernment
act in the according to Buchanan. Finally, beca
public interest rather than in their own i use of
nterest. its large size and scope, governme
But since all policy makers are h nt will
uman, face difficult and complex decisions.
Buchanan claims, they will behave Expert
like other economists will need to be hired, wh
human beings; they will attempt to o will
maximize point out instances of market failure
their own utility rather than beh as the
aving cause of particular
altruistically and enacting legislati problems and
on and recommend an even greater role
policies that are best for the whole nation. for
Thus, government.
politicians will act in ways that fur Going even further, Buchanan (
ther their 1980)
election (and continued employme identifies another sort of wastefulnes
nt) rather s that
than in ways that promote the welfar stems from big government and gove
e of their rnment
constituents. policy making. When government f
In addition, Buchanan notes orms a
that large part of the national economy,
politicians are unlikely to be draw any
n from
those who prefer a minimal role 172
for
government, for such people are unl
ikely to
be attracted to government service.
Rather,
politicians will be interested in s
ocial
engineering or in improving social
well-
being. This will require large budge
ts. Also,
politicians will need to be re-
elected
periodically. Control of large bud
gets
enables politicians to pass out the l
argesse
that improves their chances of ree
lection.
Likewise, unelected public employ
ees will
recommend and propose large bu
dgets,
since this will create jobs for them,
and also
give them more people to supervi
se and
greater incomes. The system is thus
biased
towards large budgets and large gov
economics has led politicians away f
rom
decision they make will have a large ibalanced budgets.
Buchanan (1958, 1977) has argu
mpact ed
on business firms. Firms will, of nec vigorously against government deficit
essity, s and
be extremely concerned with gover public debt. He contends that public de
nment ficits
policy and will try to influence po have many negative effects. They redu
licy ce the
makers. In their attempt to influen capital of the nation. When the gover
ce nment
government decisions, businesses sells bonds to finance its debt, it com
will petes
devote enormous resources to lobb with private sellers of debt and pushes u
ying p the
government officials. This takes awa cost of borrowing (interest rates). As a r
y from esult,
the resources that they could put in private investment declines. In the lon
to the g run,
production of goods. problems are even greater. A rising debt
Rather than a mechanism to im , with
prove rising interest burdens, increases th
economic performance, Buchanan ( e
1978) likelihood of a government default.
sees Keynesian economics as “a disea In
se that addition, Buchanan (1986) has argue
over the long run can prove fatal f d that
or the future generations suffer from the de
survival of democracy.” It leads ficit
to because they must pay higher taxes,
permanent government deficits and a whose
public burden is not offset by interest payme
debt that gets rationalized with the nts to
motto bond holders.
“we owe it to ourselves, so it is o As noted earlier, Buchanan does not
kay.” deny
Keynesian economics is also a dise that economic outcomes can be less
ase, than
according to Buchanan (1977, p. 4), ideal. In contrast to Keynes, howeve
because r, he
it has ended the moral restraint contends that sub-optimal outcomes al
on ways
politicians to behave in ways that arise because individuals cannot benefi
are t from
fiscally responsible; in particular Key trade. Government policies that furth
nesian er
beneficial
trade. This involves changing the rule
constrain individual action is thus s of the
economic game by finding instituti
not the onal,
solution. Rather, the solution must organizational or constitutional chang
involve es that
creating opportunities for mutually will allow such trade to flourish. Bu
chanan (Buchanan 1977, p. 159).
sees the political economist as some Constitutional rules are also imp
one who ortant
identifies rule changes and makes because they keep a bare majority
everyone of the
aware of the benefits that would foll nation from imposing costs on eve
ow from ryone
them. else. For example, a simple majorit
Thus, his solution to the probl y, by
ems of imposing higher taxes on others, c
excessive government is a “consti ould
tution benefit themselves at the expense of
revolution” (Buchanan and de Pierr a large
o 1969), minority. The way to prevent suc
which reassesses and changes the h a
rules of tyranny of the majority is to chang
government. Without constitutional e the
limits, rules, or the national constitution,
democratic governments expand to and
o much require that all tax increases be app
and become too intrusive. Constit roved
utional
constraints must be placed on gov
ernments
to keep them from trampling on in
dividual
rights, while at the same time cha
nneling
individual self-interest towards the
common
good. Frameworks, institutions or ru
les must
be developed that limit the abilit
y of
politicians to act in ways that adva
nce their
own interests but not the public int
erest.
One institutional change that B
uchanan
has long advocated is a constituti
onal
amendment for a balanced budge
t. He
believes that only through a chang
e in the
constitutional framework can fi
scal
responsibility and economic healt
h be
restored. “Just as an alcoholic might
embrace
Alcoholics Anonymous, so might
a nation
drunk on deficits and gorged wit
h
government embrace a balanced b
udget…”
JAMES M.BUC
HANAN Works by Buchanan
by large majorities (say, two-thirds Public Principles of Public Debt, Ho

of mewood,
elected representatives). Illinois, Richard D.Irwin, 1958
While other economists tend not t The Calculus of Consent: Logical Fou
o rate ndation
Buchanan highly (he does not have a of Constitutional Democracy, Ann
n Ivy Arbor,
League education and does not do h Michigan, University of Michigan
ighly Press,
mathematical economics), Buchanan 1962, with G. Tullock
has “Pragmatic Reform and Constitution
had a policy impact that goes far be al
yond Revolution,” Ethics, 17 (1969), pp. 9
that of any late twentieth-century 5–104,
economist, with the possible excepti with A.de Pierro
on of The Limits of Liberty: Between Anarchy an
Milton Friedman. Rising dissatisfac d the
tion Leviathan, Chicago, University of C
with government, public support fo hicago
r tax Press, 1975
reductions and reductions in governDemocracy in Deficit: The Political Le
ment gacy of
spending, and balanced bu Lord Keynes, New York, Academic
dget Press,
amendments can all be seen as inst 1977, with R.E.Wagner
ances The Consequences of Mr. Keynes, Inst
of the influence that Buchanan has h itute of
ad in Economic Affairs, 1978, with J.Burt
the policy arena. Nonetheless, his gr on &
eatest R.E. Wagner
contribution is undoubtedly the pu Essays on the Political Economy, Hon
blic olulu,
choice perspective, which has forc University of Hawaii Press, 1989
ed Better than Plowing and Other Personal E
economists to take a more comple ssays,
x and Chicago, University of Chicago Press
realistic view of political agents and , 1992
policy
makers.
1
73
DOUGLASS CECIL NORTH
Works about Buchanan acts and
Constitutions: The Political Econo
Atkinson, Anthony, “James M.Buch my of
anan’s James M.Buchanan,” in
Contributions to Economics,” Sc Twelve
andinavian Contemporary Economists,
Journal of Economics, 89, 1 (1987 ed.
), pp. 5–15 J.R.Shakleton and G.Locksley, Ne
Locksley, Gareth, “Individuals, Contr w York,
Wiley, 1981, pp. 33–52
Reisman, David, The Political Economy Long
of James Island. He attended college at the Un
Buchanan, London, Macmillan, 19 iversity
90 of California in Berkeley because his
Romer, Thomas, “On James Buch father
anan’s had been transferred to San Francis
Contributions to Public Economics,” co and
Journal North did not want to be far from his
of Economic Perspectives, 2, 4 ( family.
Fall 1988),
pp. 165–79
174
DOUGLASS CECIL NORTH (
1920–)
Douglass North has made contrib
utions to
three areas of economics. He has
brought
statistical methods to the study of
economic
history. He has examined and explained t
he role
of institutions in regulating human
behavior.
And he has attempted to understa
nd the
historical forces that make economi
es rich or
poor. These three lines of research are not
quite
as diverse as they might first appear. Nor
th has
explained economic growth in ter
ms of
adopting the right institutions. He has als
o used
statistical techniques to test his in
stitutional
theories about the causes of economi
c growth.
North was born in
Cambridge,
Massachusetts in 1920. His father, a
manager
for the Metropolitan Life Insura
nce
Company, was transferred frequentl
y while
North was growing up. As a result
, North
went to school in Connecticut, Ot
tawa,
Lausanne, New York City, and on
At Berkeley, North triple major which involves the application of mathema
ed in tical
political science, economics, and phil and statistical methods to the study
osophy. of
He seriously considered going to la economic history. Until the late twen
w school tieth
after graduation, but the start of World century, economic history was primar
War II ily a
put this plan on hold. North (1995, descriptive area within economics, o
p. 253) ne
claims that because of “the strong feel shunning statistical analysis. Consequ
ing that ently,
I did not want to kill anybody, I joi North and Fogel encountered great res
ned the istance
Merchant Marine.” Three years at sewhen, during the 1960s, they brou
a gave ght
North the opportunity to do a great mathematical methods to this field. B
deal of ut they
reading and reflecting, and he deci continued to push their project and eve
ded to ntually
become an economist rather than a la succeeded in revolutionizing the stud
wyer. y of
Returning to Berkeley after the waeconomy history. North and Fogel required
r, North that
received his Ph.D. in 1952, writi all work in economic history yield test
ng a able or
dissertation on the history of life insu refutable predictions, and that these predic
rance in tions
the United States. From the 1950s un actually be tested against an alternativ
til 1983 e, null
North taught at the University of Was hypothesis that some factor was not import
hington. ant.
He then became Professor of Econo This was to be done by gathering rel
mics and evant
History at Washington University in St historical data and then analyzing this data
. Louis. with
In 1993, North and Robert Fogel we the same statistical tools used by all
re made other
joint recipients of the Nobel Prize in Econ economists.
omic Some of the earliest cliometric wo
Science. rk by
In announcing this award the No North and Fogel studied the causes
bel Prize of
committee cited the pioneering work economic growth. North (1961) exami
of North ned the
and Fogel in the development of cli extent to which trade among the Sout
ometrics, h, the
DO
UGLASS CECIL NORTH
North and the West was responsibl North; ocean transport linking the N
e for US orth, and
economic growth. He argued that ad the South; and steamboats linking th
vances in e South
transportation (canals linking the West and the West) created three differen
and the t, yet
interrelated, economic regions of the U mpact of
S. Each these institutions on individual beha
area had a different specialization— vior and
the South economic performance, as well as the
produced cotton, the North becam reasons
e the that certain institutions come into exi
financial and manufacturing center, stence at
and the certain times in history. This line of
West specialized in animal skin an inquiry
d food makes North one of the founding fathers o
products. Furthermore, each area d f the
epended new institutionalist economics.
upon goods from the other two area Most economists take economic inst
s. itutions
North then performed a sort of and rules as given; for example, they
controlled assume
experiment. He tested the hypothe markets exist, but say nothing abo
sis that ut how
regional specialization led to faster markets develop and evolve. Institu
economic tions,
growth against the alternative hypot however, affect both economic perf
hesis that ormance
regional division was not responsi and the market because institutions are all
ble for about
growth. He found that the three d
ifferent
regions did tend to expand and c
ontract
together. Moreover, he found that t
his was
primarily due to the fact that grow
th in one
region led to demand for goods in
the other
regions.
North (1977, p. 192) later came to rec
ognize
that while cliometrics can test pr
oposed
explanations for historical change,
it cannot
provide any new explanations for
economic
growth. Another approach was th
erefore
necessary, and so he began to study instit
utions
and social rules. North (1990) de
fined
institutions as constraints devised b
y people
and imposed on their political, econ
omic and
social behavior; they include habi
ts and
customs as well as formal constraint
s such as
laws. He then tried to explain the i
human beings—how they interact w would wait and let others spend the m
ith one oney to
another and how they structure their make the new discoveries. But under
world. such
These institutions affect the costs of prod economic rules, everyone loses since v
ucing irtually
goods, the ability to sell goods, and no one engages in research and devel
thus opment
economic growth rates. spending and there will be few new discover
For North, institutions matter in ies.
three Second, institutions matter for N
critical ways. First, they establish prorth
operty because they must enforce the rules o
rights and economic incentives. Witho f the
ut some economic game. Here the state beco
agreement about who owns things, peopl mes an
e will important economic actor, an actor tha
not produce and will not attempt to t faces
better key trade-offs.
themselves economically. With property On the one hand, the state must n
rights ot let
come incentives to acquire new technolog people cheat and get away with cheati
y and ng. At
to employ more efficient production the simplest possible level, the state
methods. must
For example, without patent laws ther protect citizens and businesses from r
e would obbery
be little incentive for an individual or a and from extortion, for no one would
firm to work
spend money on research and devel and produce if their gains were likely
opment. to be
Those who had not invested so hea stolen by someone else. At a more co
vily in mplex
research and development would be level, the state must make sure that rul
able to es are
copy and cheaply reproduce any dis not broken that will harm econo
covery. mic
These copycats would gain from th performance. The state must ensure
e new that
discovery without paying the resear people do not cheat on their taxes, that
ch and firms
development costs needed to make do not conspire to raise prices and r
the educe
discovery. As a result, it would not pay for fi quality, and that firms do not engag
rms e in
to engage in research activities and
have 1
competitors merely copy the results; each 75
firm
DOUGLASS CECIL NORTH
deceptive or dangerous practices. S omic
uccessful incentives to work hard, which is a n
cheating by some will encourage ch ecessary
eating by ingredient for a successful, thriving e
others, and thus reduces the econ conomy.
On the other hand, monitorin correct
g and behavior. These factors, in turn, aff
enforcement costs rise as the state ect how
tries to people will react to different situati
prevent more and more cheating. ons. In
This will contrast to traditional economic theor
require higher taxes and lead to y, which
greater sees individuals as always acting ra
dissatisfaction with government m tionally
eddling in based upon their own self-interest,
private affairs. Consider the costs of North
ensuring (1994, p. 3) sees individuals as uncertain
that everyone complies with income about
tax laws. what to do and unclear about what is
If no one gets audited, many people will in their
cheat; own self-interest. Consequently, they fal
but if everyone gets audited, the c l back
ost to the on myths, ideologies, popular belie
government becomes extremely hig fs, and
h and the habits. For example, if workers believe th
public becomes extremely dissatisfied ey are
with the treated well, they will work hard a
tax laws. The state must walk a f nd be
ine line productive; if citizens believe in p
between allowing some cheating on olitical
taxes and democracy they will vote; and if people b
eliminating almost all cheating through elieve
greater
monitoring and higher taxes, whic 176
h itself
creates economic disincentives an
d slower
economic growth. This decision sho
uld create
an institutional framework or set o
f rules in
which businesses and people are mostly
honest
about paying the taxes they ow
e the
government. In more general t
erms,
governments must establish an environ
ment in
which most everyone plays by the
economic
rules, but the rules are not oppres
sive to
economic actors.
Third, institutions matter according t
o North
because they are closely related to
ideology,
or the psychological and social mak
e-up of an
economic community. Institutions
help
determine how people view fairness and
that the government guarantees the q rather than create goods and service
uality of s,
goods they will purchase more goods. Coneconomic growth will suffer.
trary Conversely, the right set of institutio
to Gary Becker, who believes that penaltie ns will
s and lead to greater economic growth and
rewards imposed on individuals are benefit
more everyone. North (1981, Ch. 5) argues
important than institutional ideology, that
North ideology or belief systems may red
holds that if people believe the eco uce
nomic undesirable behavior (like stealing)
system is fair, there is less chance thby
ey will imposing extra-legal penalties on thieves.
steal; and if people have faith in t As a
heir result, individuals will be less likely to
government they will be less likely to engage
cheat on in behaviors that undermine the foun
their taxes and more likely to vote. In dations
fact, for of the economic system.
North excessive penalties may incr One question frequently asked of
ease North is
undesirable behavior if people come to be why “inefficient” rules or institutions
lieve would
that the system is not fair and that pcontinue to exist. North (1981) has an
enalties swered
are far out of proportion to the seriou that political markets are inefficient.
sness of Special
crimes. interest groups have an incentive to o
As such, institutions are important be rganize
cause and get the government to pass favo
they can keep economies from reachi rable
ng their legislation; but since the loss to everyo
growth potential. This will occur wne else
hen from these benefits is small, they hav
institutions provide incentives to en e little
gage in incentive to organize and oppose spe
unproductive activities. If people v cial
iew interest groups. Voters have little incen
institutional rewards as arbitrary and tive to
unfair, be informed since there is really no chance t
and therefore fail to work hard, this w hat
ill slow one single vote will determine the outc
down economic growth. If firms l ome of
obby any selection. In addition, issues tend
government officials for special ben to be
efits,
candidates with charisma but no substanc
e, and
complex, which leads voters to ig for the status quo. This analysis als
o helps
nore the explain why voters are so dissatisfied
issues. As a result, ideology takes over with the
—people candidates they must continually vot
vote for simple but wrong-headed e for as
ideas, for well as the level of political campaig
ning. Institutional Change and American
The new institutionalism of North s Economic
traddles Growth, Cambridge, Cambridge U
both traditional economics and tra niversity
ditional Press, 1971, with Lance E.Davis
institutional economics (see also The Rise of the Western World: A New Ec
VEBLEN). onomic
Yet, it occupies an uneasy place relative to History, Cambridge, Cambridge U
both. niversity
The behavioral assumptions that Press, 1973, with Robert Paul Tho
North mas
employs are quite different fro “The New Economic History After T
m the wenty
assumptions made by most econo Years,” American Behavioral Scie
mists. For ntist, 21
North, individuals are socialized t (December 1977), pp. 187–200
o behave
according to rules, and these insti
tutional
constraints are an important influe
nce on
behavior. This view has made tra
ditional
economists uneasy with his work. On th
e other
hand, the work of North is highly q
uantitative
and formal. This had made tradi
tional
institutionalists skeptical of his wor
k.
Although he has caused unease
in many
corners, North has been a creativ
e and
pioneering economist. He is one
of few
twentieth-century economists who
has dared
to ask big questions like “what c
auses
economies to grow and decline?” A
nd he has
attempted to provide a big answer
to this
question, one that recognizes the
uneasy
relationship between social instituti
ons and
individual self-interest.
Works by North
The Economic Growth of the United Stat

es, 1790–
1860, New York, Prentice Hall, 196
1
KENNETH Js to
.ARROW Economics and Economic Histo
ry,”
Structure and Change in Economic Histor Scandinavian Journal of Economic
y, New s, 96, 2
York, W.W.Norton, 1981 (1994), pp. 185–93
Institutions, Institutional Change and Richard Sutch, “Douglass North and th
Economic e New
Performance, Cambridge, Cambri Economic History,” in Explorations in th
dge e New
University Press, 1990 Economic History, ed. Roger L.Ran
“Shared Mental Models: Ideologies som,
and Richard Sutch, and Gary M.Walton, New
Institutions,” Kyklos, 47, 1 (1994), York,
pp. 3–31, Academic Press, 1982, pp. 13–38
with Arthur T.Denzau
“Douglass C.North,” in Lives of the
Laureates:
Thirteen Nobel Economists, 3rd ed KENNETH J.ARROW (1921–)
n., ed.
William Breit and Roger W.Spe
ncer, Kenneth Arrow is best known as a theo
Cambridge, MIT Press, 1995, pp. 2
51–67
retical
economist with extremely broad and
diverse
Works about North interests. His many important contrib
utions
Goldin, Claudia, “Cliometrics and the have gone beyond economics proper, to inc
Nobel,” lude
Journal of Economic Perspectives, 9, 2 mathematical programming, social a
(Spring nd
1995), pp. 191–208 political philosophy, and health care.Yet Ar
Libecap, Gary D., “Douglass C.North,” row
in New is best known for two very techni
Horizons in Economic Thought: Appr cal
aisals of contributions—his impossibility theor
Leading Economists, ed. Warren J. em,
Samuels, which established social choice as a field wit
Hants, Edward Elgar, 1992, pp. 227 hin
–48
Johan Myhrman and Barry R.Wein 1
gast,
77
“Douglass C.North’s Contribution
KENNETH J.ARROW and read
rather than play outside with friend
economics, and his proof of the exi s. This
stence of presented a problem for his mother
general equilibrium. Arrow was bor when he
n in New misbehaved.
York City in 1921 to a middle-class
family of At first, she would send him to his r
Romanian-Jewish origins. A voraci
ous reader oom, but
as a child, soon realized that nothing suited
Arrow preferred to stay home Kenneth
better. He would trudge away with
a volume w to
of the encyclopedia under his arm enroll in the Ph.D. program in econ
and enjoy omics.
himself immensely. She then rev Arrow then became interested in th
ersed the
e logic
procedure: Kenneth’s punishment
was to be of social decisions. His dissertation,
sent out to play. Social
(Feiwel Choice and Individual Values (Arrow
1987, pp. 1951),
Through exposure to the wor was completed in 1951.
ks of
Bertrand Russell, Arrow developed i 178
nterests
in mathematics and mathematical l
ogic in
high school. He attended the City
College
of New York, mainly because it w
as free:
his father, whose business was hi
ghly
successful in the 1920s, had lost ev
erything
during the Depression of the 1930s.
At City
College Arrow studied mathematic
s, logic,
and statistics. He graduated in 19
40 with
the Gold Pell Medal, awarded f
or the
highest grades in the graduating cla
ss.
Arrow intended to be a high
school
teacher, but with no employment pr
ospects
he enrolled at Columbia University
to study
mathematical statistics with Har
old
Hotelling. Hotelling’s
course in
mathematical economics provided
Arrow
with his first exposure to economi
cs. In
1941, Arrow received an
MA in
mathematics and then went off to
serve in
World War II. After the war, he retu
rned to
Columbia to continue his studies
in
mathematics and statistics. Flaunt
ing a
fellowship, Hotelling enticed Arro
good C, must also prefer A to C.
Arrow proved that social choice, or
Upon completing his Ph.D., Arrow ac social
decision making, is not rational. In par
cepted ticular,
a position at Stanford University. Fo he demonstrated that the decisions m
ur years ade by
later he became a full professor there. In 1 groups of people will not necessarily
968, follow
he accepted a position at Harvard, but retu the transitivity principle. Consider, f
rned or
to Stanford in 1979. Arrow was awa example, the choices that have to be m
rded the ade by
Nobel Prize in Economic Science in a family. To keep things simple we a
1972. ssume
Arrow’s major contribution to ec three choices (A, B, and C). To keep
onomics things
is the proof of the impossibility theore concrete we can think of the choices a
m in his s three
doctoral dissertation. This contribut movies that a family considers rentin
ion g—
revolves around the notion of how gr Aladdin, Barney, and Cinderella. Thr
oups of ee
individuals, such as family members children have to choose among th
or the ese
owners of a firm, make decisions or alternatives; they cannot see all three
choose movies.
among alternatives. When analyzing indiEach child wants to maximize his or her utili
vidual ty.
choice, economists assume that each indi If all the children agree on which movi
vidual e they
is rational and can rank order the di want to see, there is no problem. Ho
fferent wever,
alternatives available to them (see many times this does not happen an
also d the
EDGEWORTH). Specifically, rationa children have different preferences am
l choice ong the
requires that individual preferences three movies.
among In particular, suppose that child #1
alternatives are consistent and transitive. prefers
To be Aladdin to Barney and Barney to Cin
consistent, an individual choosing good A derella;
over that child #2 prefers Barney to Cinderel
good B, cannot also choose good B o la and
ver good Cinderella to Aladdin; and that child #3 pre
A. For transitivity, an individual who fers
prefers a Cinderella to Aladdin and Aladdin to
good A to good B, and also prefers gooBarney.
d B to
arise when the children get together
and must
Each child has consistent and tra decide which movie to watch. Taken
together,
nsitive the three children together prefer Al
preferences, as defined above. But addin to
problems Barney since child #1 and child #3 bo
th prefer legislator
Aladdin to Barney. They also prefer #3 will vote for A over B. Then when
Barney to A goes
Cinderella, since child #1 and child up against C, C will win since legisl
#2 prefer ator # 1
Barney to Cinderella. The transitivity p and legislator #2 prefer C to A. But
rinciple suppose
requires that Aladdin is preferred to Cin we made the first choice A versus C.
derella. Now C
However, child #2 and child #3 wins since legislator #2 and legislator
prefer #3 will
Cinderella to Aladdin, thus violati vote for C over A. But B will win a
ng the gainst C,
transitivity principle. The implicati because of votes from legislators #1
on Arrow and #2.
drew from this analysis was that soc Finally, let B versus C be the first
ial choice choice.
could not be rational because it vi Legislators #1 and #2 both prefer B
olates the to C, so
transitivity principle. Put another they each vote for B. But when B c
way, it is omes up
impossible (hence, the “impossi for a vote against A, A will win bas
bility ed upon
theorem”) to derive a social or gro votes from legislator #1 and #3. Thus, the
up choice order
from individual preferences. Put ye in which bills (or candidates) get pres
t another ented to
way, “there cannot be a completely
consistent
meaning to collective rationality. W
e have at
some point a relation of pure power
” (Arrow
1974, p. 25). What this all means is t
hat while
economics can explain individual c
hoices, it
cannot explain group decision maki
ng.
Robert Paul Wolff (1970) has drawn
out the
implications of the impossibility th
eorem for
political philosophy. In the exampl
e given
above, if A, B, and C refer to diffe
rent bills
before the legislative branch, or d
ifferent
candidates for elected office (rath
er than
different movies), it turns out that th
e order in
which A, B, and C are presented will dete
rmine
the final outcome. If the first choice is A
versus
B, A will win since legislator #1 and
KENNETH Jget from different choices, and make
.ARROW rational
choices about consumption and work
voters ultimately determines the wi ; (3)
nner. Firms transform inputs into outputs usi
Winners are thus determined arbitraril ng the
y in the best technology available: and (4) Hou
political arena. Wolff argues that by r seholds
emoving receive profits from production.
the philosophical backing for demo Proving a general equilibrium exis
cratic ts also
decision making Arrow has inadver required two behavioral assumptions
tently and
provided a philosophical justificatio stipulated two conditions. The behav
n for ioral
political anarchism. assumptions are that firms maximize profits
A second major contribution by Arr and
ow was that individuals maximize utility. The
to prove mathematically that a gen two
eral conditionsArrow stipulated were that there c
equilibrium existed. As far back as Walr ould
as and be no negative prices, and that any good for wh
Pareto, and possibly as far back as ich
Quesnay, an excess supply existed had a price of zero (s
economists recognized the possibilitee
y of also VON NEUMANN). From all this,
describing equilibrium for an entire e Arrow
conomic was able to prove mathematically the e
system. Within this system, each market xistence
would of a competitive equilibrium; that is, he
clear at the equilibrium price for that showed
market. that there was a set of prices for all goo
What was missing from this vision was a p ds and
roof services such that the supply and demand
that there could actually be one se for all
t of goods and services were equal to one a
equilibrium prices to clear all mar nother.
kets The entire economic system thus could t
simultaneously. It is this proof that Arrow hus be
(and shown to exist in a state of equilibrium.
Debreu 1954; and Hahn 1971) set f While this proof will likely appear
orth in to be
mathematical terms. This proof requi abstract and pointless to the non-
red four economist, it
assumptions: (1) Households supply was important because it helped to co
labor nvince
services and consume goods; (2) Ho
useholds 1
know what they want, know the utility they
79
will
KENNETH J.ARROW not just some theoretical idea, but w
as a real
economists of the viability of ge possibility, and economies could be thou
neral ght of
equilibrium analysis. General equilibri as moving to this general equilibri
um was um.
Economists thus moved further away currency, but only for a few months i
from the nto the
partial equilibrium method of Mar future. For most goods there are no
shall, and future
began to study the impact of all e markets at all. Certainly, it would be
conomic hard to
changes on all markets in the econo find someone willing to sell me food
my. This or oil
proof was also important because it 10 years from now at some agreed
confirmed upon
for many economists the insight o price. The lack of future markets di
f Adam sturbed
Smith that the free market could Arrow and much of his subsequent
allocate work
resources efficiently and lead to a (1971, with Hahn) has attempted to s
highly how that
desirable outcome. If markets were a general equilibrium results still hel
llowed to d in a
operate without hindrance, all mark world without complete markets.
ets would The lack of complete markets has also
clear and consumers would maxim been
ize utility a theme of Arrow’s work in the econo
(given the resources they began wit mics of
h). health care. Arrow began with the obs
One important assumption mad ervation
e in the that health economics had to be stud
proof of general equilibrium was c ied from
ontained
in (2) above. For households to m 180
aximize
their utility, they have to know wh
ether to
buy various goods today or to wait
and buy
these goods in the future. This d
ecision
requires the existence of forward
markets.
Forward markets occur where we p
ay today
in order to obtain delivery of some
good(s)
in the future, or the promise of repa
yment in
the future. The simplest future mar
ket that
most people are familiar with is
the
certificate of deposit offered by ban
ks. Banks
take your money today and prom
ise to
deliver more money to you in the fu
ture. For
many goods, however, no future
markets
exist. Future markets exist for fo
reign
ociety.
A second problem in the health
the standpoint of uncertainty. This un care
market is what economists refer to
certainty as
leads to a less than perfect outcome “moral hazard.” The idea behind thi
in the s
health sector of an economy (Arrow notion is that insurance changes indiv
1983–5, idual
Vol. 6, Chs 3, 7,15). behavior. Fire insurance makes people
A first problem is that individuals less
do not careful around the home because they
have knowledge about the quality of cahave
re they insurance to pay the costs of any fire.
will receive from doctors, especially This
when attitude, though, will lead to more fi
specialists are involved. It is important res.
to find Similarly, people with health insurance
good doctors, since an incompetent docto are
r can more likely to behave in ways that inc
cost you your life. But finding good rease
doctors their risks of getting certain diseases
is timely and difficult for consumers. or
In such disabilities because their medical expe
cases, Arrow sees entry barriers as t nses
he only will be paid for by someone else. As a r
means to reduce uncertainty. Licen esult
sing of moral hazard, the demand for he
requirements guarantee to consumer alth
s that services will rise and health care spen
doctors have some medical training ding
and will soar. Arrow (1971) has shown tha
possess competence in medical matt t the
ers. In solution to the moral hazard problem i
contrast to Milton Friedman, who s co-
sees insurance, where individuals pay a l
licensing requirements as governm arge
ent- proportion of their health bill. When p
mandated monopoly power (which eople
reduces are forced to pay more for their hea
supply and increases prices) and who beli lth
eves problems, they will behave in less ri
that market forces would drive sky
out ways, have fewer health problems, a
incompetent doctors, Arrow views nd
an health care spending in the nation is br
unregulated medical market as a ga ought
me of under control.
Russian roulette that fails to benefit s
BA
RBARA R.BERGMANN
A final problem in the health care ma more about their own health than an
rket is y insurer
adverse selection. Naturally, individua does. Insurers can obtain additi
ls know onal
information, but only at great cost. equilibrium analysis, and the logic of
Moreover, a health
people who are great health risks, and wh care market that is plagued by uncertainty
o will . The
cost the insurance company more mone breadth of Arrow’s interests, and
y, have the
strong economic incentives to hide their penetrating insights that result whe
health never he
problems from the insurance co studies a specific problem, make hi
mpany m one of
(because this would entail greater the half dozen most important econ
insurance omists in
premiums). This uncertainty about the late twentieth century.
the health
risks of different individuals creates a p
roblem
for insurers. If insurance companies Works by Arrow
set rates
based upon average risks, high-risk grou Social Choice and Individual Values,
ps will New York,
purchase a lot of insurance and low-risk Wiley, 1951.
groups
will buy little or no insurance. The
insurance
company will therefore lose money
and have
to raise rates. But this will drive out even
more
low-risk groups. Premiums will co
ntinue to
rise, while more and more people wi
ll opt out
of insurance coverage. Arrow showed th
at these
problems disappear with a single-payer
system.
If everyone is covered by health ins
urance, no
one can attempt to provide plans that app
eal to
only low-risk groups and insurance co
mpanies
do not have to worry abut low-risk i
ndividuals
dropping out of the system and sig
nificantly
raising the average costs of insuring
people.
Rather than writing for the gene
ral public,
and rather than providing economic
advice to
politicians, Arrow has written primarily
for his
fellow economists. He has studied th
e logic of
group decision-making, the logic o
f general
“Existence of Equilibrium for a Com London, Macmillan, 1987
petitive Heller, Walter P., Starr, Ross M. and St
Economy,” Econometrica, 23 (July 195 arrett,
4), pp. David A. (eds.), Social Choice and
265–90, with G.Debreu Public
“Uncertainty and the Welfare Econom Decision Making: Essays in Honor of K
ics of enneth
Medical Care,” American Economi J.Arrow, 3 vols., Cambridge, Camb
c Review, ridge
53 (1963), pp. 941–69. Reprinted in University Press, 1986
Arrow ( von Weizsäcker, Carl Christian, “Kenneth Ar
1983–5 ) Vol. 6, pp. 15–50 row’s
Essays in the Theory of Risk-Bearing, Am Contribution to Economics,” Swedish J
sterdam ournal
and London, North-Holland; Chic of Economics, 74 (1972), pp. 488–
ago, 502
Markham, 1971.
General Competitive Analysis, San Fr
ancisco, Other references
Holden-Day, 1971, with F.H.Hahn
The Limits of Organization, New Yor Wolff, Robert Paul, In Defense of Anarchism,
k, Norton, New
1974. York, Harper & Row, 1970
Collected Papers, 6 vols., Cambridge,
Harvard
University Press, 1983–5
BARBARA R.BERGMANN (1927
Works about Arrow
–)
Breit, William and Spencer, Roger W. (eds.),
Lives Barbara Bergmann spent her career st
of the Laureates: Seven Nobel E
conomists,
udying
Cambridge, MIT Press, 1986 how labor markets work. These stud
Feiwel, George R. (ed.), Arrow and ies
the
Foundations of the Theory of Economi 1
c Policy,
81
BARBARA R.BERGMANN
examined the causes of unemploy poverty. To remedy these problems,
ment and she has
poverty as well as the potential cures advocated a strong affirmative action pr
for these ogram.
problems. They also examined wh Bergmann was born in New York
y women City in
receive such low wages. Bergmann 1927 and grew up in the Bronx. Her f
identified ather left
discrimination in the labor market, mai the family while Bergmann was still
nly due a child,
to excluding women from certain j instilling in her a strong belief that
obs, as a women
major cause of low wages for women and “should have their own money” (
child King,
forthcoming). But after receiving a and find out how economies actually
BA in work.
mathematics and economics from It is well known that female wor
Cornell in kers earn
1948, she could not get a job. At the sugg on average much less than male work
estion ers. Ever
of her mother, she enrolled at Tea since income data was first collected in the
cher’s late
College, Columbia University. One
year later 182
she accepted a job offer from the
Bureau of
Labor Statistics. Encouraged by the eco
nomists
at the Bureau to pursue graduate
study,
Bergmann was accepted by both Ha
rvard and
Cornell. She chose Harvard, and r
eceived a
Ph.D. in economics in 1959.
In the early 1960s, Bergmann s
pent two
years as a Senior Staff Economist o
n Council
of Economic Advisors and three ye
ars at the
Brookings Institution, a
prestigious
Washington think tank. From 1965 to 19
88 she
taught at the University of Maryla
nd before
being hired by the American Univ
ersity in
Washington, D.C., where she taught
until her
retirement. In the early 1970s she helped
found
the Eastern Economic Association and i
n 1974
she became its first President.
Bergmann has made two main contr
ibutions
to economics. First, she has argu
ed that
discrimination is a pervasive charac
teristic of
labor markets. Second, she has argu
ed against
the traditional economic methodol
ogy of
drawing conclusions from a set of
unrealistic
assumptions. Instead she has argu
ed that
economists need to go out into the r
eal world
nineteenth century, the numbers reve nurses; men are more likely to be b
aled that ank
full-time female employees in the Umanagers, while women are more likely
S earn to be
around 60 percent of full-time male empl bank tellers. Bergmann has pointed o
oyees ut that
(Smith & Ward 1984; Golden 1990). occupational segregation also frequently o
While ccurs
these facts are not in dispute, it is a within occupations. Consider food service
matter of jobs.
great contention why women earn so much “Men who wait tables generally wor
less k in
than men. Feminist economics (see expensive restaurants where the tips a
Ferber & re high
Nelson 1993) sees this pay different and no women are hired. Women tend to
ial as work
evidence of women’s second class e in the cheaper restaurants, with no
conomic male
status. It also seeks to understand th colleagues” (Bergmann 1996a, p. 42).
e causes Although the phenomenon of occu
of women’s inferior economic sta pational
tus. crowding or segregation was originally
Bergmann has been a pioneer of fe noticed
minist by Edgeworth (1922), it was Bergmann
economics; and she has identified e (1971,
xclusion, 1974) who first explained why s
or occupational segregation, as a m uch
ajor cause discrimination was prevalent. Accordi
of women’s low wages. Furthermore, ng to
she has standard economic theory, discrimination s
blamed the methodology of her fello hould
w labor be eliminated by the market because it
economists for failing to see this fact. is not
Occupational segregation involves profitable for firms to discriminate (s
keeping ee also
some jobs open primarily to women BECKER); non-discriminating firms pay l
while ower
excluding women from another set owages, earn higher profits and will eve
f jobs. ntually
Usually women get excluded from high- drive discriminating firms out of busine
paying ss.
jobs and are concentrated in relative Bergmann has pointed to substan
ly low- tial
paying jobs. For example, men compri evidence that the real world is not like the wor
se most ld
doctors, while women are more likel of standard economic theory. Court c
y to be ases
BA
RBARA R.BERGMANN
against large firms like Hertz, Pizza these firms have not been hurt throu
Hut, and gh lower
Chase Manhattan all demonstrate the e profits and they have not been drive
xistence n out of
of discrimination against women. business by their less bigoted com
However, petitors
(Bergmann 1986, p. 139). In ad wages for secretaries. Moreover, eve
dition, n when
traditional economic theory focuses women get offered non-secretarial jobs, the
primarily y will
on wage discrimination, or why tw receive meager pay offers since employers
o people know
with identical skills and abilities might b that their main option is likely to be a low-
e paid wage
different wages. It says little a secretarial job. In contrast, wages will be h
bout igher
discrimination that systematically in managerial jobs because, by exc
excludes luding
women from occupations paying r women from these positions, there will be
elatively fewer
high wages. job applicants and so greater incentive
Bergmann has also explained s will be
why firms necessary to attract workers.
discriminate against women and m To remedy the problem of occupation
inorities, al sex
and why they tend to hire white men segregation Bergmann (1996a) has a
at higher dvanced
wages. This explanation has focused a strong program of affirmative acti
on other on. She
employees rather than employers. For e
xample,
if white male workers feel uncom
fortable
having women or minorities as their
peers or
colleagues, they may not train them
and may
not assist them with difficult work
-related
problems. Or, morale problems (as a
result of
having to work with women) may l
ower the
productivity of white males. To av
oid these
possible “costs,” employers may deci
de not to
hire either women or minorities.
Going even further, Bergmann (
1971) has
explained how advantaged groups g
ain at the
expense of disadvantaged groups
due to
occupational segregation. If women can
only be
secretaries (and a few other things),
but cannot
hold managerial positions, there will
be more
job applicants for secretarial position
s than the
number of available jobs. This pus
hes down
notes that affirmative action is not ality or
meant to merit; judgments about quality are inh
remedy past wrongs; it is meant to d erently
eal with subjective and are affected by factors s
current practices. Discrimination cont uch as
inues to the gender, race and age of the candid
exist in the workplace today. Women ate. In
are paid many instances, there is not one unam
less than men, even after controlling biguous
for such best candidate for a job. In these ca
factors as education and experience ses,
levels. affirmative action says that firms shou
Occupational sex segregation also sh ld hire
ows that women and minorities.
women are currently discriminated a Bergmann has stressed that numerical
gainst in goals
the labor market. A final piece of evidence for affirmative action are important b
that ecause,
discrimination exists today comes f in the absence of such goals, firms will prom
rom ise
controlled experiments in which cl to do better but will not hire more wo
osely men or
matched pairs of individuals applied for aminorities. Only affirmative action wil
ctual l work
jobs. These studies found that both wome to end discrimination. The alternative,
n and legal
minorities were less likely than white action to prevent discrimination, is
males to both
progress in the hiring process (Elengthy and costly. In addition, indivi
EA duals
Symposium; Turner et al. 1991). discriminated against in the hiring proc
Bergmann (1996a) has argued th ess are
at the not in a position to know this or pro
benefits of affirmative action exceed t ve this.
he costs For example, job applicants can hard
of imposing this policy on business firms. ly be
One expected to know that all female can
important benefit is that affirmative action didates,
leads no matter what their qualifications, were de
to more qualified people being hire nied
d. This an interview for a particular position.
increases economic efficiency. Another Reinforcing her work in femin
benefit ist
from affirmative action is greater w economics, Bergmann has advocated t
orkplace he use
diversity. Moreover, Bergmann clai
ms that 1
there are many ways to measure qu 83
BARBARA R.BERGMANN
of alternative research methodolo 1974) criticized economists who sit
gies in in their
economics. Her Presidential addres ivory towers and maintain limited contac
s to the t with
Eastern Economic Association (Be the real world. These economists st
rgmann udy the
economy either through introspect ulations
ion or of labor markets. The basic idea be
through performing statistical tes hind this
ts of approach is to use the computer to
economic theories using data compil model
ed by the individual, firm, and government be
government. These methods, Berg havior in
mann response to various changes. But to do thi
claims, are inadequate because the s, we
y are too need to find out how workers respond
divorced from the real world and t to wage
herefore cuts and how firms respond when
cannot help understand how the re workers
al world demand higher wages. Only then is it
works. possible
The work of Robert Lucas pro to determine the impact of wage cha
vides one nges on
good illustration of this problem. employment.
Lucas has For example, interviewing worke
held that unemployment is the result of a rs who
choice have just been laid off would help ec
that people make about leisure and onomists
labor; we understand how these individuals thi
choose leisure over work wheneve nk about
r current
wages are too low. Bergmann (1989) 184
contends
that Lucas made a number of highly unr
ealistic
assumptions about the rationality o
f laid-off
workers and the way that labor mar
kets work
in order to reach this conclusion. Moreo
ver, he
failed to test any of these assumptio
ns.
In place of deducing the consequ
ences that
follow from unrealistic or false ass
umptions,
Bergmann (1973, 1990; and Bennett 19
86) has
advocated that economists go out into the
world
and begin collecting information. O
ne way to
do this is to actually survey people.
Another
approach would be to perform co
ntrolled
experiments, like those showing q
ualified
women and minorities do not progre
ss as well
as white males in the hiring process
. Finally,
economists can perform computer sim
their options. It would help econo economists to explain how labor mar
mists kets
understand why laid-off workers do actually work and to understand the ca
not uses of
immediately apply for cashier opening unemployment.
s at the Bergmann has yet to receive the h
local fast food restaurant. Surveys wo ighest
uld also accolades and awards possible for
help understand why managers of fa an
st food economist. She has not been made Pr
establishments are unable to find em esident
ployees of the American Economic Association and
at the given wage despite the existe she
nce of has yet to make the list of Nobel Prize finalist
people looking for work, and why s.
these Part of this neglect certainly stems fr
managers do not increase wages to attract om the
more fact that she is a woman (see also ROBINSO
applicants. Interviews might also al N).
low Another likely factor is a feminist orie
economists to discern how the mana ntation
ger of a that makes her male economists rat
fast food restaurant would view her
the uncomfortable. Nonetheless, Bergman
employment application of someone n has
who has helped set the agenda for feminist eco
recently lost a high-paying job. Onl nomics,
y after and her work has forced traditional l
conducting these interviews and simulati abor
ng the economists to sit up and take notice.
behavior of individuals in response to cha
nging
circumstances would economists un Works by Bergmann
derstand
whether people are out of work becau“The Effect of White Incomes on Discrimina
se there tion
are not enough jobs, or because workers p in Employment,” Journal of Polit
refer ical
leisure to labor, or for other, more c Economy, 79 (March/April 1971), pp. 294
omplex, –313
reasons. This more adequate and “Combining Microsimulation and Regr
more ession,”
scientific approach would also ena Econometrica, 41, 5 (September 197
ble 3), pp.
955–63
New York,
Basic Books, 1986
“Occupational Segregation, Wages a A Microsimulated Transactions Mode
l of the
nd Profits United States Economy, Baltimore, M
When Employees Discriminate b aryland,
y Race or Johns Hopkins University Press, 1
Sex,” Eastern Economic Journal, 1 ( 986, with
April-July Robert L.Bennett
1974), pp. 103–10 “Women’s Roles in The Economy: Teachin
The Economic Emergence of Women, g The
Issues,” Journal of Economic E Prominent Women Economists fro
ducation, 18, m the
4 (Fall 1987), pp. 393–407 Eighteenth Century to the Pres
“Why Do Most Economists Know So Litt ent,
le About
the Economy?,” in Unconvention
al Wisdom:
Essays in Honor of John Kenne
th Galbraith,
ed. Samuel Bowles, Richard Ed
wards &
William G. Shepherd, Boston, Massa
chusetts,
Houghton Mifflin Company, 1989, p
p. 29–37
“Micro-to-Macro Simulation: A Prim
er with a
Labor Market Example,” Journal of
Economic
Perspectives, 4, 1 (Winter 1990), p
p. 99–116
“Curing Child Poverty in the United
States,”
American Economic Review, 84,
2 (May
1994), pp. 76–80
A Defense of Affirmative Action, NewYo
rk, Basic
Books, 1996a
Saving Our Children from Poverty:
What the
United States Can Learn from
France, New
York, Russell Sage, 1996b
Works about Bergmann
King, Mary, “An Interview with B
arbara
Bergmann,” Review of Political
Economy
(forthcoming)
Paulin, Elizabeth “The Seditious Di
ssent of
Barbara Bergmann” in Richard P.F
.Holt and
Steven Pressman (eds), Economi
cs and Its
Discontents, Northampton, Massa
chusetts &
Cheltenham, UK, Edward Elgar, 1998
, pp. 1–
19
Polkington, Betty and Thomson, Do
rothy
Lampen, Adam Smith’s Daughte
rs: Eight
GAR ied,
Y BECKER Opportunities Diminished:
Racial
Cheltenham, UK, Edward Elgar 19 Discrimination in Hiring, Washingt
98, pp. on, D.C.,
104–17. Urban Institute Press, 1991
Other references
GARY BECKER (1930–)
(EEA Symposium) “Symposium: Race,
Gender
and Discrimination,” Eastern Eco Gary Becker is among the most ori
nomic
Journal, 21, 3 (Summer 1995), pp. 3 ginal
39–98 economists of the late twentieth centur
Edgeworth, Francis Y., “Equal Pay to y. His
Men and unique approach involves taking the econ
Women,” Economic Journal (Deceomic
mber assumption of rationality and applying i
1922), pp. 431–57 t to a
Ferber, Marianne A. and Nelson, Julie A large number of social problems normal
. (eds.), ly not
Beyond Economic Man: Feminist studied by economists. This approach h
Theory and as led
Economics, Chicago, & London, Unive to many new areas of specialization
rsity of within
Chicago Press, 1993 economics—the economics of crime
Goldin, Claudia, Understanding the Gend and
er Gap: punishment, the economics of addictio
An Economic History of America n, the
n Women, economics of the family, human cap
New York, Oxford University Press, ital
1990 theory, and the economics of discrimi
Smith, James P. and Ward, Michael P., nation.
Women’s Becker was born in Pottsv
Wages and Work in the Twentiet ille,
h Century, Pennsylvania in 1930 and grew up
Santa Monica, California, Rand Cor in
poration, Brooklyn, New York. His father was a
1984 small-
Turner, Margery Austin; Fix, Michael and S
truyk, 1
Raymond J. , Opportunities Den
85
GARY BECKER handling real problems” (Current B
iography
business owner. After graduating fr Yearbook 1993, p. 41). He then did
om high graduate
school he went to Princeton University, work in economics at the Universi
where ty of
he received a BA in economics. Be Chicago, where he studied under
cker was Milton
dissatisfied with his economic edu Friedman. Becker received an MA i
cation at n 1953
Princeton because “it didn’t seem and a Ph.D. from the University of
to be Chicago
in 1955. His doctoral dissertation (Becker 1988, 1991, 1992). Secon
(Becker d,
1957) on the economics of discriminati Becker has been instrumental in
on was explaining the way that labor mar
supervised by Friedman and was cit kets
ed by the work. He has helped develop the n
Nobel Prize Committee as an esp otion
ecially of human capital (Becker 1964) an
important contribution to economic d he
s. has helped economists to
Becker taught at the University o better
f Chicago understand discrimination in labor
from 1954 to 1957 and then acce markets (Becker 1957).
pted a
position at Columbia University. In 186
1969 he
returned to the University of Chic
ago as
Professor of Economics and Sociolo
gy. Since
1985 Becker has written a regular e
conomics
column in Business Week, explai
ning
economic analysis and ideas to the
general
public. In 1992 he was awarded th
e Nobel
Prize in economic science.
B e c k e r h a s m a d e t
w o k ey
contributions to economics. First, h
e has
taken the assumptions economists
make
about human rationality and appl
ied
them to all forms of behavior, incl
uding
non-economic matters or subjects t
hat do
not involve market transactions be
tween
individuals. Starting
with
the
assumptions that human beings a
ct
rationally and attempt to maximi
ze
utility, Becker has analyzed decis
ions
regarding fertility, marriage and di
vorce
(Becker 1973, 1974, 1977), crim
e and
punishment (Becker 1968), and add
iction
According to Becker, this is due not
to
Becker analyzes marriage decisio discrimination, but results from decis
ions
ns and made within the household about whic
family relationships in a manner an h jobs
alogous will be performed by different fami
to the traditional theory of the busine ly
ss firm. members.
Individuals spend time searching fo Family decisions about having ch
r the ildren
spouse who will provide them with can also be analyzed using the logic
the of
maximum amount of utility just as economic analysis. In contrast to Ma
firms lthus,
search for the best possible employee. who held that people could not control
Longer their
searches lead to better information reproductive urges, Becker looks at
about the
whether any possible spouse would decision to have children as analogo
be the us to
most desirable one. Consequently, this consumer decisions about purchasing
theory goods
predicts that those marrying young w like cars and vacations. Raising chil
ould be dren
more likely to get divorced, a predicti involves many costs. Parents must pa
on that y for
receives considerable support from food, shelter, clothing, toys, and edu
data on cation.
marital stability. Also, the theory predi Most important of all, the parent must
cts that spend
disappointments regarding expectatio time raising the child, which reduces th
ns, and e time
changes in expectations, will lead to available to earn income and consume
divorce. goods.
And like a firm wanting to maximize Parents must be compensated for these
profits, losses
a family can maximize utility thro with greater utility or pleasure from
ugh their
specialization; thus the husband typ children, otherwise they will not cho
ically ose to
specializes in market production and t have children. This compensation can
he wife come
typically specializes in household prod from the joy of having and raising ch
uction. ildren,
One consequence of such specialization i the desire for offspring, or the desire to
s that have
women will receive lower market someone care for you in your old age
wages. . But
with cars and vacations (which als
o give
whatever the cause of this addition pleasure) for each dollar of family i
ncome.
al utility, Given this perspective, it is possib
according to Becker children must le to
compete formulate many testable hypotheses
about available, and if the financial rewar
birth rates. Greater costs of child ds from
rearing these jobs were to increase, emplo
should reduce fertility; greater family i yment
ncomes begins to look relatively better w
should allow the family to purchase hen
more of compared to criminal activity. As the
everything, including children. Hi relative
gher gains from criminal activity fall, crime s
incomes for women will increase the hould
costs of be less prevalent. Further offshoots
rearing children, because the time of this
spent at approach have looked at how firm compl
home with children results in a greater i iance
ncome with government regulations and in
loss, and will therefore reduce fer dividual
tility. compliance with tax laws depends u
Finally, government income guarante pon the
es to the penalties and the likelihood of dete
elderly should reduce fertility rates, ction.
since one Empirical studies carried out by
benefit of children is that they will both
be around economists and criminologists (see
to support you in your old age. Heineke
The economics of crime and pu 1978) provide a good deal of support
nishment for the
is another area where Becker has t
aken the
rationality assumption, applied it to a ne
w and
different arena, and pushed out the bou
ndaries
of economics. One popular view in t
he 1950s
and 1960s was that criminal behavio
r resulted
from mental illness or social oppre
ssion. In
contrast, Becker assumed that pot
ential
criminals behave rationally, and were a
ffected
by the expected rewards and costs of
criminal
activity. Putting more money into
law
enforcement should raise the prob
ability of
being caught, increase the costs of
criminal
activity, and reduce crime. Likewi
se, if
penalties are increased, the expecte
d cost of
criminal actions would rise, and cri
me rates
would fall. Similarly, if more jobs
were
GAR ts, like
Y BECKER drug use, can reduce our concern for
future
theories of Becker on the determina consequences and thus lead to powe
nts of rful
criminal activities. addictions. Furthermore, legalizing drugs
Further drawing out the conseque may
nces of lead to a sharp increase in drug addiction sin
the rationality assumption, Becker has ce
argued the negative consequences of drug taki
that drug and alcohol addiction can be ng are
viewed less severe because with legalization th
as rational behavior. Becker starts by e price
noting of drugs will fall. Moreover, peer pr
that habits can be either good or ba essure
d. They may rise with legalization, leading to f
are good if they increase future well urther
-being. drug use and greater likelihood of add
Habits such as regular exercise, eatin iction.
g well, Becker has also made significa
and wearing seat belts all fall into nt
this contributions in the area of labor econ
category. On the other hand, habits that re omics.
duce Becker (1962) was one of the pioneer
future well-being, such as smoking ci s who
garettes developed the notion of human capita
and experimenting with drugs, are h l and
armful. then used this notion to help econo
But, Becker argues, people who deve mists
lop bad understand how labor markets work
habits are not necessarily irrational; ed.
they Analogous to physical capital, like mac
merely prefer current pleasures to future hinery
well- and plants, people can invest in them
being. An addiction, according to Be selves
cker, is through education, through training,
just a strong habit and thus also the r and
esult of through developing new skills. In fac
rationally balancing expected presen t, the
t and concept of human capital is even broad
future pleasures. This analysis leads er than
to the this, and encompasses the purchase of
conclusion that drug use should be made l health
egal care, time spent searching for better job
in order to allow each individual to m s, and
aximize migrating to other areas in search of
his or her own well-being. However, better
Becker
does introduce some qualifications t 1
o this 87
conclusion. He notes that some habi
GARY BECKER a flow of
future income.
employment. Like new plants and But also like physical capital inv
machinery, estment,
these human investments will yield human investment involves a cost. Perha
ps the Second, Becker contends that the
most important of these will be t desire to
he lost discriminate is a kind of taste or pre
earnings due to the time spent ac ference
quiring held by employers just like the desire
human capital. In addition, the diff to have
iculty of Grape Nuts cereal for breakfast every mo
acquiring new skills and knowledge rning
imposes is a taste or preference. Moreover,
a cost on the individual. People will Becker
invest in (1993) contends that discrimination
themselves, according to Becker, as depends
long as more on the tastes and attitudes of co
the future gains exceed the present costs nsumers
. Most and employees than on the attitude
empirical studies of human capital theo s and
ry have beliefs of employers. Consumers m
focused on comparing the costs a ay not
nd the want to deal with minority salesme
returns to schooling, especially a n; and
college current employees may not want to w
education. Empirical tests of huma ork with
n capital women or blacks. In such cases, fir
theory have found that human c ms will
apital not tend to hire qualified women and qual
investment does increase with great ified
er returns blacks, since such hiring will reduce
and does fall with greater costs (Mincer sales or
1974).
Several important and controvers 188
ial points
about economic inequality and discri
mination
follow from the theory of human capital.
First,
Becker (1971) has pointed out that
inequality
between two groups (such as men and w
omen,
or blacks and whites) does not show
that the
group receiving lower
earnings is
discriminated against. Earning diff
erences
will depend on differences in factor
s such as
education, skills, and experience (
or the
human capital accumulated by me
mbers of
each group). Only after we factor out the
effect
of these differences in human cap
ital on
earnings are we left with earning di
fferences
reflecting discrimination.
He has thus pioneered the study
of
worker productivity and thus be costl discrimination, crime, education, an
d
y to the marriage by economists. Every time t
firm. hat he
Third, Becker notes that discrim has ventured outside the tradition
ination al
costs employers money. If an employe boundaries of economics he turns up
r could unique
hire a woman or a black, but wan and interesting results with clear and t
ts to estable
discriminate against members of this predictions. More important, his approach
group, has
the employer will have to pay a pri opened up new avenues of research an
ce for d new
indulging this taste. The price paid is the w ways of viewing non-market human activi
age ties.
difference between the white male hirFor these reasons Becker remains the
ed and most
the woman or minority not hired. This creative economist of the late twenti
means eth
that in competitive markets discrimi century, as well as the most influentia
nation l. His
will be less likely to occur since firms influence can be measured by the la
that do rge
discriminate will face higher costs an number of citations to his work. Me
d firms doff
that do not discriminate will face lowe (1989) ranked Becker first among econ
r costs. omists
Non-discriminating firms will tend t under the age of 65 based upon the
o force total
discriminating firms out of existence. number of citations in the Social Sc
These ience
hypotheses regarding discrimination Citation Index.
have
been the subject of much criticism and
debate Works by Becker
(see also BERGMANN).
Becker has expanded the rang The Economics of Discrimination (1957
e of ),
economic analysis by looking at all indiv Chicago, Illinois, University of Chicago
idual Press,
choice as a form of rational decision- 2nd edn., 1971
making.
“Crime and Punishment: An Econ
omic
“Investment in Human Capital: A T Approach,” Journal of Political Econ
omy, 76,
heoretical
2(March/April 1968), pp. 167–217
Analysis,” Journal of Political “A Theory of Marriage: Part I,” Jou
Economy, 70, rnal of
5 (October 1962), pp. 9–49 Political Economy, 81, 4 (July/Aug
Human Capital, New York, Columbia ust 1973),
University pp. 813–46
Press, 1964 “A Theory of Marriage: Part II,” Jou
rnal of AMAR
Political Economy, 82, 2 (March/Apr TYA SEN
il 1974),
Part 2, S11–S26 Posner, Richard A., “Gary Becker’s Contribut
The Economic Approach to Human ions
Behavior, to Law and Economics,” Journal o
Chicago, Illinois, University of Chica f Legal
go Press, Studies, 23 (June 1993), pp. 211–15
1976 Rosen, Sherwin, “Risks and Rewards:
“An Economic Analysis of Marital I Gary
nstability,” Becker’s Contributions to Law
Journal of Political Economy, 85, 6 ( and
December Economics,” Scandinavian Journal
1977), pp. 1, 153–89, with E.M.Lof
andes and Economics 95, 1 (1993), pp. 25–36
R.T. Michael Shackleton, J.R., “Gary S.Becker: the Ec
A Treatise on the Family, Camb onomist
ridge, as Empire-builder,” in Twelve Cont
Massachusetts, Harvard University Pr emporary
ess, 1981 Economists, ed. J.R.Shackleton an
“Human Capital. Effort, and the Sexu d
al Division G.Locksley, New York, Wiley, 1981 pp. 1
of Labor,” Journal of Labor Eco 2–32
nomics, 3, 1
(January 1985), pp. 533–58 Other references
“A Theory of Rational Addiction,”
Journal of
Heineke, J.M. (ed.), Economic Models
Political Economy, 96, 4 (August
of
1988), pp.
Criminal Behavior, Amsterdam, Nort
675–700 (with Kevin M.Murphy)
h-
“Rational Addiction and the Effect o
Holland, 1978
f Price on
Medoff, Marshall H., “The Rankings
Consumption,” American Econo
of
mic Review,
Economists,” Journal of Economic Ed
81, 2 (May 1991), pp. 237–41 (wit
ucation,
h Michael
20, 4 (Fall 1989), pp. 405–15
Grossman and Kevin M.Murphy)
Mincer, Jacob, Schooling, Experience,
“Habits, Addictions, and Traditions,” Ky
and
klos, 45,
Earnings, New York, Columbia Uni
3 (1992), pp. 327–45
versity
“Nobel Lecture: The Economic Way o
Press, 1974
f Looking
at Behavior,” Journal of Politic
al Economy,
101, 3 (June 1993), pp. 385–409
AMARTYA SEN (1933–)
Works about Becker
Over the last quarter of the twentieth c
Becker, Gary S., Current BiographyYear entury,
book 1993, Amartya Sen has been a leading figure
New York, H.W.Wilson, 1993, pp. 4 in the
0–4 areas of welfare economics and econ
Fuchs, Victor R., “Gary S.Becker: Id omic
eas About development. He has broadened econ
Facts,” Journal of Economic Pe omists’
rspectives, 8, notion of human “well-being” so th
2 (Spring 1994), pp. 183–92 at it
encompasses not just additional cons eran,
umption in Bengal, India in 1933. His father
but also developing human potential. was a
Sen has professor of chemistry at Dhaka Univ
also studied how underdevelopment aersity,
dversely which is now in Bangladesh. As a chil
affects women and has argued that econo d, Sen
mists lived through the Great Bengal Famine of 19
who study economic development n 43.
eed to He claims (Klamer 1989, p. 136) this event h
focus more on developing opportuni ad
ties for
people. 1
Sen was born in the village of Santinik
89
AMARTYA SEN School of Economics. Then in 1977 he m
oved
a prolonged and lasting effect on him to Nuffield College, Oxford. Three ye
, and that ars later
it sparked his interest in economi he became Drummond Professor of
c Political
development. Economy at All Souls, a position pr
While an undergraduate at Pre eviously
sidency held by Edgeworth and by Hicks. In 1
College in Calcutta, Sen studied et 987 Sen
hics and moved to the US, becoming Profes
political philosophy in addition to e sor of
conomics. Economics and Philosophy at Har
He received a BA degree in Econo vard
mics from University. Sen returned to England i
Presidency College in 1953, and then B n 1998,
A, MA, this time as head of Trinity Colle
and Ph.D. degrees in Economics fro ge,
m Trinity Cambridge. In 1994 Sen served as P
College, Cambridge. At Cambridge, he resident
studied of the American Economic Associa
economics with both Piero Sraffa tion; in
and Joan 1998 he received the Nobel Prize in Econ
Robinson. Robinson supervised his omic
doctoral Science.
dissertation (Sen 1960), and attempted t The main theme in the work of S
o move en is the
his research away from “ethical rub importance of developing human p
bish” and otential.
towards abstract theory (Klamer 1989, For Sen, economics should be a
p. 139). bout
After graduating from Cambridge developing the capabilities inherent in p
in 1959, eople,
Sen taught at Jadaupur Universit and increasing the options open to
y, at them,
Cambridge University, and then at rather than about trying to produce
Delhi more
University. In 1971 Sen returned to goods or figuring out how to maximize ut
England, ility.
accepting a teaching position at the Consequently, he has been highly cri
London tical of
traditional welfare economics, whi
ch holds
that free exchange will maximize t The heart of the rationality assumption is
he well-
being of rational individuals (see the
also belief that individuals are rational uti
EDGEWORTH). Sen has rejecte lity
d the maximizers. Most economists believe
assumption of human rationality, an that
d he has individuals behave in a highly rationa
rejected Pareto Optimally (see also P l and
ARETO) logical fashion. They see people attem
as a criterion for economic well- pting to
being. figure out the consequences of different poss
ible
190
actions and the utility they can expect to recei
ve
as a result of each action. They belie
ve that
people will act to get themselves the
greatest
(expected) utility, and that allowing pe
ople to
act in this manner leads to a Pareto
Optimal
situation. Sen (1976–7) has criticized thi
s view
on a number of grounds.
He contends that utility maximiz
ation
provides a bad description of how p
eople
actually behave. To take just one exa
mple,
individuals should expect to receive n
o gain
from voting in political elections. The c
hances
that my vote will decide the outcome
of any
election are minuscule. In fact, the lik
elihood
of my getting struck by lightning while wait
ing
on line to vote is greater than the pro
bability
that my vote will decide an electi
on.
Nonetheless, I regularly vote; and so d
o large
numbers of other people.
Sen also notes that if people did a
ctually
behave according the rationality assu
mption
they would become “rational fools,” since ac
ting
selfishly can lead to some rather absurd
results. Furthermore, Sen (1985, 1987) has
“‘Where is the railway station?’ he a pointed
sks me. out problems with using Pareto Optimali
‘There’, I say pointing at the post offi ty as a
ce, ‘and welfare criterion. He notes that outco
would you please post this letter for m mes can
e on the be Pareto Optimal, yet disastrous. For exam
way?’ ‘Yes’ he says, determined to ple,
open the a case in which a few people are very ri
envelope and check whether it con ch and
tains everyone else is starving would be P
something valuable” (Sen 1976–7, p. 332) areto
. Left Optimal, since the situation cannot be impro
out of this interaction is any concern f ved
or other without taking income from the very
people, or for the sort of person one wants to wealthy
be and reducing their utility. However, the fact t
and the sort of society one wants to be hat
part of.
cording to
this perspective, well-being depends
many people are starving is obviousl upon the
things people can do and the things t
y a highly hat they
undesirable outcome. can do well. Human well-being is m
Sen (1970) also notes that aximized
utility when people are able to read, eat, a
maximization conflicts with liberalis nd vote.
m, or the Literacy is important not because of t
belief that people should be able to do wh he utility
atever it yields, but because of the sort of pe
they want so long as it does not keep others rson that
from one becomes when one can read. E
doing what they want. If many pe ating is
ople want valued not because people love foo
pornography to be banned, utility maxi d, but
mization because food is necessary for life an
would require that pornography sh d health.
ould be And people vote, not to increase thei
banned. Similarly, if a great many people r utility,
prefer but because they value a certain political s
that everyone read pornographic nov ystem
els, utility (democracy) and certain types of p
maximization demands that pornog olitical
raphy be activity.
forced on people. Yet concern for lib The number of options people have
erty would and the
allow each individual to make that d freedom to choose among options, is
ecision. another
Since the utilitarian analysis of important part of human well-being. This
individual means
welfare is inadequate, another pers that when a consumer buys some good
pective is but has
needed. Sen proposes a capabilitie no option, consumer well-being co
s-centered uld be
approach (see McPherson 1992). Ac enhanced by giving the consumer greater c
hoice, AMAR
even if the consumer does not get m TYA SEN
ore goods
at the end. than anything else, welfare is maximize
Going even further, Sen notes that tra d when
ditional illiterate people are not encouraged to read.
economics has gotten the relationshi But
p between for Sen, greater literacy would improve
preferences and actions backwa human
rds— welfare because it increases the oppor
preferences do not determine humatunities
n actions. available to people and enhances t
People do not value illiteracy and t heir
hen decide capabilities.
not to learn how to read. Rather, pe Sen has applied his capabilities appr
ople who oach to
cannot read adapt their preferences and the area of economic development. Thi
devalue s work
literacy. On the standard utilitarian begins by distinguishing economic growth
doctrine, from
because individual preferences are valu economic development. Growth me
ed more ans
producing more things regardless of
what
happens to the people producing and consu
ming
these goods; development involves “ex
panding
the capabilities of people” (Sen 1984, p
. 497).
Economic growth raises per capita incomes
and
output. Economic development invol
ves
improving the life expectancy, literacy,
health,
and education levels of people. It means mak
ing
people part of their community and al
lowing
them to appear in public without shame beca
use
they are regarded as worthwhile individ
uals.
Growth and development often go t
ogether.
But as the experience of countries such as Chi
na,
Sri Lanka, and Costa Rica illustrate, th
e right
sort of public policies can expand capa
bilities
and opportunities despite low rates of econ
omic
growth. When developing countries must d
ecide
to focus either on promoting economic
growth
or the development of capabilities, Sen co women equally, and that development
ntends policy
that they should focus on the real goal, whic should focus on men and women more
h is or less
the development of human potential. Mor equally.
eover, Sen (1990b) has shown how a pa
the success of a developing economy shoulrental
d be preference for sons leads to discrimi
judged on its growing literacy rates nation
and life against women in developing countrie
expectancy rather than on its growt s. All
h in families must constantly make decision
production or income levels. s about
Sen has also established that gend how to use the limited income at their d
er issues isposal.
are an integral part of the development pro One important decision concerns how to allo
cess. cate
He has questioned the assumption that low l
evels 1
of economic development affect me 91
n and
AMARTYA SEN are around 105 women for every 100 men. I
n the
income among all family members. developing world, however, there are
For more only 94
affluent families such decisions are u women for every 100 men. If men an
sually not d women
critical, but for poor families they ca were treated equally in developing c
n become ountries,
life and death decisions. Family me these countries should also have a ratio of bet
mbers who ween
do not receive sufficient food will die 100 and 105 women for every 100
; likewise men. Put
family members who fail to receive another way, if women were treated
adequate by their
medical care when they are sick may families in the same way that men wer
die. e treated
Sen (1993) has shown that women there would be another 100 million women
and men alive
do not have the same access to healt today in developing countries.
h care and For ethical reasons, as well as for
nutritious food. Women are less lik efficiency
ely to be reasons, Sen suggests that developme
taken to the hospital than men, and wome nt efforts
n have should focus on women. In India, for
to be sicker before they get taken to the hos example,
pital. direct feeding programs have been
Women are also less likely to be given ad more
equate successful improving the nutrition of
supplies of food (Sen 1984, Ch. 15). girls than
Sen (1990b, 1993) has documente general food disbursements that fa
d in stark milies
and in concrete terms the consequen consume at home. Programs that en
ces of this courage
unequal treatment. In the developed w women to work outside the house
orld there will give
women greater status within the family, a
nd will
enable them to claim more economic famines do not occur in democracies. S
resources
within the family. Moreover, Sen arg en and
ues that if Dréze (1996) point out that India has
the economic contribution of wom had no
en were famines since 1943, but that China h
greater and received greater recognition, ad a
female disastrous famine (with 15–30 million
children would likely receive more attent people
ion and dying of starvation) from 1958 to 1961, des
more family resources. pite
Finally, Sen’s work on famines a the fact that China has generally done a
nd hunger better
has helped economists understand the ca job than India in eliminating hunger.
uses of Mass
these important real world problems. It h starvation has less to do with the higher
as also output
changed the way that many intern that results from democratic forms
ational of
agencies approach famine prevention an government, and more to do with the fa
d relief. ct that
Poverty and Famines (Sen 1981) points democratic governments must respon
out that d to
political pressure from the electorate.
192
Prior to
the work of Sen, development econo
mists
assumed that famines were the resul
t of
insufficient food production. Sen point
ed out
that distribution issues were separate fro
m, and
more important than, the question of
food
supply. Famines could result from po
or or
unequal distribution mechanisms; famines
could
also result from great food demand in
some
sectors or regions of a country and insu
fficient
food supplies elsewhere.
The work of Sen has attempted to
broaden
the horizon of economic analysis. He
has
pressed economists to take a different v
iew of
human economic agents. He has made a str
ong
case that people have some intrinsic worth,
and
are not just rational utility maximizers. And
he
has pointed out that the goal of a onomic
well- growth and the real reason to be an eco
performing economic system is not j nomist.
ust more
goods and services, but improving the
lives of Works by Sen
most people. The unifying theme in t
he work Choice of Techniques: An Aspect of
of Sen has been a focus on creating The Theory
human of Planned Economic Development
potential or capabilities, and how this , Oxford,
leads to Basil Blackwell, 1960
greater well-being in society and wit “The Impossibility of a Paretian Liberal,” Jo
hin the urnal
household. He has seen the develop of Political Economy, 78, 1 (January-
ment of February
human abilities as the real end of ec 1970), pp. 152–7
The Political Economy of Hunger:

Famine
On Economic Inequality, Oxford, C Prevention, Oxford, Clarendon Pres
s, 1991
larendon Inequality Reexamined, Cambridge, H
Press, 1973 arvard
“Rational Fools: A Critique of the B University Press, 1992a
ehavioral “More than 100 Million Women Are
Foundations of Economic Theory,” P Missing,”
hilosophy New York Review of Books, 37 (Decem
and Public Affairs, 6 (1976–7), p ber 20,
p. 317–44 1990b), pp. 61–6
Poverty and Famines: An Essay o “The Economics of Life and Death,”
n Entitlement Scientific
and Deprivation, Oxford, Claren American, 268, 5 (May 1993), pp. 4
don Press, 0–7
1981 The Political Economy of Hunger Selecte
Resources, Values and Development d Essays,
, Oxford, Oxford, Clarendon Press, 1995, w
Basil Blackwell, 1984 ith Jean
“The Moral Standing of the Market,” Dréze and Arthur Hussain
in Ethics India: Economic Development and S
and Economics, ed. Ellen Frankel ocial
Paul, Fred Opportunity, Oxford, Oxford Universit
D. Miller, Jr. and Jeffrey Paul, Oxf y Press,
ord, Basil 1996, with Jean Dréze
Blackwell, 1985, pp. 1–19
On Ethics and Economics, Oxford,
Basil Works about Sen
Blackwell, 1987
Hunger and Public Action, Oxford, Klamer, Arjo, “A Conversation with
Clarendon Amartya
Press, 1989, with Jean Dréze Sen,” Journal of Economic Persp
“Gender and Cooperative Conflicts” ectives, 3, 1
in Irene (Winter 1989), pp. 135–50
Tinker (ed.) Persistent Inequaliti McPherson, Michael, “Amartya Sen,”
es, London, in New
Oxford University Press, 1990, pp. Horizons in Economic Thought: App
123–49 raisals of
Leading Economists, ed. Warren ROBERT E.LUC
J.Samuels, AS, JR.
Hants, England, Edward Elgar, 1992, p
p. 294– Putterman, Louis, “Amartya Sen (born
309 1933),”
in Biographical Dictionary of Diss
enting
Economists, ed. Arestis and Sawyer,
Hants,
England, Edward Elgar, 1992, pp. 49
8–505
ROBERT E.LUCAS, JR. (1937–)
Robert Lucas is known for developing the
new
classical or rational expectations appro
ach to
macroeconomics. This approach seek
s to
provide microfoundations to macroecono
mics.
It assumes that macroeconomic actor
s, like
microeconomic actors, are rational h
uman
beings who use all available information w
hen
making decisions and who attempt to antici
pate
the future. When macroeconomic act
ors are
seen as rational agents, Keynesian eco
nomics
can be rejected —unemployment will r
emedy
itself and economic policy is neither neces
sary
nor desirable.
Lucas was born into a middle-class
family
in Yakima, Washington in 1937. Sho
rtly
thereafter the family restaurant (the Lu
cas Ice
Creamery) went bankrupt, a victim of the G
reat
Depression. Due to the personal hardships
they
had to endure, Lucas’ parents, b
oth
descendants of a long line of Republ
icans,
rejected their Republican leanings and bec
ame
ardent supporters of the New Deal. arded in
Lucas attended the University of 1964, was an econometric study of th
Chicago, e ease
majoring in history. After he received with which businesses can substitute
his BA capital
degree in 1959, he began graduate s and labor in production. From 1963 t
tudy in o 1974
history at Berkeley. Recognizing that eco Lucas taught at Carnegie-Mellon Uni
nomic versity.
factors were the key forces moving He then accepted a position at the Uni
history, versity
Lucas shifted his focus to economic of Chicago. In 1980 he became the John Dew
history. ey
He soon returned to the University of Distinguished Service Professor at t
Chicago he
in order to study economics with
Milton 1
Friedman. His Ph.D. dissertation, aw 93
ROBERT E.LUCAS, JR. ming
expectations. With rational expectation
university. In 1995, Lucas received s people
the Nobel look forward as well as backward.
Prize in Economic Science, primaril Expected
y for his inflation depends not just on past price cha
contribution to rational expecta nges,
tions but on how current conditions or c
macroeconomics. urrent
Beginning with Keynes, macroe economic policies might change thi
conomists ngs. Just
recognized that expectations affec because inflation has averaged 3 per
t the cent for
economy; but they had only a rud years does not mean it will continue t
imentary o do so.
understanding of how expectation Falling unemployment and rapid m
s were oney
formed. Some macroeconomists growth, for example, might lead pe
took ople to
expectations as static or fixed. Ot expect that prices will start to increa
hers saw se more
expectations as adapting to past cha rapidly in the future.
nges. On Although Muth (1961) first set f
this view, if inflation had gone up 3 orth the
percent in notion of rational expectations, Luc
the past, people would expect 3 as has
percent been its strongest proponent and has mad
inflation to continue. After a few y e this
ears of 4 approach widely known. It was Luc
percent inflation, people would cha as who
nge their insisted that rational expectations
views and expect future inflation t be
o be 4 incorporated into macroeconomic a
percent. nalysis;
Lucas insisted that people were smar and it was Lucas who drew out
ter than the
this and more sensible when for consequences of this assumption
for
macroeconomic theory and policy. T
wo main One way to see this approach is through t
consequences of rational expectations
are that he
there is no short-run trade-off bet conflict between the macroeconomic
ween s of
inflation and unemployment, and Keynes and traditional labor econom
that ics.
economic policy tools are ineffect Keynes attempted to explain why eco
ive and nomies
cannot improve economic outcom experience prolonged bouts of hi
es. This gh
work began what has come to be c unemployment. Labor economics se
alled the es
“new classical school” of macro unemployment as the consequence of to
economics o high
because these results return macroe wages; if workers would accept pay cu
conomics ts, this
to preKeynesian conclusions. would eliminate the prob
lem.
194 Macroeconomists from the 1940s thro
ugh the
1960s generally sided with Keynes and vie
wed
unemployment as primarily involuntary.
Lucas
changed all that.
New classical economics barkens
back to
the classical approach to macroecono
mics. It
assumes that markets, including labor mar
kets,
always reach a point at which supply
equals
demand. Unemployment will therefore
be the
exception rather than the norm, and w
ill tend
to disappear as labor markets adju
st.
Unemployment is looked at as a tem
porary,
disequilibrium phenomenon that will r
emedy
itself. New classical economics also a
ttempts
to put macroeconomics on firm microecon
omic
grounds. It supposes that economic acto
rs will
be rational and will behave in ways
that
maximize their well-being.
Lucas (1969b) examines the labor
supply
decision as a choice that each worker
makes hin this
between labor and leisure. Workers ha framework, unemployment is explaine
ve some d as a
sense of the real wage they would receive f voluntary choice made by workers w
rom ho are
working. They then decide whether to waiting for real wages to rise to its normal lev
work or el.
not by comparing this real wage aga A similar decision must be made
inst the by
benefits from leisure time. If expect business firms (Lucas 1972, 1973).
ed real When
wages are higher than normal, work prices rise for the goods it produces,
ers will a firm
have an incentive to work more. In co must decide whether that price rise is
ntrast, if due to
expected real wages are lower than greater demand for what they produc
usual, e (thus
workers will take more leisure and w necessitating additional production) o
ait until r to a
real wages rise before working. Wit
e the real
wage and withhold their labor by quitting
general rise in all prices, which woul their
job or turning down job offers with
d not call too low
for greater production. Like the wage offers. Businesses also make
worker, mistakes
business owners face labor-leisure t about demand and sometimes produce to
rade-offs; o little
and like the worker, the business firm wil and hire too few workers. But becaus
l only e people
want to produce more when it gets are rational beings, who are forward
more for looking
what it produces. in how they form expectations, mista
Because people do not have kes will
all the get corrected shortly and unemploy
information possible at their disposal, t ment will
hey will disappear.
make errors in their labor and pro This analysis of the
duction causes of
decisions. For example, workers ma unemployment dovetails with a se
y assume cond
that a given pay increase represents an in contribution due to Lucas, one that h
crease as come
in real wages, or businesses may thi to be known as “the Lucas Critiqu
nk that a e.” One
price rise for what they produce is a normal exercise in economic analys
n increase is is to
in the relative price for their product rath employ a macroeconomic model to st
er than udy how
part of an overall price increase. changing fiscal policy and/or monet
According to Lucas, unemploymen ary policy
t results impacts the whole economy. In the
from individual workers and businesses 1960s it
making was assumed that these models cou
mistakes of this sort. Workers mistak ld help
policy makers guide the economy to ROBERT E.LUC
wards full AS, JR.
employment with low inflation. In t
he 1970s, macroeconomic relationships will re
stagflation seemed to show that fis main
cal and unchanged in the face of any change in
monetary policies were relatively ineff policy.
ective in But this will not be true, Lucas (1978,
solving macroeconomic problems. Ec p. 52)
onomists contends, because “a change in poli
needed some explanation for this policy cy
failure. necessarily alters some of the structur
Lucas provided that explanation. al
Lucas (1976, 1978) criticized th parameters…in a highly complex fashi
e use of on….”
large-scale macroeconomic models to Without knowing which econ
evaluate omic
the consequences of different eco relationships remain the same, which
nomic change,
policies (see also TINBERGEN). His c and how they change, an econometric
riticism model
was that these models all is of no value in assessing alternative
assume policies.
Going even further, Lucas (1978, p. 56) clai
ms
that the poor track record of econo
mic
forecasting models (for example, their
failure
to explain the stagflation of the 1970s)
shows
that macroeconomic relationships
do
frequently change.
In practice, the Lucas Critique mea
ns that
economic behavior will change in resp
onse to
a policy change. Certainly, rational individ
uals
who attempt to maximize their own well-
being
should change their behavior in the f
ace of
changing economic policy. These beh
avioral
changes, in turn, will change macroec
onomic
relationships. These behavioral chang
es will
also make macroeconomic policies ineffe
ctive.
One example of this (pointed out b
y Barro
1974) concerns the effects of government d
ebt.
According to the Keynesian view, a tax
cut by
the government will lead to increased s is
demand stimulated.
for the goods and services. But tax c Another important example of the
uts also Lucas
lead to larger government deficits. A Critique in action concerns the Phillip
ccording s Curve
to rational expectations macroecono (see also SAMUELSON). Lucas (1972) sh
mics, ows
rational citizens will realize that these that the traditional argument for the
deficits Phillips
must be paid back in the future and Curve assumes irrational macroecon
that the omic
government must raise taxes to do so. actors. He then goes on to explain w
People hy the
will therefore save most of their tax cu Phillips Curve will likely be vertical in the lo
t so that ng
they can pay their higher taxes in th run. If policy makers attempt to expa
e future. nd the
Tax cuts no longer increase consumer spe
nding 1
and employment; instead, saving 95
ROBERT E.LUCAS, JR. fooling
workers into believing that the high
economy and lower unemployment er wages
they will offered by businesses represents an in
generate expectations of higher in crease in
flation their real wages. Lucas points out that
among rational economic agents. Work workers
ers will can be fooled once or twice, but that i
not want to work more if they are s it. The
paid less, next time the government tries to st
and so employment will not incre imulate
ase and employment through additional gov
unemployment will not fall. The on ernment
ly impact spending, workers will expect to se
of stimulative demand policies is rising e higher
prices. inflation and no increase in their real wage
In the long run, then, economic policy ca s. As
n only a result, people will not seek more
change prices or the rate of inflation; work and
it can do less leisure, and these policies will
nothing about unemployment. Ther fail to
e is no stimulate employment. This is true as
inflation-unemployment trade-off; t well for
here is money policy. Central banks cannot conti
only, following Friedman, a natur nually
al rate of fool people about what they are doi
unemployment. This rate is determin ng and
ed by the thereby expand the economy. Since fi
decisions made by workers and fir scal and
ms, and monetary policies cannot be used to
cannot be modified by any economi improve
c policy. economic performance, Lucas (1972) ad
Lucas argues that stimulative fis vocates
cal policy fixed and predictable rules for both f
can only increase employment by iscal and
monetary policy. For fiscal policy he sug
gests a
balanced budget, and for monetary classical or rational expectations app
policy an
announced rule of money growth. roach
When the Royal Swedish Acad came to dominate macroeconomics in t
emy of he late
Sciences awarded the Nobel Prize i twentieth century.
n 1995, it
noted that no one has had a greater Works by Lucas
impact on
macroeconomics since 1970 than Luca
s. Lucas “Price Expectations and The Phillips C
explained how economic agents urve,”
American Economic Review, 59, 3 (June 1
form
969a),
expectations and how these expect
pp. 342–50, with Leonard A.Rapping
ations, in
“Real Wages, Employment and Inflation,” Jo
turn, affect economic outcomes
urnal
and
of Political Economy, 77, 5 (September/
performance. In so doing, he has c
October
hallenged
1969b), pp. 721–54, with Leonard A.Rap
the Keynesian orthodoxy that economi
ping
c policy
“Expectations and the Neutrality of Money,” Jo
must be used to remedy the prob
urnal
lem of
of Economic Theory, 4 (April 1972), pp. 1
unemployment. As a result of his work, th
03–24
e new
“Some International Evidence on Output-
Inflation
196
Tradeoffs,” American Economic Rev
iew, 63, 3
(June 1973), pp. 326–34
“An Equilibrium Model of the Business
Cycle,”
Journal of Political Economy, 83, 6 (Dec
ember
1975), pp. 1,113–44
“Econometric Policy Evaluation: A Criti
que” in
K.Brunner and A.Meltzer, eds. The
Phillips
Curve and Labor Markets, Amsterda
m, North-
Holland, 1976, pp. 19–46
“After Keynesian Macroeconomics” in
After the
Phillips Curve: Persistence of High Infl
ation and
High Unemployment, Boston, Massa
chusetts,
Federal Reserve Bank of Boston, 1978, pp.
49–
72, with Thomas J.Sargent
“Rules, Discretion and the Role of the Ec
onomic
Advisor,” in Rational Expectations
and
Economic Policy, ed. Stanley Fischer, C
hicago,
Illinois, University of Chicago Press, Political Economy, 104, 4 (August 1
1980, pp. 996), pp.
199–210 661–82
Studies in Business Cycle Theory, C
ambridge,
Massachusetts, MIT Press, 1981 Works about Lucas
Models of Business Cycles, Oxford, Basil Bl
ackwell, Chari, V.V., “Nobel Laureate Robert E.Lucas,
1987 Jr.:
“Nobel Lecture: Money Neutrality,” J Architect of Modern Macroeconom
ournal of ics,”
ROBERT E.LUC
AS, JR.
Journal of Economic Perspectiv
Muth, John F, “Rational Expectations a
es, 12, 1 nd the
(Winter 1998), pp. 171–86 Theory of Price Movements,” Econ
ometrica,
Fisher, Stanley, “Robert Lucas’s Nobel
29, 3 (1961), pp. 315–35
Memorial
Prize,” Scandanavian Journal o
f Economics,
98, 1 (March 1996), pp. 11–31
Klamer, Arjo, Conversations with
Economists:
New Classical Economics and
Opponents
Speak Out on The Current Co
ntroversy in
Macroeconomics, Totowa, New J
ersey,
Rowman & Allenheld, 1984
Other references
Barro, Robert, “Are Government B
onds Net
Worth?,” Journal of Political
Economy, 82
(1974), pp. 1,095–117
197
GLOSSARY
Absolute advantage A theory holding that whichever country can produce a good
more efficiently
will export that good (also see comparative advantage).
Accelerator A theory of investment which holds that investment increas
es whenever the
economy expands.
Adding up problem Concerns whether summing the marginal productivity
of all inputs used by
the firm will equal the value of output, and thus whether sales proceeds can pay factors o
f production.
Adverse selection A problem in the insurance industry, whereby people ta
ke out insurance
who are more likely to file claims than the population in general.
Arbitrage The simultaneous purchase and sale of some asset in two diff
erent markets in
order to make money from the price differential.
Asymmetric information Differences in knowledge by two parties to s
ome trade or
transaction.
Cambridge Controversy A dispute between Cambridge, England and
Cambridge,
Massachusetts in the mid-twentieth century concerning how to measure c
apital.
Cantillon Effect The differential impact of money on the economy depe
nding upon how
money enters the economy and who gets the money.
Cardinal utility The belief that consumers can distinguish how much more
they prefer one
bundle of goods to another bundle of goods (see ordinal utility).
Class struggle A conflict between capitalists and workers.
Cliometrics The new economic history, which uses advanced statistical te
chniques to test
hypotheses about economic history.
198
G
LOSSARY
Comparative advantage The doctrine that it is relative efficiencies (or
relative inefficiencies)
that determine the goods a country will export (see absolute advantage).
Complimentary goods Two or more goods usually consumed together,
like gasoline and
automobiles.
Conspicuous consumption Expenditures made to impress others rather th
an improve one’s
well-being.
Constant returns to scale Occurs when an increase in inputs leads to a p
roportional increase
in output.
Consumer sovereignty The belief that each consumer is the best judge o
f their own well-
being and should be allowed complete freedom in purchasing goods.
Consumption function The relationship between consumer spending an
d income.
Contract curve A curve within the Edgeworth Box connecting the po
ints at which two
individual’s or two countries’ indifference curves are tangent.
Correlation coefficient A measure of the relationship between two econ
omic variables, or
the extent that they move together.
Cost-benefit analysis A tool for evaluating investment projects and gov
ernment spending
programs by comparing all the benefits that will result from the project a
nd all the costs of
the project.
Creative destruction The process by which new innovations and tec
hnological
breakthroughs come to destroy old products and production processes.
Cumulative causation A positive or negative feedback mechanism inv
olving two or more
variables, so that increases in one variable lead to increases in the sec
ond variable, which
increases the first variable again, etc.
Differential theory of rent Belief that the rent on any plot of land is
determined by the
difference between the productivity of that plot and the productivity of th
e least fertile land.
Diminishing marginal utility The satisfaction received from consuming a
good will decline
with each additional unit of the good that is consumed.
1
99
GLOSSARY
Diminishing returns When additional workers (or other factors of pro
duction) produce less
than the previous worker (or factor) hired.
Division of labor Specialization in the production process whereby tasks
are divided into small
operations and individual workers are assigned to do just one task.
Dual labor market hypothesis The theory that there are two different labor mark
ets in developed
countries—one for skilled workers and one for unskilled workers.
Dumping The practice of charging less for some good abroad than the firm charges
in its domestic
market.
Econometrics The part of economics that measures economic relation
ships using statistical
techniques.
Economies of scale Reductions in the cost of producing goods as a resul
t of producing larger
quantities of the good.
Edgeworth Box A diagram which combines the indifference curves of t
wo individuals or two
countries in order to determine the outcome of their attempts to trade wit
h each other.
Effective demand The demand for goods and services which is backed
up with the ability to
purchase those goods and services.
Elasticity of demand The percentage change in consumer purchases divi
ded by the percentage
change in price of a good. This shows how much sales change given a pr
ice change.
Elasticity of substitution A measure of how much business will change t
heir use of inputs into
the production process as a result of changes in the cost of buying that inp
ut. If the elasticity of
substitution is zero, factors of production are always used in fixed propor
tions no matter how
expensive the cost of some input becomes. If it is greater than zero, then
higher wages will lead
business to use more machinery and less labor.
Equation of exchange MV=PQ, or the money supply (M) times the n
umber of times each
dollar gets spent (V) equals the output of the economy (prices times quan
tities).
Ex ante-ex post Distinguishes that which is planned (ex ante) from wh

at actually occurs (ex
post).
Expenditure tax An income tax that exempts all savings from taxation.
200
G
LOSSARY
Exploitation The appropriation of surplus value by owners of capital.
Externalities The costs (or benefits) of producing a good for consumption
that are not paid for
(or are not received) by the ultimate consumer. For example, pollution i
mposes a cost on all
society, but these costs are not part of the price of a polluting good.
Factor price equalization theorem Free trade in goods leads to equal
wages among trading
partners and equal profit rates.
Feminist economics A branch of economics that employs feminist theor
y in order to uncover
the causes and consequences of women’s economic oppression. Fiscal
policy The use of
government spending and government tax policy to direct the economy.
Free rider problem Because some goods or benefits (for example, the
benefits of defense
spending and higher wages due to unionization) are available to every
one, people will not
voluntarily pay for them; therefore unless people are forced to pay for thes
e goods they will not
get produced.
Game theory The study of interdependent decision-making.
General equilibrium A situation where all markets in an economy ar
e simultaneously in
equilibrium.
Gresham’s Law “Bad money drives out good money”. This law stems fro
m the fact that people
will hold on to money that is more valuable (has more precious metals i
n it) and pass on to
others money that is less valuable.
Income effect The increased quantity of some good demanded by cons
umers as a result of
higher consumer incomes.
Incomes policy Government attempts to control wage and price increases
, and thus inflation.
Increasing returns Occurs when additional workers produce more out
put (on average) than
previously hired workers.
Indifference curve A set of points, representing different combinations of
two goods that yield
the same level of satisfaction to the consumer.
Infant industry argument The claim that protection from foreign comp
etition is justified for
firms that are just starting up in an industry.
2
01
GLOSSARY
Input-output analysis A mathematical representation of the economy th
at shows how much
of various different inputs are needed to produce one more unit of every
good.
IS-LM model A macroeconomic model showing how the goods market
(IS) and the money
market (LM) reach equilibrium together.
Kondratieff waves Long run (45 to 60 years) cycles in economic activit
y.
Labor theory of value A theory holding that relative prices of goods dep
ends on the relative
amounts of work required to produce that good.
Law of demand The view that (other things being equal) the lower the p
rice for some good,
the more of that good consumers will buy.
Law of supply The view that as prices rise for some good, business fir
ms will produce and
sell more of that good.
Leontief Paradox The surprising finding that the US, rich in capital, w
as exporting goods
that used relatively large amounts of labor and relatively small amounts
of capital.
Life cycle hypothesis The belief that individuals gear their annual co
nsumption to their
expected average lifetime income rather than to their current income.
Loanable funds theory of interest Holds that interest rates are determine
d by the supply of
savings and the demand for loans.
Lucas Critique The argument that large-scale macroeconomic models
cannot help make
macroeconomic policy because making any policy changes will alter
the macroeconomic
model.
Macroeconomics A study of the performance of the entire economy.
Marginal cost The extra cost of producing one more unit of output.
Marginal productivity Additional output that results from hiring one mor
e worker (or using
one more input).
Marginal productivity theory of distribution The view that the incom
es received by each
input in the production process is equal to its marginal productivity.
202
G
LOSSARY
Marginal propensity to consume The proportion of any additional in
come that is spent by
consumers.
Marginal revenue The additional revenue received by a firm when it p
roduces and sells one
more good.
Marginal utility The utility consumers get from the last unit of some go
od that they consume.
Market socialism An attempt to combine the characteristics of capitalist and so
cialist economies
by using the market to set prices and allocate resources but having the g
overnment own most
large enterprises.
Mark-up pricing The view that firms set prices by adding a (percentage) increas
e to their costs.
Mercantilism An early economic doctrine stressing that nations must ru
n trade surpluses and
accumulate money if they are to grow and develop.
Methodological individualism The belief that economic phenomena sho
uld be explained only
as a result of individual choices.
Methodology A study of the methods used in trying to understand how
economies work and
how economic laws operate.
Monetarism A doctrine holding that inflation stems from too much mone
y in the economy.
Monetary policy The attempt by a central bank to influence economic
outcomes through its
ability to control interest rates and/or the domestic money supply.
Money illusion When individuals react to changes in monetary terms (th
ey are happy because
they got a pay raise) rather than to changes in real terms (the greater pay c
an buy no more than
the previous paycheck because prices have gone up also).
Monopsony A market in which there is only one buyer of some factor of
production.
Moral hazard A problem arising from insurance systems; insurance causes
people to behave in
more risky ways, thus increasing the chance they will need to collect fro
m the insurance pool.
Multiplier The relationship between a change in spending and the impact
of that change on the
entire economy.
03
GLOSSARY
Natural rate of unemployment The lowest rate that unemployment can
go before it results in
accelerating inflation.
New classical macroeconomics A twentieth-century school of macroe
conomics that
combines rational expectations and a belief that there exists a natural rate
of unemployment
for all economies.
New institutional economics A study of how and why economic inst
itutions (such as
property rights, markets, and the state) come into existence.
Nominal interest rate The rate of interest in today’s prices or ignoring the
impact of inflation
(see real interest rate).
Occupational segregation The practice of hiring primarily women or mi
norities for certain
types of jobs and hiring white males for an entirely different set of jobs.
Opportunity cost The cost of some foregone alternative.
Ordinal utility The belief that consumers can only distinguish that they
prefer one bundle
of goods to another bundle (see cardinal utility).
Pareto Optimality When an economy’s resources are distributed in suc
h a manner that
no one can be made better off without making someone else worse off.
Partial equilibrium Economic analysis that looks at just one market in
isolation from all
the other markets in the economy.
Permanent income hypothesis A theory of consumption holding that c
onsumer spending
depends on average expected income over several years rather than on c
urrent income.
Phillips Curve A trade-off between inflation and unemployment. The
curve shows that
when inflation rises unemployment falls and vice versa.
Physiocracy The first school of economics, headed up by François Quesn
ay. The Physiocrats
held that only agriculture was productive.
Physiocratic theory of rent The view that rents are determined by the su
rplus produced on
a plot of land.
204
G
LOSSARY
Pigou Effect (real balance effect) The argument that during a recession
declines in prices
will increase the real wealth of consumers and thereby increase spendin
g.
Poll taxes Taxes of some fixed amount that everyone has to pay regardle
ss of their income
or their spending habits.
Population principle A belief (due to Malthus) that population growth
would exceed the
growth of the food supply.
Predatory pricing The practice of lowering prices to unprofitable levels
in order to drive
your competitors out of business.
Price discrimination The practice of charging different prices for some
good to different
consumers.
Prisoner’s dilemma A famous result in game theory which shows th
at individual self-
interest may not lead to an optimal outcome.
Progressive tax A tax that falls more heavily on wealthy households t
han on low and
middle-income households. The income tax is an example of a progres
sive tax.
Proportional tax A tax which has all households pay the same fraction
of their income to
the government.
Public choice The economic study of politics.
Public finance A study of government spending and tax policy.
Purchasing power parity A view that exchange rates will tend towards
levels so that two
currencies will be able to buy the same set of goods in their respective c
ountry.
Quantity theory of money Belief that changes in the quantity of mone
y lead directly to
changes in the price level.
Radical subjectivism The belief that only individuals themselves are ca
pable of knowing
what is best for themselves.
2
05
GLOSSARY
Rational expectations The belief that businesses and individuals will lear
n about the effects of
government policy and change their behavior in a way that will count
eract any government
policies.
Real balance effect See Pigou Effect.
Real interest rates Nominal interest rate minus the rate of inflation. T
he real interest rate
represents the gain in purchasing power for a lender and the loss of pur
chasing power for a
borrower.
Regressive tax A tax whereby the poor pay larger fractions of their inc
ome for the tax than
middle-class and wealthy households. Sales taxes are a good example of
a regressive tax.
Roundabout production Production methods using more machinery and
capital, and requiring
a longer period of time between when production decisions are made
and when goods are
produced and ready for sale.
Samuelson-Stolper Theorem Shows that tariffs on imports increase the r
eturns to those inputs
that are heavily used in producing domestic goods which compete with th
e taxed good.
Social Darwinism The belief that in all social and economic interaction
s “the fittest”, or the
best competitors, will win out.
Specie flow mechanism A process whereby trade imbalances automatical
ly correct themselves
because they lead to changes in the domestic money supply and price lev
el.
Stagflation The simultaneous occurrence of high unemployment (stagna
tion) and inflation.
Subsistence theory of wages The view that wages will tend to fall to a level that is
just sufficient
to let workers survive.
Substitution effect The effect on sales for some good due to a change in
price. Higher prices
cause people to purchase (substitute) other goods.
Surplus The difference between the output of some economy and the inputs req
uired to produce
that output.
Surplus value The value of a product over and above the wage and depreciation cos
ts of producing
that good.
206
G
LOSSARY
Tâtonnement A “groping” process by which equilibrium can be reached in all m
arkets at once.
Total utility The total amount of satisfaction that one gets from consuming
a certain quantity of
goods.
Usury (laws) Laws that regulate or prohibit charging (high rates of) intere
st.
Utilitarianism The philosophical doctrine that people should seek to promote the g
reatest possible
happiness in society.
Utopian socialism A belief that the problems of capitalism could be solved
by establishing co-
operative communities not dominated by the profit motive.
Wage fund doctrine A theory of the demand for labor which holds that em
ployers must have a
fund of capital available to pay workers during the production of goods.
Welfare economics The part of economics which studies how to maximiz
e the well-being of
the nation by both increasing output and changing its distribution.
Yield curve A diagram showing how interest rates change as the time to maturity o
n some asset
increases.
207

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British Library Cataloguing in Publication Data

portant The Economic Writings of Sir Willia

An Essay Concerning Human Und

Letwin, W. The Origins of Scientifi

Essai sur la nature du commerce Bordo, Michael “Some Aspects of the

Figure 1 The Tableau Économique

Essays on Some Unsettled Questions o

The Communist Manifesto, New Yor

Heilbroner, Robert, Marxism: For and

Jaffé, William, Essays on Walras, ed. in Ten Great Economists, New Yor

The Collected Works of Carl Menger,

Groenewegen, Peter, A Soaring Eagle:

Cirillo, Renato, The Economics of Vilfre

Capital and Interest, 3 vols. (1884 an

Lectures on Political Economy (190

The Theory of the Leisure Class (1899),

Appreciation of Interest, New York,

Protective and Preferential Import

Dillard, Dudley, The Economics of

FRIEDRICH HAYEK The Challenge of World Poverty: A

JOAN ROBINSON saw with

Eichner, Alfred S., The Megacorp and Oli

Figure 15 Income and substitution ef s of

Mayer, Thomas, Truth versus Precisio

by large majorities (say, two-thirds Public Principles of Public Debt, Ho

The Economic Growth of the United Stat

The Political Economy of Hunger:

Ex ante-ex post Distinguishes that which is planned (ex ante) from wh

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