Last update: 14 September 2018

Lecture 1
Objectives of lecture 1
 To provide an understanding of;
o What an economy is.
o How economists conceptualise an economy
o How economists approach the study of an economy
o How economists seen its functioning and the results of this functioning.

Introduction
 It is generally agreed by economists (i.e., those who study the economy) that an
economy is an integrated system of production, distribution and consumption.
 Economists take as their point of departure that we are material beings; that
consume products and services in order to sustain our lives.
 It is recognised that we need to produce the products and services we consume,
and that we typically do this in a cooperative fashion. That is to say, production
takes place in the context of “a division of labour”, meaning that the economy
should not be seen as comprising self-sustaining individuals.
 It is also recognised that what is produced needs to be distributed between those
doing the producing, and the society at large.
 The analysis of an economy is typically about how production, distribution and
consumption take place.
 Most economists are concerned to explicitly or implicitly analyse the dominant
form of economic organisation we live in today – the capitalist economy. It is the
analysis of this form of economy that is the focus of the present lecture series.
 It is agreed that a capitalist economy is one in which property is fundamentally
private, products are produced by firms to be sold for money, and there is
competition between entrepreneurs/capitalists seeking to maximise their earnings
from the sale of their products.
 Economists differ over how to conceive of such an economy, how it works, and
the results of its working. The two groupings considered in the present lecture
series are the Neoclassicals and the Heterodox approaches.
o Neoclassical economists can be seen as orthodox economists and including
most economists teaching in Universities and working in key government
organisations, while Heterodox economists can be seen as those occupying
the fringes of the system – mostly in academia.
 The approach of the lecture series is to first critically explain the Neoclassical
approach to understanding a capitalist economy and then use the criticisms of this
approach to construct the alternative Heterodox approach.

Approach to explaining the economy

Neoclassicals
 Neoclassicals begin their analysis of the capitalist economy by analysing the
markets for products and factors – the exchange of products and factors – in

1
 terms of the utility maximising behaviour of individuals (and firms as owned by
individuals). This is referred to as the microeconomic foundations. They use this
basis to explain the functioning of the economy as a whole or the macroeconomy
– the growth of aggregate output, changes in the aggregate money price level, and
the balance of payments and the exchange rate.
 A distinction is drawn between real and monetary phenomena. Microeconomic
analyses are typically seen as pertaining to real phenomena, dealing with relative
prices, quantities of products produced, real factor incomes and quantities of
factors demanded and supplied. Macroeconomic analyses are seen as pertaining to
both real and monetary phenomena. The real phenomena include aggregate output
or economic growth, employment and unemployment and the distribution of
income. Monetary macroeconomic phenomena are seen as including inflation, the
balance of payments, and the exchange rate.
o Real phenomena are seen as explained by real factors (mostly the
preferences of individuals and the physical productivity of factor inputs), and
monetary phenomena by monetary factors (mostly the quantity and price of
money).
o It is argued that individuals take decisions with respect to quantities of
products and factors to be bought and sold on the basis of real factors
(relative prices, real factor rewards, etc).

Criticisms
 Seeing the utility maximising individual (or any other alleged behaviour of the
individual) as the basis for understanding capitalist economic phenomena leads to
a mistaken view of these phenomena. In fact the reason for doing so is largely an
ideological one – to sanitise and justify the workings of the system.
 An understanding of the capitalist system requires an understanding of capitalist
production and the process of the accumulation of wealth by capitalists, the basis
of which is profit.
 The distinction between real and monetary phenomena and factors determining
them is an artificial one which results from the necessity to oppose objective
explanations prices and economic phenomena in general.

Heterodox
 Begin their analysis of the capitalist economy by analysing the money prices of
goods produced and sold by producers needing to cover their money costs,
including wages paid to the direct producers. The aim of this starting point is to
focus on what is seen as the core foundations of the capitalist economy – the
process of production and reproduction of commodities.
 This core is then extended by conceiving of producers as capitalist producers
who produce goods for sale in the market in order to cover their money costs and
allow for a certain money rate of profit. It is this that is used as a basis for
explaining what is conceived of as macroeconomic phenomena, i.e., growth,
inflation, etc.
 Heterodox economists deny that there is an analytical separation of real from
monetary phenomena, or their explanations in terms of real and monetary factors.

2
Conceptualising a capitalist economy
 The different approaches to the explanations of the capitalist economy are
accompanied by different conceptualisations of these economies, notwithstanding
general agreement that capitalist economies are characterised by private
property, markets and competition between capitalists.

Neoclassicals
 Neoclassicals typically conceive of an economy in the first instance as
comprising individuals (as consumers) and enterprises or firms as producers of
products consumed by individuals. When expanding on the economic basics
Neoclassicals typically bring in to the analysis government and banks.
o Individuals, enterprises, and banks are referred to as “economic agents”.
 Enterprises are seen as producing products and selling these to individuals as
consumers of these products for money in markets for the products. Markets are
physical or virtual places where products are sold by enterprises and bought by
individuals for certain prices. Prices are seen as sums of money that need to be
paid by buyers of goods to enterprises in order to purchase the products being sold
by them. Enterprises are seen as setting whatever prices they wish, provided there
are buyers for the products, and individuals buying whatever products they wish,
provided they pay the required prices for these. Prices are seen as determined in
markets as a result of bargaining between individuals and firms as demanders and
suppliers of products.
 Individuals obtain the money required to buy the products by selling factor
services to the enterprise for a certain money income in markets, with the
magnitudes of incomes (or prices of factor services) seen as determined in
markets for factor services. The factor services sold are labour services, capital
services and land (or property) services. Individuals, as owners of these factor
services, are seen as free to sell or rent them to whomever they want for whatever
price they wish, providing there are buyers of these services at the required prices.
The money incomes these factors receive are wages, interest and rent. Some
Neoclassicals conceive of a fourth factor as entrepreneurship or entrepreneurial
services to which income in the form of profits accrues.
 At a later stage in their analyses, Neoclassicals extend this basic conceptualisation
to include government, financial markets, trade and international capital flows.

3
Criticisms
 It is misleading to conceive of the capitalist economy as being understood as
comprising individuals governed by utility maximisation or any other behavioural
attribute.
o Firms are seen as owned by utility maximising individuals – entrepreneurs.
 Modern behavioural economics argues that all the problems with Neoclassical
economics stem from the assumption that the behaviour of the individual is that of
utility maximisation. They argue that experiments not only falsifies this
assumption but suggests other behaviour – which provides a more realistic
explanation of economic phenomena. Apart from the fact that this behaviour can
be anything the researcher wants it to be, it leaves in tact the general principle that
economic phenomena can be explained by the behaviour of individuals – the
aggregation of this behaviour.
 Although Neoclassicals formally conceive of goods being exchanged for money
and the prices being explained as money prices, in fact the exchange they are
conceiving of in the first instance is one commodity for another (i.e., barter) with
the price being explained as the relative price – the quantity of one commodity
commanded by another.
o The reason for this conceptualisation of the exchange process is that
Neoclassicals want to explain price in terms of the (relative) subjective
worth individuals attaches to products (see later). To be able to explain
relative prices as relative money prices Neoclassicals would have to first
explain money prices (i.e., the quantity of money commanded by different
commodities) in terms of the relative subjective preferences of individuals.
To do this, money would have to be seen as representing the subjective worth
(or preferences) of individuals per se. By definition, the subjective worth (or
preferences) of individuals for commodities is not quantifiable and therefore
cannot be added, even for the individual.
 Although Neoclassicals formally conceive of the exchange of products being
explained as between firms as producers and sellers of products and individuals as
buyers, in fact they conceive of the exchange process as in the first instance
between (utility maximising) individuals. It is argued that the owners of firms
are individuals that are motivated by utility maximisation – they produce and
acquire an income in order to enhance their consumption satisfaction.
o This conception of the exchange of products being essentially that between
utility maximising individuals is important if one is to be able to explain
relative prices in terms of relative expected satisfaction or preferences for
products. It is for this reason that early Neoclassicals argued that the
foundations of the economic system need to be analysed as a pure exchange
system – with exchange being between individuals naturally endowed with
commodities.
o Hence Neoclassicals often ignore the fact that buyers of products in product
markets are also firms buying inputs to produce goods – firms as producers of
the products. This is necessary in order to avoid having to argue that when
firms buy inputs they are doing so with a view to producing commodities (or
acquiring commodities in exchange for what is produced) which enhance the
consumption satisfaction of the owners of the firms.
o Of course when those exchanging products are seen as producers it is still
necessary for Neoclassicals to conceive of them as owned by individuals

4
 trying to increase their consumption satisfaction, rather than simply to
accumulate wealth in the form of money as capital in order to facilitate the
continuing expansion of wealth.
 Conceiving of the exchange of products in the first instance as between
individuals as buyers of products and firms as producers raises the question of
whether prices can be seen as determined in markets as such (i.e., bargaining
between buyers of the product and firms as producers and sellers). If production is
to continue, it is accepted that prices need to be such that they cover the costs of
producing (or reproducing) the product. This suggests that producers need to be
seen as setting a certain minimum price for the products prior to them being
brought to market. If they are set by firms then it is difficult to avoid the
conclusion that in a normal situation (i.e., one where the firm is not operating at
full capacity) it should be unit costs that determine the prices they set.
 Neoclassicals have good reason to exclude entrepreneurship as a factor input.
This is because entrepreneurs are the owners of enterprises and it is enterprises or
firms that are seen as employing factor inputs. To avoid entrepreneurs being seen
as employing themselves, they need to be seen as a special kind of factor input –
one that employs other inputs, and is not bought and sold in a market. Another
reason for excluding entrepreneurship as a factor is that it is difficult to conceive
of it and explaining profit as given by its contribution to the production of
commodities. Specifically, Neoclassicals want to explain profits in terms of the
productivity of entrepreneurship, but, obviously, cannot it in a way that allows its
quantification and permits an explanation of the income accruing to it as a certain
rate of profit on entrepreneurship.
o Neoclassical get around this by arguing that entrepreneurs too own capital
and obtain a rate of profit on this capital, but one that is different to the rate of
interest. This is theoretically confusing and messy.
 Neoclassicals also find the conceptualisation of capital very difficult, one
compounded by the fact that money is necessarily excluded from the analysis in
the first instance – the analysis being the explanation of relative and not money
prices. In order to conceive of capital in a way that precludes the necessity for the
explanation of the interest on capital as explained by surplus labour time,
Neoclassicals conceive of capital as an array of physical inputs into production,
and this array of inputs as one homogeneous entity that can be referred to as
capital, with the rate of interest on capital being the physical income (physical
products) accruing to ow
 ners of this capital (so-called “capitalists”) that is loaned to entrepreneurs. One
problem is how to conceive of aggregate the physical inputs into production in a
way that allows them to be referred to as capital and conceive of the interest
accruing to the owners as a certain rate. A second is how to conceive of a market
for physical inputs as capital which is separate from a market for these inputs as
simply a product market. A third problem is why the inputs into production
exclude the wage goods needed to keep the workers alive and happy.
o Most textbooks avoid discussion of this problem and simply conceive of
capital as the sum of money lent by individuals (via banks) to entrepreneurs
to buy physical inputs into production. There is no indication how money is
supposed to reduce physical inputs to equivalence, and why expenditure on
wages is excluded from the capital advanced.
 It is difficult to conceive of the demand for, and supply of, loan capital as
determined by the relative strength of demand and supply for these funds when

5
 the central bank in most capitalist countries not only sets the base interest rate,
but appears to influence the movement of the whole structure of rates.
 There is also no recognition of the coercive nature of the economic structure that
requires one part of the population, the largest part, to sell their labour services
in order to maintain their living standard.
o In modern advanced economies these structures include consumerism and
debt (starting with debts incurred when studying), with periodic periods of
unemployment (and reduced levels of support for unemployed, single parents,
etc).
o In developing countries these structures are long-term unemployment and
poverty for large parts of the population.
 It is unclear that wages can be meaningfully conceived of as being determined in a
market for labour rather than in the production process involving labour. This is
because the wage offered to workers wanting to join an enterprise is typically that
negociated by the firm with those already in employment. It would be
inconceivable that new employees added to the work force would be able to
negociate different wages for the same job as those in employment, or that the
firm would change the wages already negociated with those in employment in line
with wages promised to new employees.

Heterodox
 Heterodox economists also see the basic economic system as one comprising
private property, markets and competition between producers of products, but
deny that;
o The prices of products to be explained are relative prices,
o The incomes of services to be explained are real incomes,
o The prices and incomes (as alleged prices of factor services) are determined
in markets for products and factor services, and explained by the activities of
utility maximising individuals.
 Prices are seen as money prices mostly set by producers in order to recover
costs and appropriate a certain commensurate rate of profit.
o Prices are not seen as determined in markets – as a result of the interaction of
buyers and sellers
o Producers are seen as producing as much as possible to maximise their
profits.
 Heterodox economists see producers as those seeking to accumulate wealth in
the form of capital – a sum of money that is expanded on the basis of the
production and reproduction of commodities for prices that exceed their costs.
 The purchase of goods is seen as for two different purposes; for the satisfaction
of consumption needs and as inputs into a production process the aim of which is
to make a profit. The motivations for the two types of purchases are very different.
 Producers of commodities make us of factor inputs in the production of goods, but
these inputs are not all bought in markets, and the magnitudes of incomes accruing
to them are not determined in markets for them.
 The producers of commodities are seen as capitalist enterprises owned by
entrepreneurs or capitalists. These producers advance capital to undertake
production, with some of this capital being borrowed in financial markets. They
obtain a profit in relation to the capital advanced after covering all costs (material

6
 inputs used up in production and wages) and paying interest to those banks and
financial institutions they borrow money from.
o Heterodox economists define capital in the first instance as the money
advanced by entrepreneurs to purchase all material and labour inputs into
production. Some of this money is borrowed, but most comes from profits of
the producer.
 Producers do not borrow from financial institutions to fund their long-term
investment outlays – to expand the level of output. This comes from profits.
 Interest accrues to banks and other money lenders – not producers – in payment
for the money they lend to firms and individuals. The rate of interest is determined
in financial markets, with the base interest rate being heavily dependent on the
policy adopted by central banks.
 Producers pay wages to workers for their labour, but these wages are not
determined in labour markets. They are determined in the process of
production. New recruits get what others in the company get in terms of pay.

Functioning of an economy
Neoclassicals
 Neoclassicals see the driving force of all economies as the utility maximising
choices of individuals (with modern behavioural economics providing other
explanations of the behaviour of individuals).
 Neoclassicals see the utility maximisation of individuals in the context of private
property (including intellectual property), “free” markets, perfect competition,
free trade, and free international capital flows leading to;
o Balance (or equilibrium) in individual markets – between suppliers and
demanders of products,
o The best allocation of productive resources in the sense of maximisation of
welfare and minimisation of costs of production (referred to as economic
efficiency),
o A just distribution of income – one reflecting productivity of factors and
choices of individuals supplying them,
o A tendency towards stable economic growth, full employment, no inflation
and no balance of payments and/or currency problems.

7
 Any instability in the system is attributed to either market failure or government
intervention. The only role for government is seen as setting and maintaining
laws and regulations designed to protect private property, ensure the smooth
functioning of markets, and prevent monopolies forming.
 Neoclassicals see government interference in the economy as damaging price
signals and optimum resource allocation.

Criticisms
 One important ideological purpose of Neoclassical economics has been to deny
the driving force of the capitalist system to be the accumulation of wealth on the
basis of profits arising from the exploitation of labour – the Classical view of
the economic system.
o To provide an alternative explanation of profit Neoclassicals required an
alternative explanation of prices (“theory of value”) to that of the Classical
economists – an alternative to the labour theory of price. This alternative is
the subjective theory of price – that the behaviour of individuals, as utility
maximisers, provides the basis for explaining prices.
o Modern behavioural economics is yet another attempt to rescue
Neoclassical economics in the context of a growing awareness of its serious
limitations, by trying to distract attention from the real source of its failings.
 Neoclassical economics does not see that the capitalist system requires (relative)
inequality and economic insecurity of the majority of the population. It is this
that drives individuals to offer their labour services at wages dictated by firms.
That is, inequality, unemployment, consumerism and debt, poverty, etc are all
necessary bases for profits and the accumulation of wealth by a few in the
capitalist economic system.
 Neoclassicals fail to see that the tendency of capitalist production is one of
periodic overproduction – in the drive of capitalists to accumulate wealth on the
basis of profits.
 They also do not see that the capitalist system is necessarily unstable, with
economic growth, inflation, interest rates, etc., all moving in cycles over time.
 Finally, Neoclassicals do not see that the state is a capitalist state (largely doing
the bidding of the wealthy and powerful), and is always interfering in the
economy at the behest of the rich and powerful.

Heterodox economists
 Heterodox economists see profits and not individual behaviour as the driver of the
economic system.
 It is denied markets tend towards balance in supply of and demand for products.
In fact, they are seen as constantly moving towards and away from balance as a
result of the drive of capitalists to make profits.
 Heterodox economists see inequality, periodic high levels of unemployment,
poverty (especially in some parts of the world), consumerism, and indebtedness
of ordinary people, as necessary features of the capitalist economic system.
 Heterodox economists the capitalist economy is necessarily unstable and subject
to periodic ruptures, episodes of high inflation, high unemployment, balance of
payments problems, etc. These tend to be accompanied by conflicts in defence of
basic living standards.

8
 For Heterodox economists the state is a capitalist state – mostly influenced by
the rich and powerful. It has an important role to play in developing and
regulating capitalist societies and markets, and developing capitalism in less
advanced economies.
Last update: 16th September 2018

Lecture 2
Overview
 Lecture 2 seeks to explain the FUNCTIONING OF PRODUCT MARKETS
according to Neoclassicals. It seeks to explain why commodities are worth what
they are worth and why we produce more or less of one than another. That is, it
seeks to explain the price and quantity produced of individual commodities.
 It is important to note that the price that is being explained in the first instance is
the relative and not money price of a good, since for Neoclassicals (as for some
Heterodox) it is the relative price that provides signals for the behaviour of
individuals and allocates resources.
 The Neoclassical analysis of product markets uses the concepts of DEMAND and
SUPPLY, with the focus being on the determinants of demand and supply.
o For text book Neoclassical economics supply refers to the supply of goods
by firms but for strict Neoclassicals supply refers to the offer of goods in the
process of exchange by individuals who are naturally endowed with goods.
 Neoclassicals explain how the interaction of demand and supply explains the price
and quantity of a product, and why and how this interaction between them tends
towards an equilibrium price and quantity – a price and quantity where there is
no longer any tendency for change.
 Having explained the notion of equilibrium price and output, Neoclassicals then
proceed to try and show why this equilibrium can be regarded as giving rise to
maximum consumer welfare and productive (min average cost) and allocative
efficiency1. It should be noted that the ultimate aim of neoclassical product market
price theory is to show that market determined prices give rise to an optimal
allocation of resources in the sense of maximum consumer welfare and
minimum cost.
 A secondary aim, at least of textbook Neoclassical economics, is to argue that
producers produce at cost and increases in prices are brought about by rising
costs (with profits being argued to be part of costs).

Criticisms
 Neoclassicals (and Neoclassical textbooks) are unclear as to what prices are
being explained, viz., money (i.e., the dollar price of a commodity) or relative
prices (the exchange ratio between two commodities or even one commodity and
many/all other commodities). This is because they recognise that in the real world
prices are in fact money prices but want to argue that it is relative prices that
govern the behaviour of individuals and results in the allocation of resources.
Hence, they need to conceive of the money prices of commodities being explained

1
Allocative efficiency refers to the best possible use of the productive resources at the disposal of a
society.

9
 in a way that actually translates into relative prices. To do this they conceive of
prices in several different ways, all of which are problematic theoretically.
 Neoclassicals fail to see that it is not prices that allocate resources but profits.
Specifically, it is not prices but profits that shifts resources from sector to sector.
The two are not the same thing. Prices can move in a different direction to profits.
 In the final instance, the Neoclassical theory of price is essentially an attempt to
replace an objective theory of price (the labour theory of price) with a subjective
theory of price – price being explained in the final instance by the relative
preferences of (or expected satisfaction derived by) individuals for (from)
commodities. The reason for this is the need to deny that it is the expenditure of
labour time, or, more precisely, surplus labour time, that is the source of profit (a
key component of price). Neoclassicals need to conceive of the price to be
explained as relative and not money price because they are unable to explain
money in terms of subjective worth.

Contents of lecture
General
 Neoclassicals explain the price of the product by the interaction of market demand
and supply. This causes them to focus on the determinants of market demand and
supply.

Market demand
 The market demand for a product is seen as the aggregation of the demand for
these goods by all individuals in a society (and also all other societies when
international trade is taken into account).
 This means that the starting point for Neoclassical analyses of the market demand
for a product is the demand by an individual for the product.
 The individual demand for a product is typically explained by its PRICE,
INCOME LEVEL (nb., normal, inferior and luxury goods), TASTES,
EXPECTED PRICE and PRICES OF RELATED GOODS (nb. complements and
substitutes).
 The starting point for analysis of the product by an individual is usually taken to
be the impact of price on this demand. The relationship between the price and
the demand for the product is argued to be given by the individual DEMAND
CURVE.
 The individual demand curve is assumed to slope down from left to right because
of diminishing marginal utility.
 Diminishing marginal utility is the tendency for the extra satisfaction derived
from the consumption of the last unit of a good to fall as increasing quantities of it
are consumed.
 Diminishing marginal utility is used by Neoclassicals to explain why prices fall as
more of any good is demanded – the downward sloping individual demand curve.
o Utility and marginal utility has been replaced by preferences and the
marginal rate of substitution between commodities by the individual (as
depicted by indifference curves) in most modern economics texts. The reason
for this is to avoid the connotation that satisfaction is something that is
objective and measureable (as in the next slide). By definition it is subjective
and, therefore, not measureable objectively. The present lecture series will

10
 continue with the use of marginal utility analysis since it is typically more
intuitive.
 Market demand curves link different quantities of a product demanded by all
individuals in a society to the prices they are willing to pay for the different
quantities of it demanded. Market demand curves are derived by aggregating
(adding together) individual demand curves linking various quantities of a product
demanded by an individual to the prices individuals are prepared to pay for the
different quantities.
 Individual demand curves, and therefore market demand curves, linking prices to
quantities demanded, are derived assuming that all other factors (apart from price)
which impact on the demand for a product are held constant. The most important
of these other factors are argued to be INCOME LEVEL (nb., normal, inferior and
luxury goods), TASTES, EXPECTED PRICE and PRICES OF RELATED
GOODS (nb. complements and substitutes).
 Of particular note in respect of the non-price factors is taste. For Neoclassicals
tastes of individuals are naturally given.
 The impact of changes in any of these non-price factors on the quantity of a good
demanded is shown in a two-dimensional graph by a movement inwards or
outwards from the verticle axis of the individual (and therefore market) demand
curve.

Criticisms
 Neoclassicals, especially Neoclassical textbooks, do not make clear that when
explaining relative prices it should be relative demand (the demand for one
commodity as opposed to another) that matters and not absolute demand (the
money demand for a product). Yet in most Neoclassical textbooks the notion of
relative demand (like relative price) is missing.
o The problem is that if it is the money demand for a commodity that is
being explained (with a view to explaining its money price), changes in this
demand would typically be dominated by a change the money incomes of
individuals alongside the value of money and such that the demand for all
commodities would tend to rise at the same time along with their money
prices. This means that changes in demand for commodities could not be
argued to give rise to changes in their relative prices and, therefore, provide
signals guiding the behaviour of individuals.
o Also, if what is being explained is the money price of the commodity then
money must be recognised as the measure of exchangeable worth, and its
worth determined in the context of individuals setting money prices – which is
destructive for Neoclassical thinking.
 Neoclassicals tend to ignore in the first instance the fact that the demand for a
product can be by firms and this would not be motivated by utility maximisation
as it is for the individual – even assuming utility maximisation is the motivation of
individuals. The usual Neoclassical response to this is that producers are
individuals undertaking production with a view to exchanging the produced goods
for other goods with a view to maximising their consumption satisfaction. That is,
producers are assumed to be surrogate consumers motivated by, say, consumption
satisfaction, and not wealthy individuals seeking to expand their wealth.

11
 Tastes are not natural but can be influenced by habit, custom, tradition and
advertising. For Neoclassicals advertising is only to INFORM not PERSUADE.
If it is accepted that it persuades, then it does considerable damage to the
Neoclassical model.
 Some critics argue Neoclassical analyses of demand assume changes in relative
market prices of goods do not affect income distribution and therefore preferences
of individuals for particular goods. Allowing for changes in relative prices to
affect income distribution (and therefore the structure of preferences) could mean
a highly unstable market demand curve.
 Critics from even within the Neoclassical school point out that adding individual
demand curves to get a market demand curve means of necessity assuming that it
is possible and meaningful to add individual preferences to get aggregate
preferences. In fact, it has been shown that the only way of doing so is to assume
all individuals behave alike or that there is only one consumer in the market.

Market supply
 The market supply of a product is seen as the aggregation of the supply of these
products by all firms producing the product in a given society (and also all other
societies when international trade is taken into account).
 This means that the starting point for Neoclassical analyses of the market supply
of a product is the supply of it by an individual firm.
 The supply of a product by an individual firm is determined by a number of
factors including PRICE, TECHNOLOGY, WORK EFFORT, TAXES and
SUBSIDIES and INPUT PRICES.
 The starting point for analysis of the product supply by an individual firm is
usually taken to be the impact of price on this supply. The relationship between
the price and its supply is argued to be given by the individual firm’s SUPPLY
CURVE.
 The individual supply curve is argued to be upward sloping because of the
assumption of increasing costs. Costs are assumed to increase over the short-
run because of diminishing marginal productivity and over the long-run
because of (internal) diseconomies of scale.
 Neoclassicals define the short-run as a period of time when at least one factor
input is fixed (usually capital and land), and the long-run as a period of time
when all factor inputs are variable. The assumption that at least one factor input is
fixed over the short-run usually translates into the assumption of full capacity
utilisation (although not for all Neoclassicals).
o In many textbooks reference is made to inputs and/or resources and not
factor inputs although what is meant is actually factor inputs with capital
seen as produced material inputs having a lifespan in excess of one
production period – capital and fixed capital being synonymous.
 When some factors are assumed fixed over the short run an increase in output is
argued to be brought about by an increase in the quantities of the variable factor
inputs (usually labour). Neoclassicals argue that the increase in output
accompanying the increase in the variable factor input diminishes with time after
initially increasing. Hence, the notion of diminishing marginal productivity
(following increasing marginal productivity) of the variable factor. Diminishing
marginal productivity translates into rising unit costs (costs per unit of output) of
the product. If less is being produced by more and more workers, the unit cost of

12
 what is being produced must rise (assuming that the price of the factor input,
labour, stays the same).
 When explaining short-run costs Neoclassicals distinguish between fixed and
variable costs, with fixed costs pertaining to the fixed factors of production and
variable to the (one) variable factor. Unit fixed costs are assumed to fall
continuously as output expands (due to the increase variable factor input added),
while unit variable costs are assumed to fall as output expands, due to diminishing
marginal productivity of the variable factor input.
 When all factor inputs are variable, over the long run, the diminishing marginal
productivity of individual factors can no longer be invoked to explain increasing
costs. Hence the need for an alternative explanation of rising unit costs. This
alternative is provided by the notion of decreasing economies of scale. What
decreasing economies of scale means is that as the individual firm produces on an
ever larger scale it incurs increasing costs related to the large scale. The most
frequently cited of these problems is managerial and logistical problems. The
increasing costs translates into increasing unit costs.
 The costs which are seen as rising and impacting on prices as a result of
diminishing marginal productivity and diseconomies of scale are marginal costs.
Marginal costs are the additional (total) costs arising from the production of an
extra unit of output. To avoid losses from increased production, firms need to
increase prices to cover the increase in the marginal costs.
o It is of note that strictly speaking the costs which matter for businesses in
Neoclassical economics are what are referred to as opportunity costs.
Opportunity costs are the returns from the (second best) alternative use of the
productive asset in question.
o It is also of note that for Neoclassicals costs include profits. The logic for
this is that since wages and rent are treated as costs because firms need to pay
wages and rent to obtain labour and land inputs profit (or interest) should also
be treated as a cost since it is required to obtain the capital input. To include
profit as part of costs Neoclassicals invoke the notion of an economic profit.
A positive economic profit is the profit over and above costs which include a
normal profit (based on a normal profit rate – the return to the material inputs
in relation to the value of these inputs). Normal profits are the opportunity cost
of using capital in an alternative (second best) activity. If firms are earning
only a normal profit, their economic profit would be zero. If they are earning
an abnormal profit, the economic profit would be positive.
o Since profits are seen as profits on fixed capital outlays, unit profits are
seen as falling along with unit fixed costs over the short-run, even though the
firm will be earning a normal profit rate.
 Adding all the individual supply curves of individual firms producing a given
product gives the market supply curve. In the derivation of the market supply
curve it is assumed TECHNOLOGY, WORK EFFORT, TAXES and SUBSIDIES
and INPUT PRICES are given.
 The impact of these other factors on the output of all firms is typically shown in a
two-dimensional graph by the movement of the supply curve either inwards or
outwards from the verticle axis.

13
Criticisms
 It is questionable whether it is meaningful to assume fixed factors of production
over the short run. Apart from the fact that technology does not really permit
adding labour without other material inputs, critics argue that most inputs into
manufacturing production are produced inputs. Hence, it makes no sense to
assume these are fixed (i.e., cannot be increased) while assuming output is
flexible.
o Sraffa notes that the more narrow the definition of an industry or a
product, the less plausible it is to assume fixed inputs into production. Inputs
into the industry can be drawn from other industries. Sraffa also notes that the
broader the definition of an industry, the less plausible it is to assume that
changes in the factor price into the industry in question does not affect the
factor price of other industries.
 It is questionable whether it is plausible to assume full capacity – empirical
studies show businesses typically operate with excess capacity.
 If the price being explained is relative price then the costs which explain this
must be conceived of as relative costs, which begs the question of how one is
expected to conceive of an upward sloping supply curve and rising costs for all
firms.
 Empirical evidence and common sense casts doubt on the Neoclassical contention
that unit costs rise as the scale of production (level of output) increases when all
factor inputs are variable.
o The plausibility of the assumptions of managerial and logistical problems
accompanying the growth in scale of firms is dubious.
 It is extremely doubtful that firms calculate their marginal costs of production
and use these as a basis for pricing. Among other things, to calculate marginal
costs would require firms to know the increase in total costs for a one unit
increase in output.
 The notion of opportunity cost as being a guide for business decision-making is
similarly questionable.
 The notion of an economic profit is seen as little more than an ideological
justification for profits – putting it on the same basis as wages for labour.
 Adding individual supply curves to derive a market supply curve requires one to
assume that all firms in an industry operate with similar techniques of production.
 Neoclassicals are even less clear than in the case of demand that when they are
explaining the supply of the product in the context of explaining its relative price,
they are explaining relative supply and, underlying this, the relative costs of
producing it. Indeed, in most textbooks the notion of relative supply, like relative
demand, is missing. The problem is that, if it is the money costs of producing a
product that are seen as underlying the upward sloping supply curve (relating the
supply of the product to its money price), the changes in these (money) costs
would have to be seen as accompanying changes in the value of money and,
therefore, the money costs of producing all commodities. This in turn means that a
change in the (money) price of the product cannot be seen as providing signals for
producers to expand their absolute or relative production of the commodity.

14
Equilibrium
 This concept shows that the unfettered interaction of demand and supply will
result in an EQUILIBRIUM price which will balance the desires of the buyers of
products (demand) with their availability (supply).
 It is argued that if price either exceeds or falls below its equilibrium level, with no
change in any of the factors determining demand and/or supply, the forces of
supply and demand will bring the price level back to its equilibrium level.
o If price rises above its equilibrium level then supply will exceed demand
and the price will fall back to its equilibrium level. The two forces which
ensure this return of price to its equilibrium level are a reduction in the level of
demand and competition among suppliers to sell their goods.
 Shifts in the equilibrium price level are caused by shifts in demand, as a result
of changes in income, tastes, etc., and supply, as a result of changes in technology,
management, worker effort, etc.

Criticisms
 When commodities are seen as being produced and reproduced, then the costs of
production have to be regarded as the primary determinant of the price level,
not demand and supply, especially over the long-run. That is to say, it is costs that
determine prices in the final instance and not demand. Changes in demand will
only have a bearing on prices through changes in the costs of production.
 The existence of an equilibrium price depends crucially on the existence of
(monotonically) downward sloping market demand curves (i.e., continuously
downward sloping demand curves) and, more importantly, upward sloping market
supply curves. For reasons given above neither need necessarily to be the case.
 Market participants may not have accurate information regarding available
products and prices. This could result, in among other things, multiple price
levels. This is a criticism from within the Neoclassical school.
 Prices may be “sticky” or “rigid” – the tendency for prices not to fall. This is also
a criticism from within the Neoclassical school.

Maximum welfare
 Neoclassicals invoke the assumption of CONSUMER OPTIMISATION to show
that the market equilibrium corresponds to a point of maximum welfare. The
assumption is that consumers equate the marginal utility of each good (e.g., MU
of mangoes) with the amount of money they spend on the last unit of that good
(i.e., the amount spent on mangoes) such that all marginal utilities in relation to
the amount spent on the last unit of each good are equal. If all individuals do this
then by definition,

15
Criticisms
 The implicit presumption is that one can meaningfully talk of aggregate utility or
marginal rates of substitution between commodities.
 Consumers lack the information and processing power to optimise in respect of
every consumption decision. In fact, market demand is better analysed in terms of
advertising, fashion, environment, culture, etc.

Productive efficiency
 Neoclassicals invoke the notion of PERFECT COMPETITION to show that the
market equilibrium corresponds to productive efficiency, i.e., minimum average
cost.
 Neoclassicals compare perfect competition with monopoly to show that a perfect
competition environment will result in lower average costs and higher output.
 The key assumptions of perfect competition are that firms are; price takers,
earning a normal rate of profit, can produce as much as they wants for the given
market determined price, and there are no barriers to entry in any sector. This
means that no individual firm can influence price; all firms faces a FLAT
DEMAND CURVE.
 Since all perfectly competitive firms must take prices as given, they can only
decide on which level of output to produce. For Neoclassicals this decision is
guided by profit maximisation. Specifically, firms will choose an output level
which maximises profit. This output level for Neoclassicals is where MC=MR.
 At this output level it is assumed the perfectly competitive firm will also be
producing at minimum average cost. The minimum average cost result follows
from the assumptions that there are no barriers to entry. With no barriers to entry
firm cannot charge a price in excess of that consistent with minimum average
costs (which includes a normal rate of profit).
 MONOPOLY is where there is a single firm in an industry. In this case the firm
faces the same (average and marginal) cost curves as firms in perfect
competition but a different demand curve. The demand curve facing the
monopoly firm is the industry or market demand curve, which is downward
sloping.
 Although Neoclassicals are not clear on the matter, it appears that Monopolists too
will chose a profit maximising level of output, i.e., where MC=MR. This level of
output is seen as being lower than in perfect competition and resulting in a higher
level of average costs (and price).

Criticisms
 Although it is certainly true to say that the individual firm does not set the prices
for the products it produces, this does not mean that it is incorrect to conceive of a
certain average firm producing a standard product setting the price of the
product (to cover its profits and yield and acceptable profit).
 Profit maximising firms do not set output levels where marginal cost equals
marginal revenue but rather tend to expand output as much as possible. The
reason they do so is that in reality firms face declining average cost curves and not
U-shaped average cost curves.

16
 It is unclear that all firms in an industry face the same horizontal demand curve.
This would deny that firms compete with one another by differentiating their
products – by producing slightly different products and advertising.
 One of the premises of profit maximising perfectly competitive firms is they face
U-shaped cost curves. As noted above, this is empirically as well as logically
doubtful.
 Not all firms in the same industry have the same technology and, therefore, the
same cost curves and profit rates. One of the ways in which firms compete with
one another is precisely the lowering of their relative costs of production.
 Many Neoclassicals themselves admit that monopoly industries arise because of
economies of scale. If this is the case then the Neoclassical comparison of
monopoly with perfect competition falls apart. For one thing it cannot be argued
that perfectly competitive firms are necessarily lower cost producers than
monopolies.
 If the monopolist also maximises profit by choosing an output level which
corresponds to MC=MR it too needs to be seen as a price taker. Yet, it is known
that monopolists set prices in order to maximise their profits.

Money prices
 As noted above, the Neoclassical product market analysis is in principle
concerned with the explanation of relative prices. However, since it is recognised
that prices are in fact money prices, what Neoclassicals do is explain the relative
prices of products as relative money prices assuming the value of money is either
constant or given, and then explain the value of money subsequently to derive the
money worth of each commodity.
 For Neoclassicals the value of money will depend on the quantity of money in
relation to the quantity of commodities. When there is an increase in the quantity
of money in relation to the quantity of commodities, the value of money will fall
and the average money prices of all commodities will rise. The relative prices of
commodities will, however, remain unchanged unless relative preferences for the
commodities change.

Criticisms
 Neoclassicals are unable to translate relative prices into relative money prices
without making some questionable assumptions – e.g., that money reflects a
certain quantity of general utility for the individual. The notion of general utility is
of course contrary to the very foundations of Neoclassical thought.
 The Neoclassical explanation of the value of money requires Neoclassicals to
aggregate commodities in some way other than in terms of their money value.

Underlying logic
 Neoclassicals seek to emphasise the importance of the price mechanism in the
OPTIMAL ALLOCATION OF RESOURCES (i.e., max welfare and lowest
cost). It is the price mechanism which serves to coordinate the division of labour.
It is the price mechanism which serves to coordinate demand and supply since it is
the sole factor that both of them have in common. Heterodox economists, and
17
 common sense, suggests that far more important in the coordination of economic
activities is profits. It is of note, however, that some Heterodox economists,
following Nicholas Kaldor, see quantity signals as more important than prices in
coordinating activities.
 Neoclassicals want to show that if the market is allowed to work such that there
are no constraints to demand and supply, it (the interaction of demand and supply)
will result in a unique equilibrium sets of prices which will reflect;
a) (natural) PREFERENCES OF INDIVIDUALS, and
B) MINIMUM COSTS OF PRODUCTION where the costs comprise factor
rewards which are determined by preferences of individuals (e.g., between
work and leisure, present and future consumption, etc) and productivities of
factors.
 Neoclassicals want to show that all economic phenomena can be explained in
terms of the natural (selfish) behaviour of individuals.
 It is of note that Neoclassicals are not alone in explaining the workings of the
system in terms of market demand and supply. Heterodox economists also use
demand and supply. However, the differences between the two concerns the prices
being explained, their perceived role in the functioning of the economic system,
and how they are determined.

Key elements for an alternative theory of product market

behaviour
 Prices being explained should be money price.
 Money prices should be seen as those facilitating the expanded reproduction of
the commodity.
 Demand for commodities should be seen as both consumer and business demand.
o Businesses should also be seen as demanding commodities, and this
demand is motivated by their desire to make profits and not for owners of
the firm to consume products, or consume other products with the revenue
from the sale of the products.
o The consumer demand for the commodity should be seen as being
influenced by advertising and marketing strategies of companies.
 Firms do not set prices on the basis of marginal unit costs, but rather (expected)
average unit costs.
 Firms do not operate at or near full capacity levels.
 Firms see average unit costs falling with expansions in scale and the introduction
of new technologies.
 The magnitude of prices need to be seen as determined by costs in the final
instance (even if the scale of output is seen as determined by demand).
 Although one can accept that markets (prices and output level) move in a way so
as to result in a balance in demand and supply, the norm is imbalance – firms
constantly trying to expand production and take market share from rivals.
 A competitive environment is not one where firms produce at an output that
equates marginal cost with marginal revenue, but one where producers use
marketing and technology change to expand production and take as much market
share as possible.

18
 Last update: 8th September, 2018

Lecture 3
Objectives of lecture
 The lecture seeks to explain price and output in product markets from a
HETERODOX perspective.
 It seeks to show that price is fundamentally determined by the conditions of
supply and output by the conditions of demand.
 The analysis also aims to show there is no tendency towards equilibrium in
product markets for Heterodox economists.

Contents of lecture
 Most Heterodox economists also explain price and quantity in product markets in
terms of demand and supply, but their explanation of the nature of product
market demand, and especially supply, curves is different from that of
Neoclassicals.
 For Heterodox economists, there is no such thing as perfectly competitive product
markets, at least not in the sense of Neoclassical economists (with producers
maximising profits by allegedly selecting levels of output which equate marginal
cost with marginal revenue). For Heterodox economists product markets are
characterised by competitive market structures. The characteristics of such
product market structures are; a few dominant firms, firms set money prices, firms
operate with excess capacity, firms are allowed to enter and exit the sector freely,
and the average firm earn an economy average rate of profit allowing for risk and
difficulty in production.
o Some sectors can be classified as monopolistic or oligopolistic meaning
that there are certain barriers to entry allowing firms in these industries to
obtain above economy average rates of profit.
 Firms (in competitive sectors) set prices on the basis of average unit costs plus a
mark-up (given by the industry average). The average unit costs are calculated on
the basis of average operating capacity. Most firms typically operate with excess
capacity – at around 75%-80% of full capacity. It is argued that unit average costs
fall (or are perceived to fall) as output expands, due to the nature of fixed and
variable costs. Unit money labour costs are assumed to fall while unit material
costs are assumed to be either constant or fall.
 Unit money labour costs are assumed to fall due to continuous increases in
labour productivity. For a given or even rising money wage rate, unit labour
costs can be assumed to fall as labour productivity rises - especially since workers
will not be allowed to bargain for salary increases which exceed the increase in
the physical product they produce. For non-Marxist Heterodox economists unit
labour costs are assumed to be constant largely because wages are fixed at the
beginning of production for the entire production period (say one year) and labour
productivity is assumed not to fall with increases in labour employment due to the
existence of excess capacity.
 Unit material costs are assumed to be constant (or possibly fall) due to the fact
that an increase in the quantity of outputs produced requires a corresponding

19
 increase in the physical inputs used. For non-Marxist Heterodox economists the
unit material costs comprise unit fixed costs (i.e., the costs of inputs that do not
vary with a change in the quantity of output) and unit variable costs (i.e. the costs
of inputs that vary with the quantity of output), with the unit fixed costs being
assumed to fall as capacity utilisation rises while the unit variable costs are
constant – hence total unit material costs being argued to fall as output rises.
However, it should be noted that what is also assumed is a certain level of excess
capacity – hence casting doubt on the logic of falling unit fixed costs.
 With costs falling and prices constant, the profit margin can be expected to rise
as output rises.
 That is to say, the firm’s product supply curve is flat such that demand has no
bearing on prices.
 Demand only has a bearing on the level of output. It is only in exceptional
circumstances (when output reaches the full capacity level and the economy as a
whole is in a economic boom) that demand has a bearing on prices.
 One of the implications of Heterodox product market analyses is that there is no
tendency for product market equilibrium. This is because the firm can always
make a larger profit by expanding production (given the existence of downward
sloping demand curves). Full capacity will never be reached because, as soon as
capacity utilisation exceeds a certain level, the firm will invest to expand capacity.
The incentive and finance for investment comes from the expanded profits.
 The value of money is given by the productivity of labour, prime costs that affect
all products (such as prices of raw materials), and, aggregate excess demand. If,
for example, productivity rises, there will be downward pressure on money prices
of commodities and, therefore, upward pressure on the value of money.
 If the money prices of raw materials rise/fall
 there will be an upward/downward pressure on unit money costs and,
 therefore, a corresponding upward/downward pressure on the average money
price level
 and a corresponding downward/upward pressure on the value of money.
 If the government runs a large budget deficit or if private credit is allowed to
expand massively (in excess of the growth of nominal GDP) then there will be
upward pressure on the aggregate money price level and downward pressure on
the value of money.
o Note, upward pressure on the value of money means that a given unit of
money can buy more commodities (average money prices are lower), and
downward pressure on the value of money means that a given unit of money
can buy less commodities (average money prices are higher).

Last update: 16th Sept 2018

Lecture 4
Objectives of lecture
 The lecture seeks to explain the functioning of the so-called factor markets from
the perspective of Neoclassical economics.

20
 Factor inputs for Neoclassicals typically include labour, capital, land, and (on
occasion) entrepreneurship.
 Factor inputs are not to be confused with commodity inputs. The former are
seen as services provided by individuals to producers of commodities in return for
which the owners receive an income. The factors themselves do not change hands,
only the services they provide. Commodity inputs are basically produced goods
which are bought and sold for a price. It is argued that capital services constitute
the services provided by the goods comprising capital.
 In their factor market analyses Neoclassicals seek to explain the determination of
the price and quantity of factors (labour, capital, etc.) utilised in production.
 As with the product market analysis, the Neoclassical factor market analysis
makes use of the notions of demand and supply. The interaction of the demand
for and supply of factor inputs are seen as determining their price and the quantity
of them used in production.
 As with their product market analyses Neoclassicals pay considerable attention to
the notion of equilibrium in these markets and why and how these markets tend
towards this equilibrium.
 In their analyses of factor markets, Neoclassicals seek to show that factor incomes
(or factor prices) reflect the contribution of factors to production and preferences
of individuals supplying the factor services. This contribution is determined by
productivity of the factors, and the magnitude of the contribution by the choices
of the owners of the factor services.
 Typically Neoclassicals use the factor market analyses to argue that the shortage
of capital in developing countries is caused by an excessively low real interest
rate, state banks and limited development of private financial markets, and high
unemployment in these countries is caused by an excessively high real wage
level and low labour productivity.
 The analysis is also used to argue that if wages are to rise then labour productivity
must rise.
 Neoclassicals are typically at pains to argue that wages have nothing to do with
profits and vice versa.

Criticisms
 Critics argue that it is difficult to conceive of entrepreneurship and define capital
in an unambiguous manner.
o Some Neoclassicals define capital as long-lasting inputs, without being
specific as to what long-lasting means, others define capital as any non-labour
produced input into production.
 Critics deny that it is meaningful to talk of “factor markets”, certainly in the case
of capital and entrepreneurship. Rather, what is more meaningful is a discussion
of the determinants of aggregate income shares in an economy.
o It is of note that many Neoclassicals deny or ignore entrepreneurship as a
factor input, and many textbooks avoid discussing capital as a factor input.
o One problem is that few, if any Neoclassical textbooks, provide an explanation
of the determination of profits/interest.
 Critics argue that while it is certainly true that aggregate income levels will move
with productivity, they also argue that income shares will move inversely to one
another.

21
Contents of lecture 4
General
 Factor markets are explained by the demand for and supply of factors.
Interaction of demand and supply will determine the quantity of factors used
in production and their price.
 The price of the factor is seen as the return to the factor for the use of its
services over a certain period of time. Typically Neoclassicals conceptualise
these returns as real returns – i.e., money returns allowing for inflation.

Criticisms
 Most textbooks provide limited treatments of factors markets, paying most
attention to labour markets.
 It is assumed that all factors are SUBSTITUTABLE for one another and that
factor proportions are variable. However, even allowing for the fact that
Neoclassicals find it difficult to unambiguously define capital, it can be argued
that there is a limited substitutability of produced and non-produced inputs for
labour and vice versa.
 When it is accepted that factor inputs are no longer fixed (i.e., over the long run)
Neoclassicals simply assume that there is a tendency for productivity of factors to
fall.

Labour market

Definitions
 The price of labour is given by the REAL WAGE.
 What is assumed to be bought and sold in the labour market is LABOUR
SERVICES and not the workers themselves. The workers are paid a wage to
provide their services to businesses for the purposes of producing goods and
services.

Criticisms
 Critics question whether what is sold and bought in the labour market is
particular labour services (e.g., carpenter, plumber, electrician, etc) or labour
power in general – the ability to produce saleable commodities and a surplus of
saleable commodities. A surplus of saleable commodities refers to an excess of
these in terms of their money value which is over and above the cost of producing
them.
 Critics (Post Keynesians) argue that the price of labour is the money and not
real wage, since workers cannot bargain over the price.

Demand
 The analyses of the demand for labour typically begins with an analysis of the
demand by individual firms for labour in a given industry or sector, and then these

22
 individual demands are aggregated to give the industry or sectoral demand for
labour.
o It is of note that the economy-wide demand would pertain to the
macroeconomic dimension.
 The demand for labour by the individual firm is seen as a function of a number of
variables including the price of labour (the real wage), the relative prices of other
factor inputs, the productivity of labour, income taxes, and those factors
influencing the demand for commodities produced by labour (so called derived
demand).
 The first factor typically considered is the real wage (W/P). The relation between
the real wage and the demand for labour is referred to as THE LABOUR
DEMAND CURVE. It is assumed that there is an inverse relationship between
the real wage and the demand for labour such that the labour demand curve is
downward sloping.
 The downward sloping labour demand curve linking the real wage and the
individual firm’s demand for labour is explained by the DIMINISHING
MARGINAL PRODUCTIVITY OF LABOUR. It is of note that the price of
the products of labour is now assumed fixed (whereas in lecture 2 it was the price
of the factor inputs that was assumed fixed). Hence, a fall in the productivity of
labour must translate into a lower real wage if there is to be an expansion in the
demand for labour.
 As noted above, the other factors of relevance for the explanation of demand,
apart from the real wage, are the productivity of labour and a number of derived
demand factors including income, tastes, prices of related goods, etc. Particular
emphasis is placed on the productivity of labour.
o Neoclassicals typically see productivity of labour as linked to skills,
and these in turn to education (private vs state). Some Neoclassicals see
productivity as linked to taxation, with high and low taxes explaining rising and
falling productivity.
o Derived demand refers to the relative demand for products or using
more labour intensive techniques (viz., services).
 A change in any of these other factors is shown as a shift in the labour demand
curve outwards away from, or inwards towards the, verticle axis.

Criticisms
 The short-run downward sloping demand curve for labour as explained by the
diminishing marginal revenue product of labour pre-supposes that labour can be
varied while capital and other inputs remain fixed, at least over the short-run. This
suggests that firms are operating at full capacity – which is empirically
untenable. Most studies show that firms typically operate with excess capacity.
 Neoclassicals do not see that the demand for labour can rise along with rising real
wages if profits rise, and that the latter may even allow a rise in real wages. In
fact the argument is that the major explanation for changes in the demand for
labour in a capitalist economy is changes in the demand for the products of labour
(and the profits of the firm selling these products) and not either a fall in the real
wage (which would actually dampen such demand) or a rise in productivity. It
needs noting in this context that a rise in productivity does not necessarily imply a
rise in profitability. Much will depend on what is being produced and the
environment in which it is being produced.

23
 One can question the validity of assuming a diminishing marginal productivity
when for the most part factor inputs have a fixed ratio to one another – machines
typically require a certain number of workers. That is, one can question the
assumption of substitutability of labour for capital (and other factor inputs).
 To argue that relative factor prices influence the relative demand for labour also
suggests that factor inputs are substitutable. This does not happen in modern
economic systems.
 It is argued that as labour becomes more productive less labour is demanded and
not more.
 It can be argued that a fall in real wages would cause the demand for the products
of labour to fall (as a result of wages being lower than the prices of the goods
being bought by workers) leading to a fall, rather than a rise in demand for labour.

Supply
 The labour market supply is seen as the aggregate of labour supply by individuals
(i.e., hours of labour individuals seek to supply).
 Hence, labour market analysis begins with a study of the factors determining the
supply of labour by an individual.
 The factors affecting labour supply are the real wage, preferences for work and
leisure, institutional factors affecting these preference (e.g., labour laws, break-up
of unions, social security, unemployment benefits, breaking of taboos regarding
the employment of different gender, ethnic and other groupings, and taxes),
population growth, and immigration.
 The individual labour supply curve linking the supply of labour and the real wage
is referred to as THE LABOUR SUPPLY curve. It is argued to be upward sloping,
meaning that a higher real wage is required for an increasing supply of labour.
 The upward slope of the labour supply curve is explained by a DIMINISHING
MARGINAL RATE OF SUBSTITUTION between work and leisure. As
workers supply more labour time they place an increasing value on their leisure
time. Technically, this means that the labour supply curve is flat at low levels of
working hours offered but becomes steeper as labour offers more working hours -
a proportionately higher wage is required to compensate for progressively greater
sacrifices of leisure time.
 Changes in the other factors influencing the supply of labour apart from the real
wage (viz., preferences of workers between work and leisure, institutional factors,
taxes, etc) are shown by a shift in the labour supply curve inwards towards, or
outwards from, the verticle axis.

Criticisms
 Labour cannot bargain for a real wage, since they cannot control future
prices. It is argued that businesses typically arrive at wage bargains with labour
before they set prices.
 Most workers are not able to choose the number of hours they work.
 Seeing the supply of labour as a choice between working and leisure is a
misrepresentation of the nature of labour supply. For most labour there is not
a choice of how many hours in a day, or days in a week, they work. For many the
choice is between working or living an impoverished life.

24
 The relationship between the supply of labour and the real wage is not as
depicted by the upward sloping labour supply curve of Neoclassical theory. For
example, at higher levels of real wages increases in real wage may cause less
labour to be supplied, and, at low wage levels reductions in real wages may cause
more labour to be supplied – since real wages may be near the subsistence level.

Equilibrium
 Changes in the real wage rate are seen as important in explaining equilibrium in
the labour market.
 It is argued that if the labour market is allowed to work there should be no
unemployment, at least no structural unemployment, since everyone who wants
to work can work. It is for this reason that the definition of unemployment was
changed in the 1990s to exclude those who have been unemployed for more than a
certain period of time (e.g., 9 months), on the basis of the argument that those
unemployed for longer than this period can be presumed to prefer leisure!
 Neoclassicals argue that if there is unemployment it is because the price of
labour is too high, say due to institutional factors such as trades unions, minimum
wages, pensions, health insurance, etc., or the demand for labour is too low –
usually because the productivity of labour is seen to be too low.
 In the context of economic development, Neoclassicals use the real wage and
productivity of labour to explain unemployment.
 It is also assumed by Neoclassicals (usually in the context of economic growth
theory) that if wages are too high then there will tend to be a substitution of
capital (machines) for labour.
 Neoclassicals argue that for real wages to rise the demand for labour curve needs
to shift outwards in relation to labour supply (i.e., the other factors influencing
demand need to change). Neoclassicals typically suggest the most important way
this can happen is if the productivity of labour were to rise. The latter could be
due to either workers working harder and/or becoming more skilful.

Criticisms
 The Neoclassical notion of full employment is dependent on the contention
that there is always work available for those who want it. This is rarely the case
in capitalist countries where unemployment is functional (especially in
recessionary periods) and is a norm in many developing countries.
 Reducing wages in a situation of unemployment would worsen the problem
of unemployment since lower wages would cause the demand for goods and
services by workers to also fall leading to a fall in the demand for the workers
producing these goods.
 Wages are not, and cannot be, flexible in the manner supposed by
Neoclassical economics. This is because wages are of necessity fixed for
significant periods of time (see Heterodox analysis in lecture 4).

Capital market

Definitions
 Capital markets are not often discussed in the mainstream textbooks. This is at
least in part because there are considerable problems defining capital and the
return to capital in an unambiguous manner.

25
 From a Neoclassical perspective, capital is in fact best defined as a stock of (long-
lasting) physical inputs (or the money required to command these inputs). It
is argued that capital goods are bought by businesses for the productive services
they provide.
 The price of capital refers to the price paid for the services provided by the
capital goods. This is given by the real return. This is the return to the owner of
the capital goods over and above her/his cost. It is the opportunity cost of the use
of the capital goods. Some economists define the real return as the real interest
rate – the nominal rate minus the rate of inflation.
 The real rate of return is defined as the physical surplus produced by machines
in proportion to the machines. It is seen as falling over the short-run due to the
diminishing marginal physical productivity of capital.
 The source of the real return to capital is seen as the physical productivity of
this capital – the physical productivity of the machines.
 The magnitude of this real return (or magnitude of profit) is seen as rising along
with the productivity of the machines and the expansion of output, but at a
diminishing rate.
 Most Neoclassicals do not distinguish between interest and profit and see
interest as profit. These Neoclassicals typically ignore the role of the
entrepreneur in capitalism.
 The demand for capital is seen as the demand for the non-labour long-lasting
material inputs into production by firms, or investment demand. It is taken as the
sum of money that is used to pay for these non-labour inputs.
 The supply of capital is seen as the supply of money to buy these inputs, and is
seen as coming from the savings of individuals.

Criticisms
 Typically most economics textbooks ignore the discussion of capital markets as
factor markets. Examples are Krugman and Wells (2006) where there is no
discussion of capital in the chapter on the distribution of income.
 The notion of capital goods as goods providing capital services is difficult to
understand since for one thing it is difficult to understand what capital services
means. If it means being able to produce other goods, this could be said to apply
to ordinary tools purchased by individuals who do not use them to produce a
financial profit in the same way that firms do. If it means the service of producing
a profit, this begs the question what such goods might be, i.e., what are goods
which produce a profit and where could one buy them.
 The notion of a market for capital is also difficult to understand since it suggests
that there is a market for income generating means of production. While there are
certainly markets for borrowing and lending money as well as buying and selling
inputs (long lasting and other) these cannot be argued to constitute markets for
income generating assets. Indeed, whether loans obtained from banks or inputs
purchased in shops constitute capital depend on the purpose to which these are
given/obtained. Money can be loaned as capital (i.e., requiring the borrower to pay
interest on the loan) without it being also borrowed as capital (i.e., used to
generate an income). Similarly, a computer can be sold as capital (i.e., produced
as a good by a capital firm the sale of which will yield a profit to the firm) and

26
 bought as a capital input but it may also be bought as a final consumption good
yielding no financial reward for its purchaser.
o One way in which Neoclassicals get around this is to argue that the
return to the owner of capital is not necessarily financial but needs to be
understood in terms of expanded the satisfaction it gives rise to.
 Neoclassicals exclude the money advanced to pay wages (and pay for inputs
which have a life span of one production period) when defining capital, without
any real rationale for doing so. This is especially problematic since businesses
typically compute their rates of return on capital advanced taking into account the
money they advance to pay for all inputs into production.
 Neoclassicals assume that the source of interest is the productivity of long-
lasting inputs but fail to explain how more physical outputs are produced by given
amounts of physical inputs, or why non-long lasting physical inputs do not
produce a physical surplus.
 It is unclear how one can conceptualise the real interest rate (the return on
physical inputs). In theory it is the physical commodity return in relation to the
commodities advanced as capital. The problem is that for these two magnitudes to
be comparable one has to assume they are the same commodities. Hence, the
absurd notions of capital and returns to capital which abound in Neoclassical
theory including capital as corn or putty and the return to capital in terms of corn
and putty. The Walrasian general equilibrium version of the theory assumes
capital is any commodity (not necessarily one which is an input into production)
whose rate of return in terms of itself is positive!
 Those who distinguish between capital and entrepreneurship admit that it is
difficult to talk about the demand and supply of entrepreneurship. For one thing,
there is no way to quantity entrepreneurship. Capital markets are deemed to
allocate capital to their most productive uses through the real interest rate
mechanism (seen as the price of capital services). Even granting there are capital
markets, the question is what profits are supposed to do in terms of allocating
resources. Are they supposed to allocate entrepreneurial skills? If so how are
these defined and measured? What is the rate of profit on entrepreneurial skills?
 Where Neoclassicals make a distinction between interest and profit (one being
the pure return to capital for parting with liquidity and the other being the risk
premium) it is unclear what profit constitutes a return to? Many Neoclassicals
argue it is a return to the entrepreneur (the owner of the enterprise), but this causes
trouble when discussing the marginal product of entrepreneurship.

Demand
 The demand for capital is associated with investment demand; the demand
for long-lasting inputs to expand production. Although this is seen as a demand for
the real physical resources to undertake investment and the real rate of interest is
the expected real or physical rate of return resulting from the investment, there is a
tacit assumption that this investment demand is the demand for real money
balances to buy the required non-labour inputs and the rate of interest is the real
rate paid to the suppliers of this money.
 The market demand for capital is given by the sum of the demand for capital
by individual firms.
 The demand for capital by an individual firm is argued to be a function of a
number of variables, including the price of capital (the real rate of interest on the

27
 borrowed sum of money), the price of other factor inputs, the productivity of
capital, and those factors influencing the demand for the product (including the
relative price of the product, income, tastes, etc).
 The first factor influencing demand which is analysed is the real rate of
interest (approximated by the nominal rate of interest given in financial markets
minus the rate of inflation).
 The curve depicting the relation between the demand for capital and the real
interest rate is referred to as the demand for capital curve.
 The demand for capital linking the price of capital with the quantity of capital
demanded by the individual firm is argued to be downward sloping on the
assumption of diminishing marginal revenue productivity of capital.
o As more capital is employed the marginal productivity is assumed to
diminish. With given prices for the products produced with the extra capital the
additional revenue obtained is also assumed to fall. But the tacit assumption is
that all other inputs except for capital are fixed.
 The influence of factors other than the real rate of interest on the demand for
capital is shown by a movement of the demand for capital inwards or outwards
from the verticle axis. The other factors were noted above and include the prices of
other factor inputs, the productivity of capital, and derived demand factors such as
income, tastes, etc..
o The productivity of capital is linked to technological change and
typically seen as introduced into the individual production process via
borrowings.
o The derived demand factor refers in principle to products produced
using capital intensive processes.

Criticisms
 Following from the definition of capital, there is no reason to suppose that a firm
considers its investment demand (demand for capital) as only the purchase of
long-lasting material inputs into production (i.e., fixed capital), or even just
material inputs into production. Specifically, there is no reason to exclude non-
lasting material inputs or, and most importantly, the outlays on hiring labour.
 If the demand for capital is seen as the demand for money to buy long lasting
non-labour inputs then the rate of interest should be seen as the real rate of interest
that needs to be paid to the lenders of this money. However, this would suggest
that the firm’s demand for borrowed funds will depend on the extent to which its
returns are able to cover these costs and compensate it for the risk of undertaking
the investment – i.e., an entrepreneurial profit. Otherwise one is assuming that
production is only for the purpose of paying an interest to the lenders of the
money. But if indeed there is need to generate a profit over and above the interest
paid to the lenders of the money, there is no reason to suppose the demand for
capital is inversely related to the real rate of interest that needs to be paid for the
borrowed funds. It is perfectly possible for the real rate to rise along with the
demand for the funds provided that the rate of profit is rising. Indeed, the rise in
the rate of interest would be made possible by the rise in the rate of profit.
 Many Neoclassicals typically avoid explaining why and how the demand curve
for capital is downward sloping, except for saying that it is the consequence of
diminishing returns. However, diminishing returns over the short run can only be

28
 explained by diminishing marginal revenue productivity over the short-run, and
this necessitates the assumption that other factors cannot be varied. Aside from the
fact that this suggests the existence of excess capacity over the short-run, it
contradicts the fundamental premise of Neoclassical economics justifying rising
costs of production over the short-run, i.e., the only factor that can be varied over
the short-run is labour. And, over the long-run, when all factors are variable, it is
difficult to understand what might explain diminishing returns to capital – as
separate from diminishing returns to other factors.
 To argue that the demand for capital is related to the relative price of capital
suggests that capital is substitutable with other factors of production.
 It is implicit in the Neoclassical explanation of the demand for capital that an
increase in the productivity of capital translates into an increase in profitability.
But in fact an increase in productivity may be accompanied by a fall in
profitability.

Supply
 The supply of capital is technically the supply of the resources or “services”
needed for investment. The more savings there are the more of a country’s
resources are deemed to be devoted to activities other than consumption, i.e.,
investment.
 The supply of capital is associated with savings by individuals (real resource
savings) because it is understood in terms of consumption foregone by
individuals. That is to say, the capital borrowed by firms is the result of savings
or non-consumption by individuals.
 The supply of these capital services is not the supply of the machines by
individuals but rather the supply of money to buy the machines.
 The market supply of capital is seen as the aggregation of the individual
supply of capital by individuals – the market supply of capital services. Hence,
the analysis of the supply of capital should begin with the determinants of the
supply of capital by an individual.
 The supply of capital by an individual is seen as determined by; the price or
real rate of interest, the level of income, natural preferences of individuals
between consumption and savings, the institutional factors affecting these
preferences, and inflation.
 The focus in the first instance is on the link between the supply of capital by
the individual and the price of capital or the real interest rate. This relationship is
typically depicted by THE CAPITAL SUPPLY CURVE. This curve is seen as
upward sloping (getting more verticle as capital supply rises) because of a
diminishing marginal rate of substitution between present and future
consumption. As individuals supply more capital (i.e., the more they postpone
present consumption) they place an increasing value on present consumption.
Technically, this means that the capital supply curve becomes steeper as capital
supply increases, since a proportionately higher real interest rate is required to
compensate for progressively greater sacrifices of present consumption.
 Aggregating individual capital supply curves gives the market supply curve.
Other factors influencing the supply of capital, aside from the real interest rate, is
depicted by the movement inwards and outwards of the market supply of capital
curve. The other factors which are responsible for this movement of the market

29
 capital supply curve have been noted above and include the level of income,
preferences of individuals (their natural preferences to save) and institutional
and economic factors. Examples of institutional factors include the development
of the financial system, and tax policies, and examples of economic factors
include inflation and inflationary expectations.

Criticisms
 The supply of capital should not be thought of as individual consumption
forgone but rather investment finance.
 Savings, in the sense of investment finance, do (does) not come from
individual savings with financial institutions (as implied by Neoclassical
analyses) but retained earnings (profits) of companies.
 It is unclear that the more you save the progressively higher the interest rate
has to rise to encourage you to save more. Typically, rich individuals will save
(to finance investment) most if not nearly all their incremental income even
without any increase in real interest/profit rates. Other critics argue that high real
interest/profit rates might even encourage dissaving for certain income groups.
 If the rate of interest rises then profits will fall and so will savings. Hence, the
Neoclassical analysis only makes sense if we assume the rate of interest is profit.
But this contradicts the demand for capital analysis.

Equilibrium
 Changes in the real interest rate are seen as giving rise to equilibrium in the
capital market – a balance between demand and supply of capital.
 If there is an excess of demand for capital for Neoclassicals it is because the
real interest rate is too low, say due to financial repression and government
controls.
 It is argued (usually in the context of growth theory) that if the equilibrium
real interest rate is too high then labour will be substituted for capital.

Criticisms
 The rate of interest balances the demand for and supply of loans and not capital
invested in productive activities. If the rate of interest is taken as the rate of profit
then there can be no equilibrium in the analysis since both curves would be
upward sloping (see below).
 A rise in the real rate of interest in the context of an excess demand for capital
may not eliminate the excess demand but merely cause profits to fall such that
both the supply and demand for capital fall (further).
 A high real rate of interest will not cause labour to be substituted for capital.
Rather it may simply depress the demand for loan capital.

The distribution of income

 The message of the Neoclassical approach is that the distribution of income is
determined by the productivity and choice of individuals.

30
  Wage differences between individuals in a given industry are due to choice
(choosing to work more) and/or productivity (working longer and harder to
produce more).
 Wage differences between industries are due to productivity differences of
workers in the different industries, which in the end could be explained by
skill differences. It could also be explained by workers working longer in
some industries – choosing work over leisure.
 Profit differences within a given industry must be because of cost (and
therefore productivity) differences.
 Profit differences between industries are denied in the context of perfect
competition, but if they exist are said to be because of monopoly practices in
some industries.
 If profits rise in relation to wages it is due to relative productivities of the
two. It is denied that increases in profits could be due to decreases in wages.
 It is denied that the source of profit is the excess labour performed by
workers (those who sell their labour services for a living) – excess over and
above what is needed to pay for their wages.
 Wealth accumulation by individuals in the form of greater quantities of
capital at their disposal is argued to be due to choice – the choice of future
over present consumption.
 It is denied that wage differences could be due to institutional factors such as
background, school, family, profession (certain professions are more highly
rewarded due to the role they play in ensuring the class system and profits
generation and accrual), etc. If institutional factors are admitted they tend to
be trade unions or government (wage legislation, paying government workers
more than private sector can afford, etc).

Criticisms
 Critics deny that the distribution of income can be understood as determined in
the markets for factors and reflecting the productivity of factors and choices
of their owners. Rather, the distribution depends on the institutional setting.
o Profits, interest and wages are not determined in markets for
entrepreneurs, capital and labour.
 Critics deny that the demand for labour and capital depend fundamentally on
their respective physical productivities. They argue this demand depends
more on the profitability of the enterprise as a whole.
 Critics deny it is possible to talk of a demand for labour independently of a
demand for non-labour inputs contra the Neoclassicals.
 Critics question the possibility of computing the contribution of capital to
the total product when one cannot even define capital (and even more so
entrepreneurship) unambiguously.
 Critics deny that labour receives a real wage equal to its contribution to
production.
 Critics deny that the supply of labour is fundamentally based on choices
between work and leisure and that the less people are paid the more they will
substitute leisure for work, especially those on low wages. It is argued that in
fact most individuals have little choice about how much labour time they
supply.

31
  Critics deny that wealth accumulation is the result of choices between
present and future consumption. They question the conclusion that rich people
became rich because they save more, i.e. sacrifice present for greater future
consumption. Rather, they see rich people become rich because they benefit
from the exploitation of labour.

Key elements for an alternative

 There is no such thing as factor markets and factor prices bringing the
demand for and supply of the factors into equality with one another. There are
factors of production and incomes accruing to these factors, but they are not to be
explained by the demand for and supply of the factors.
o Profits are not determined in the market for entrepreneurs.
o Interest is not determined in the market for money – the central bank
sets the rate of interest and supplies unlimited sums of money at this rate of
interest.
o Wages are set by firms for existing employees on the basis of the
profits they are seen as generating – allowing for certain socio-economic
structures.
 There is no market for entrepreneurs, and entrepreneurship cannot be seen as
a factor of production separate from capital.
 Entrepreneurs or productive capitalists are to be seen as distinct from money
lending capitalists.
 Capital cannot be seen as either the sum of material inputs required to
produce all commodities, or even the money to buy these material inputs. Rather,
it should be seen as the money advanced to buy all inputs into production with a
view to appropriating a certain rate of profit in relation to the value of the money
outlaid.
 The return on capital should be seen as profit and not interest. Interest is
paid out of profits to money lending capitalists.
 The demand for capital needs to be understood as investment demand by
firms. This demand does not depend on the money market rate of interest but on
the rate of profit (and/or magnitude of profit) accruing to the producers.
 The supply of capital should be understood as the money outlaid to finance
investment, with the primary source of this seen as coming from profit.
 The return on capital cannot be seen as determined by the physical
productivity of physical inputs into production. Rather, it is determined by labour
productivity and measured by labour time.
 What the entrepreneur buys is a certain amount of labour time (to produce
goods of a value that exceed the costs of producing them) and not particular
skills. What the entrepreneur pays is a certain money wage.
 The demand for labour does not depend on the productivity of labour, but on
the profitability of what is produced.
 The supply of labour does not depend on either the real or money wage but
on the institutional setting – labour having only their labour power to sell. In
modern times consumerism and debt replace poverty as the spur for labour to
obtain jobs at the going wage rate.
 The wage rate (wage per unit of labour time) is agreed (even if not paid)
before production takes place. Hence, it cannot be argued to be determined by the

32
 productivity of labour. In fact, the wage rate is determined by the profitability of
production and the general institutional setting.
 The distribution of income is not determined in the market, but rather by the
institutional setting which is designed to make workers less able to bargain over
wages, viz., consumerism, debt, the legal system (limits on workers rights), low
pensions, no public healthcare, etc.

Last update: 8th Sept 2018

Lecture 5
Objectives of lecture
 The lecture seeks to the price and quantity of factor inputs into production from a
HETERODOX perspective.
 It seeks to show that the incomes accruing to factors, and the quantity of them
used in production, depends on relative power relations (between labour and
capital, and between productive/industrial and financial capital) and the
quantity of factor inputs depends on the level of profits.

Contents of lecture
General
 Heterodox economists deny that entrepreneurship is a factor of production.
Entrepreneurs are owners of firms that hire factors in the process of producing
goods.
 The Heterodox economists deny that there are factor markets as such, although
it is accepted that one can conceive of the demand for and supply of labour and
land.
 Heterodox economists see the price of factors as the return (or incomes
accruing) to these factors for a given period of time. Typically Heterodox
economists see these returns in money and not real terms.
 Heterodox economists deny that the magnitudes of these incomes are determined
in factor markets, by the supply of and demand for these factors in these markets.
o Profits, wages and rent are determined in the process of production.
o Interest is determined by central banks.

Capital
 The logic of heterodox analyses suggest the explanation of the returns to factors
should begin with profit as the return to capital owned by entrepreneurs.
 Heterodox economists deny there is such a thing as a capital market – a market
for material inputs, or the money to buy these inputs, which yield a profit.
 For Heterodox economists capital is best defined as a sum of money used to buy
all inputs into production which results in a profit in relation to the money outlays
which is appropriated by the owner of this money and the production process
which it is used to undertake.

33
 Heterodox economists typically make a distinction between types of capital;
between productive and financial capital. Productive capital refers to capital in
the productive process; whether it assumes the form of money or physical long-
lasting inputs. It is the capital of the entrepreneur. Financial capital refers to
capital in the financial sector which is lent to, and borrowed by, the productive
capitalist. It typically only assumes a money form.
 Heterodox economists define capital in the productive system as the money
advanced which is used to purchase all inputs into production, including labour
services.
 A corresponding distinction is drawn between profit and interest. Profit is the
return to those involved in production (industrial capitalists). It is seen as a
reward for risk. Interest is the return to those who lend money (i.e., the
financial capitalists) to the firms involved in the production of goods and
non-financial services (i.e., the productive capitalists) and others (e.g.,
consumers). It is seen as a reward for parting with money (as potential capital).
 The source of profit (and therefore also interest) is seen the productive efforts of
labour; whereby labour produces goods of a greater value than is paid to them in
terms of their wages (and other input costs).
 The magnitude of profit will depend on the institutional environment and the
extent to which labour can be disciplined by capital. For a given institutional
setting changes in the magnitude of profit depend on changes in output and the
productivity of labour. The total amount of profits appropriated by firms rises as
output rises and the productivity of labour rises. The more firms can produce and
sell the more total profit they make. The more they can use the existing amount of
labour to produce the expanded output, without paying labour more for the
expansion, the greater the profit they can obtain. Much of the increase in
productivity of labour is, because of this, due to the advance of technology.
 The rate of profit is the ratio of the money value of profit to the money value of
the capital advanced. It is seen as having a tendency to fall periodically due to the
rise in investment outlays.
 When talking of the demand for capital or investment demand, Heterodox
economists typically refer to demand for productive capital. That is to say it is a
demand to purchase inputs into production – including labour.
 This demand is argued to be dependent on past, current and expected
profitability, with the latter dependent to some extent on the former (past and
current profitability). Expected profitability is not, however, mechanically related
to past and current profits. It varies depending on the optimism of producers –
hence the tendency for investment to overshoot periodically due to excessive
optimism.
 To the extent that investment demand by the individual firm is seen as a function
of actual profits and the latter is related to the demand for the products of the
firm, aggregate investment demand can be seen as being fundamentally linked to
the final aggregate demand for all products. For Heterodox economists, this
demand is not a function of the marginal physical productivity of the productive
assets, even if one could ascertain what this is.
 The supply of capital is seen as the finance required to buy the requisite
productive assets. The source of this finance is seen to be for the most part the
retained earnings or actual profits of companies and not the savings of
individuals resulting from choices they are alleged to make between present and

34
 future consumption. Heterodox economists argue that little of the finance
required to buy long-lasting physical inputs into production comes from outside
the company.
o In developing countries an additional source of financing is the state;
either bank credit or the state budget.
 Heterodox economists argue that, if anything, savings (investment finance) are (is)
inversely related to the (real) interest rate since it, interest, represents a deduction
from profits. That is to say, the higher the rate of interest the lower the rate of
profit.

Equilibrium
 Heterodox economists deny that there is any variable which can be argued to
bring the demand for and supply of capital into equality such that the two are in
equilibrium. Above all, they deny that the interest rate, even the real interest rate,
brings into equality the demand for and supply of capital.
 Following from this, Heterodox economists deny that a deficiency of capital can
be rectified by an increase in the real interest rate. In fact such an increase will
worsen the problem of a deficiency.
 Heterodox economists argue that typically changes in expected profits based on
changes in actual profits trigger an increase in investment and savings (the finance
available for investment). This process continues and eventually a discrepancy
arises between expected profits and actual profits (with expected profits
continuing to rise while actual profits start to fall). The investment-profits gap
begins to be filled by financial markets - credit. Eventually it is recognised that
expected profits are not going to materialise and those extending credit ask for
their loans to be repaid. This causes a collapse in investment by the producers as
they try and cut back on expenditures to meet their financial obligations. The fall
in investment gives rise to a further fall in actual profits thereby reinforcing the
pessimism among business investors.
 The whole process is continuously in motion and never at rest – never in
equilibrium.

Labour
 Heterodox economists too agree that what is bought and sold in the labour market
are labour services.
 They argue that the return to labour is the money wage and not the real wage.
 In Heterodox labour market analyses the supply of labour is seen as given for any
agreed real wage level. Workers bargain with employers for a certain money
wage and then employers put up prices to cover any increase in money wages they
may have to concede. The extent to which businesses can transfer increases in
money wages fully to prices will depend crucially on the degree of competition in
the particular industry and the overall state of the economy.
 It is assumed that there is always unemployed labour which can be utilised at the
given (real) wage rate. This means the labour supply curve is typically flat up to
the full employment level. Unemployment is important to keep labour under
control and prevent unions and labour organisations from bargaining for excessive
wage increases.

35
 The supply of labour can increase over time because of population growth and
institutional factors such as changes in welfare, laws concerning the participation
of women, etc.
 There is no agreed Heterodox view regarding the demand for labour. Most
Heterodox economists deny that the level of real wages and productivity have
much of a bearing on the demand for labour. They point instead to the
importance of profits and investment by firms. As profits rise businesses expand
investments, which also means increasing their demand for labour. Some
Heterodox economists, following Keynes, see this demand as determined by the
real wage in the same manner as Neoclassical economists and using the same
rationale - the diminishing marginal revenue product of labour. However,
although they accept that this suggests a fall in the real wage could in principle
increase the demand for labour, they follow Keynes in arguing that the fall in real
wages would also most likely damage the demand for the products of labour and
thereby could have an overall negative impact on the demand for labour.

Equilibrium
 Heterodox economists deny that changes in the real wage bring into equality the
demand for and supply of labour. Rather, they argue that changes in investment
and the demand for the products of labour explain changes in the quantity of
labour employed in production. That is to say, there is no such thing as
equilibrium in the labour market, and certainly not so-called full-employment
equilibrium. For Heterodox economists unemployment is a necessary feature of
capitalism – the mechanism required to discipline labour and moderate wage
increases.
o Heterodox economists see credit based consumerism as an added and
increasing manner in which labour is disciplined.
 Heterodox economists also deny the notion of substitutability of labour for
capital, if the returns to one are in excess of market clearing levels. Heterodox
economists in fact believe in fixed relations of inputs; increases in the demand for
one factor are typically accompanied by increases in the demand for other factors.

Income distribution
 Heterodox economists explain incomes shares at the general level in terms of
power relations.
 They explain wage differences within industries in terms of a) the relative power
of different companies – allowing them to earn more profits some of which can be
paid out to the workers, b) institutional factors such as discrimination between
workers due to gender, colour, etc., c) regional variations, etc.
 They explain wage differences between industries in terms of a) profit
differences between them, b) differences in strength of labour organisation in the
different industries, and c) institutional factors which encourage salary differences
for functional reasons (e.g., the high salaries accruing to lawyers, accountants, etc
– in this case differences between occupation).
 They explain profit differences within an industry by a) differences in the
technologies used by different companies, b) the nature of product differentiation
in the sector, and c) marketing, etc.

36
 They explain profit differences between industries by a) relative monopoly
strength of producers in different industries (enabling higher degrees of mark-up),
b) institutional factors, and c) government support, etc.
 Heterodox economists see income shares (profit vs wages) as being determined
by institutional factors, including power relations between labour and capital,
and not productivity and individual choice.
 Heterodox economists see profits and wages as moving inversely to one another,
i.e., an increase in wages can cause a fall in business profit margins where
businesses are not able to recover the increase in price increases. This is
especially true if workers are able to index link wage increases.

Last update: 10 September 2013

Lecture 6
Objectives of lecture
 To explain concept of elasticity.
 To explain price and income elasticity of demand and price elasticity of supply.
 To note the significance of price elasticity for revenue.
 To explain the importance of the concepts in terms of the exports of LDCs.

Contents of lecture
Elasticity in general
 Elasticity means “responsiveness”

Price elasticity of demand

 This refers to the responsiveness of the quantity demanded to a change in price.
 If the percentage change in demand is greater than that of price then demand is
said to be price elastic.
 If the percentage change in demand is less than that of price then the demand is
said to be price inelastic.
 If both the change in demand and price are equivalent there is said to be unit
price elasticity of demand.
 The sign for price elasticity of demand is negative indicating that quantity
demanded changes in the opposite direction to price.
 Revenue will typically rise in the case of a price elastic demand curve if the price
falls. Revenue will rise in the case of a price inelastic demand curve if price rises.

Income elasticity of demand

 This refers to the responsiveness of the quantity demanded to a change in income.
 If the percentage change in demand is greater than that of income then demand is
said to be income elastic.
 If the percentage change in demand is less than that of income then the demand is
said to be income inelastic.

37
 If both the change in demand moves in the opposite direction to income (as in the
case of so-called inferior goods) then there is said to be negative income elasticity
of demand.

Price elasticity of supply

 This refers to the responsiveness of the quantity supplied to a change in price.
 If the percentage change in supply is greater than that of price then supply is said
to be price elastic.
 If the percentage change in supply is less than that of price then the supply is said
to be price inelastic.
 If both the change in supply and price are equivalent there is said to be unit price
elasticity of supply.

Price and income elasticity and LDC exports

 The problem for primary product LDC exporters is that demand for their
product tends to be price elastic (when price falls in a downward direction),
income inelastic, and the supply of their products, especially export products,
price inelastic.
Last update: Friday, Monday, April 29, 2013

Lecture 8
Objectives of lecture
 To indicate the major focus of MACROECONOMICS
 To indicate the relevance and importance of the study of macroeconomic
phenomena.

Contents of lecture
Growth
 GROWTH is defined as an increase in aggregate output.
 Generally reference is made to the annual rate of increase in output.
 A distinction is drawn between long-term or the trend rate of growth, and
the short-term or cyclical rate of economic growth.
o Heterodox economists typically refer to trend vs cyclical growth and
Neoclassicals to long-run vs short-run rates of economic growth.
 Growth is typically measured by the annual rate of change in GDP at
constant prices. It is sometimes measured by the annual rate of change of
GNP at constant prices. The difference between GDP and GNP is that the
latter looks is a measure of all goods produced by enterprises owned by
nationals of a country whether geographically located in or outside of the
country, while GDP simply looks at what is produced in a given country,
whether by local or foreign enterprises. World GDP and world GNP are, by
definition, equal.

38
 GDP is measured using a combination of techniques. One is by direct survey
of goods produced, e.g., cars by the 10 largest manufacturers, or potatoes
but the 500 largest farms. The other technique is by estimation; taking the
value of what is produced in a sector and then estimating the rise in prices in
that sector and deducting it from the increase in value.
 Growth is seen as important by most economists in the sense of being a
precondition for higher living standards and economic power.
 Growth is seen as important for a government’s popularity only over the long-
term.
 For developing countries, with a population growth of about 1.5% per annum a
good trend growth rate would be above 5%. A rapidly growing developing
country could be expected to achieve an average rate of growth of around
7%+.

Inflation
 INFLATION is defined as an increase in the aggregate money price level.
 Generally reference is made to the annual rate of inflation.
 Distinctions are also drawn between short-term fluctuations and long-term
trends, but this distinction is not as common as with growth.
o Again, there are differences between Neoclassical and Heterodox
which stem from a denial of cycles by Neoclassicals.
 Distinctions are also made between consumer, producer and economy-wide
inflation. Consumer inflation is a measure of price increases in consumer
goods. Producer inflation is a measure of price inflation in goods that are
used as productive inputs by producers. And, economy-wide inflation
measures the rise in prices of all goods produced in a country. It excludes
import prices, whereas both consumer and producer inflation measures take
this into account.
 Inflation is seen as particularly important for governments’ popularity over
the short-term. It is well-known that as elections near government’s become
particularly worried about their performance on the inflation front.
 Inflation is seen as particularly important for businesses in general, and
certain sections in particular. Financial markets typically do not like inflation
because it erodes the value of financial assets (e.g., the value of loans) and
typically causes bond and other financial market prices to fall.
 Economists differ about what levels of inflation are ideal. Neoclassicals
tend to favour zero or very low levels of inflation, while Heterodox
economists are less worried about inflation, particularly if it accompanies
(and is mostly due to) a rapid growth process.

The balance of payments and exchange rate

 THE BALANCE OF PAYMENTS is a set of accounts which records inflows
and outflows of money resulting from the transactions between the
residents of a country and the outside world.

39
 The accounts may be presented in local currency and/or foreign currency
(typically US dollar) terms.
 Money flows between countries for a number of reasons including trade,
income payments, investments, etc.
 The balance of payments accounts typically comprise 3 major sub-accounts;
the CURRENT, CAPITAL and FINANCIAL accounts. Money flows between
countries are organised into these three sets of sub-accounts.
 Money flows into and out of a country flow through FOREIGN EXCHANGE
MARKETS where local currency is exchanged for foreign and visa versa.
When money comes into a country it comes in as foreign currency and is then
exchange for local currency. When it goes out of a country local currency
exchanges for foreign currency and then the foreign currency goes out of
the country.
o Distinctions are drawn between long and short-run as well as trend
and cyclical movements in the external balance of a country.
 The exchange ratio of one currency for another in the foreign exchange
market is known as THE EXCHANGE RATE of one currency in terms of
another. If the exchange rate of a country’s currency is such that more
units of its own currency are exchanged for a foreign currency then
economists say that the local currency is depreciating in value or becoming
weaker. If less units of a country’s currency are being exchanged for the
foreign currency then economists say the local currency is appreciating in
value.
 If a country experiences a balance of payments deficit it means that more
money is flowing out of the country than flowing in. When this happens the
country is said to be losing its reserves of foreign exchange or currency. If
the country has a balance of payments surplus then more money is flowing
into the country than flowing out and the foreign exchange reserves held by
the country can be expected to be growing.
 Typically economists focus on current, and especially trade, account flows
of a country since the latter are said to reflect the competitiveness of the
economy. Most theories of the balance of payments are actually theories of
the trade balance. The bigger the trade balance as a proportion of GDP the
more positively a country is viewed by economists.
 When looking at foreign CURRENCY RESERVES economists use the yardstick
of reserves in relation to imports (typically the months of imports the
reserves could finance). The usual benchmark for a developing country’s
reserve holdings is 3 months of imports. It is argued that anything below
this figure is problematic.
 A deficit in the balance of payments is also known to put pressure on the
exchange rate, causing it to depreciate (possibly alongside losing reserves).
A surplus in the balance of payments is seen to cause the exchange rate to
appreciate (possibly alongside a growth of reserves). The logic of the
argument here is that a deterioration of the balance of payments represents

40
 a fall in the demand for the local currency in relation to the foreign
currency, while a surplus represents the opposite.
 A strong balance of payments and a large holding of reserves is considered
important by many developing country government’s because it avoids
possible disruptions to normal economic activities (most of which require
imports) and the likelihood of external interference in their economic
affairs.
 A continuous or large depreciation of the currency is considered by most
economists as something to be avoided since typically it is accepted as giving
rise to domestic inflation (putting upward pressure on interest rates) and
possibly dampening economic growth.
 Note the key points to be made here are a) that the balance of payments is
not simply the trade balance, nor even the trade balance and money market
capital flows (which respond to interest rate differences), and b) that the
flows of money into and out of a country imply pressures on a country’s
exchange rate in a market determined environment.

Last update: Saturday, September 15, 2012

Lecture 9
Objectives of lecture
 To understand the key concepts used in macroeconomic analyses.
 To understand basic macroeconomic theories of growth, inflation and the
balance of payments.

Contents of lecture
Basic concepts
 The major elements of the macroeconomy which economists use to explain
the phenomena of economic growth, inflation and the balance of payments
are PRODUCTION, INCOME, EXPENDITURE and SAVINGS.
 The value of production (which is taken to be the quantity of what is
produced times the prices of each item) is equal to the value of income,
which in turn is equal to the value of total expenditure on all goods and
services. A change in one is seen as giving rise to a change in the other such
that the equality is maintained between all three items.
o It is of note that for Heterodox economists the value of production
is equal to the value of income and the value of the revenue accruing to
firms which is required for the replacement of the material inputs used
up in the process of production, including fixed capital. Profits are the
surplus accruing to the capitalist over and above costs, where costs
include the replacement of used up inputs. That is to say, aggregate

41
 income is equal to the aggregate net product and not aggregate gross
product.
 A crucial distinction is drawn between REAL and NOMINAL or money value
of production, income and expenditure. An economist tends to see increases
in the real value of these values positively, and increases in the nominal
values of these variables less positively.
 An important question which is asked is when the value of production rises
does it represent a real (quantity) or nominal (money price) increase.
Similarly, when the value of income rises does it represent a real or nominal
increase. A real increase in the value of income implies that the increased
value of income represents more goods and services. This would only be the
case if more goods and services were produced. It would represent a
nominal increase in income if more goods and services had not been produced.
Finally, when the value of expenditure rises a real increase would be implied
if the increase in value represented an increase in the quantity purchased.
If the increase in value simply reflected higher prices being paid then the
increase in value of expenditure is said to be a nominal increase in value.
 AGGREGATE OUTPUT is seen as comprising CONSUMPTION and
INVESTMENT goods. Consumption goods are those goods destined for final
consumption. Investment goods are those which are produced as inputs into
production. These goods include so-called fixed capital, such as machines
and factories, and working capital, such as raw materials (and also stocks of
finished goods).
 The goods and services produced in an economy are typically seen as being
produced in different sectors. At the most aggregate level these sectors
are AGRICULTURE, INDUSTRY and SERVICES. Each of these sectors is in
turn dividable into sub-sectors. For example, the industry sector is seen as
comprising manufacturing, mining and quarrying, construction, and export
processing.
 AGGREGATE INCOME is seen as comprising mostly wages (and salaries),
profits, interest and rent. It also includes surpluses of government
corporations and income of the self-employed.
 AGGREGATE EXPENDITURE is seen as comprising private consumption
expenditure (C), private investment expenditure (I), government expenditure
(G), and expenditure of foreigners on local goods (exports) minus
expenditure of locals on foreign goods (M). With respect to the latter it
needs noting that what is being sought in the expenditure estimate is how
much expenditure there is on local goods and services.
o It is of note that for Heterodox economists aggregate expenditure
includes expenditure on material inputs used up in the process of
production. This is not the same as investment expenditure – which is the
expenditure on inputs (including labour) which facilitates the expansion of
production. That is to say, the aggregate expenditure in the textbooks is
in fact aggregate net expenditure. For Neoclassicals investment

42
 expenditure is expenditure on fixed capital with a view to the expansion
of production.
 In the simple Heterodox model it is assumed that all income received by
factors is spent directly on consumption and investment goods, or taken by
government in the form of taxes or leaks out of the system through imports.
The income received by factors which is spent directly on investment goods
is really the retained earnings of companies accruing to the owners and
managers of the companies. Neoclassicals however see the money which is
spent on investment goods as having first been saved. They see some of this
savings coming from private individuals out of income (and being transferred
to investors via the financial system), some coming from government as a
result of taxed income not spent, and yet other savings as coming from
foreign sources in the form of an excess of imports over exports. These
economists introduce the notion of AGGREGATE SAVINGS.
 AGGREGATE SAVINGS is seen as equalling aggregate investment (private
and government). It comprises PRIVATE SAVINGS, GOVERNMENT
SAVINGS and FOREIGN SAVINGS. Private savings is what individuals do
not spend on consumption goods. The tacit assumption is that this savings
finds its way to investment financing. Government savings is defined as what
the government does not spend out of its tax income. This is sometimes
referred to as forced savings. The assumption is that this saving ends up as
investment financing. Foreign savings refers to the net resources a country
can command from outside to finance investment. It is assumed that a
surplus of imports over exports translates into resources available to finance
investment either directly or indirectly (through lowering the requirement
for domestic production of consumption goods to meet domestic consumption
demand).
 Heterodox economists typically focus on aggregate expenditure and its
components while Neoclassicals typically focus on aggregate savings and its
components. The Heterodox argument is that it is expenditure which drives
investment and therefore growth, while the Neoclassical argument is that it
is savings that drives investment and therefore growth.

Basic macroeconomic theories

Neoclassical
 Neoclassicals argue that an increase in aggregate money expenditure does
not translate into an increase in aggregate output (even if there is
unemployment). The crucial assumption that the Neoclassicals make is that
output is not responsive to changes in aggregate money expenditure, either
over the long-run or the short-run. Over the short-run it is assumed this is
because factor inputs, inlcuding labour are fixed. Over the long-run (ans also
over the short-run even if there is unemployed labour) it is assumed this is
because businesses know that prices will rise along with the increase in

43
 expenditure so their costs will rise and therefore the increase in
expenditure is only a nominal increase in expenditure. It needs to be said
that some Neoclassicals admit to some increase in output over the short-run
because businesses make mistakes; they believe the increase in expenditure
is a real increase and not a nominal increase.
 Neoclassical economists argue that the fundamental impact of an increase in
aggregate money expenditure is inflation and a deterioration in the external
payments situation and/or a depreciation in the exchange rate.
 Neoclassicals argue that increased expenditure results in inflation in the
short-run because quantity can be assumed to be fixed, while in the long-run
(when all inputs are flexible) it results in inflation because individuals know
that increases in money expenditures will not give rise to an increase in
output only an increase in money prices (rational expectations).
 Neoclassicals argue that the increased expenditure will give rise to a
worsening balance of payments because it will cause import expenditures to
rise and the inflation, given fixed exchange rates, will cause exports to fall
(due to assumed rising export prices).
 Neoclassicals argue that the excess expenditure will also put pressure on the
exchange rate insofar as it causes an imbalance in the demand for and supply
of the local currency in relation to the foreign currency. They argue further
that the weakening currency could help rectify the imbalance by making
imports more expensive and exports cheaper. Accordingly, Neoclassicals see
balance of payments problems as resulting from a combination of excess
demand and an absence of a market-clearing exchange rate.
 Neoclassicals argue that the increase in aggregate money expenditure cannot
take place unless there is an increase in the MONEY STOCK – the money
help by individuals. Individuals may want to spend more but unless they have
more money they would not be able to do so. The principle reason advanced
for an increase in the money stock is an increase in the amount of cash in the
system. The latter is typically seen to result from the need of government
to finance their BUDGET DEFICITS.
 Neoclassicals argue that increases in economic output result from increases
in aggregate (real) savings. When real savings rise, real investment rise and
this causes output to rise. The sources of increases in real savings are
increases in domestic private and government savings and foreign savings.
The increase in private savings is due to higher real interest rates and a
development of the financial system. Increases in government savings is due
to a reduction in the budget deficit. The increase in foreign savings is due
to an increase in the trade deficit, which is funded by an inflow of foreign
capital. In the context of developing countries Neoclassicals also see
“institutional factors” (like property rights, price liberalisation, free trade,
etc) playing a role in promoting economic growth.
o Some commentators note that the requirement for a trade deficit in
respect of foreign savings contradicts the view that the trade deficit is
seen as a negative product of increases in expenditure resulting from an

44
 increase in the money stock. However, Neoclassicals would contend that
the latter increase in the trade deficit has no implications for output
expansion (and therefore a long-term improvement in the trade deficit)
unlike the increase in foreign savings.

Heterodox
 For Heterodox economists an increase in aggregate expenditure leads to an
increase in aggregate output. The increase in expenditure is seen as giving
rise to an increase in investment (by causing profits and, therefore,
expected profits to rise). The rise in actual profits provides the necessary
finance for investment (i.e., the savings). The key emphases of Heterodox
economists with regard to expenditure tend to be on government spending
(G), and net exports (X-M).
 For Heterodox economists inflation is explained for the most part by cost
increases (note from the microeconomic analysis prices are cost plus a mark-
up). Increases in aggregate expenditure typically are not the main source of
inflation.
 When explaining the balance of payments, Heterodox economists draw a
distinction between advanced and developing countries, and for developing
countries between manufacturing producers/exporters and primary goods
producers/exporters. For advanced economies and developing country
manufacturers what matters in the explanation of balance of payments
trends is relative costs and the competitiveness of the exchange rate.
Countries with relatively high costs (labour and others), and/or a non-
competitive exchange rate, will tend to have weak balance of payments. For
Heterodox economists a competitive exchange rate is one which promotes
exports and domestic import-substituting producers (see lecture 10 notes
for a further explanation of this point). Excess demand pressures can
explain balance of payments problems at some junctures and for a few
countries. For raw material and other primary producing countries balance
of payments problems are typically explained by adverse trends in their
terms of trade and foreign debt servicing costs.
 Heterodox economists argue that changes in the money stock are typically
induced by the prior demand of individuals for more money and that
governments are for the most part powerless to resist increases in the
demand for money. That is to say changes in the money stock are seen to be
“endogenous” – determined by the economic system and not government.
Last update: 2nd April 2015

Lecture 10a: Growth

Objectives of lecture
 To understand how growth is defined and measured.

45
 Most important part of the lecture is to understand competing theories of
economic growth as applied to developing countries; the Neoclassical and
Heterodox.
 The focus is on long-run or trend growth and not short-run or cyclical growth

Contents of lecture
Neoclassical approach
 In general Neoclassicals make no distinctions between growth and
development
 The explanation of trend growth is clustered into four major categories of
explanations; institutional factors, the supply of factor inputs in the
production process, the demand for these inputs, and macroeconomic
stability.
 It is of note that savings is still fundamental to the explanation of growth,
but now when one looks at actual growth processes in developing countries
other factors are brought into the picture.
 The correct institutional setting requires the following:
a) The creation and safeguarding of property rights clearly establishing
asset ownership and corresponding income accrual rights. Among other
things this implies the transfer to private ownership of all property held
by government and privatisation of all state-owned enterprises.
Critics argue that it is unclear that all privately owned land will be used in
the most productive manner and that land may be held for speculative
purposes or simply left idle for strategic considerations.
b) The operation of private markets for commodities, services and factors
in which the unfettered forces of supply and demand are allowed to
determine prices of these commodities, services and factors. It is
argued that market determined prices are such that they cause the
resources of a society to be allocated optimally – maximising welfare (and
by implication minimising the costs of production). Allowing markets to
work implies, among other things, the elimination of all price controls or
supports including those with respect to food, restraining the power of
organised labour, and creating active markets in land.
Critics argue that some markets operate imperfectly because of sticky
prices and a lack of information, justifying government intervention.
Critics also argue that private market prices do not reflect the social
costs and benefits which arise from these prices. One case in point is
the market for agricultural food items, and the significance this has for
wage costs and general food security.
c) A competitive business environment in which no firm is so big that it can
significantly influence the prices of products. Competitive business
environments are supposed to be least-cost environments which
encourage the adoption and rapid diffusion of advanced technology. At a

46
 policy level this suggests the break up of large local companies (whether
government or private) which exert an undue influence on the local
market, and/or the liberalisation of these markets to allow foreign firms
to enter.
Critics argue that the norm is one where firms set prices and the market
determines the level of output.
Critics argue that there is virtually no sector, even in the advanced
countries, where the competitive ideal exists – which firms face a
perfectly elastic demand curve and only earn a normal profit.
d) The privatisation of government owned and run businesses. This follows
to a large extent from the preceding three institutional requirements,
but with some added justifications, including the reduction of the fiscal
burden of government that support for state enterprises often adds to.
Critics argue that not all privatisations will lead to improved productive
efficiency in the form of lower average costs. In the case of
monopolistic industries the tendency will be for significantly higher
prices and/or increased fiscal burden for the government.
e) A perfectly liberalized international trade regime such that government
does not in any way deter imports or provide support for exports. The
basis for this liberalised trade policy is the so-called doctrine of
comparative advantage which was first clearly articulated in the early
part of the 19th century by the British economist David Ricardo. The
modern incarnation of this doctrine, the factor endowments version of
the doctrine (the so-called Hecksher-Ohlin-Samuelson theory), suggests
that in a liberalised trade environment countries should specialise and
trade with each other according to their natural comparative advantage
which, in the case of developing countries, would mean that they should
specialise in raw materials, agricultural goods, and, possibly, labour-
intensive manufactures.
Critics argue that the general theory of comparative advantage rests on
two unrealistic assumptions; that each country can produce all traded
goods (including the ones they import), and that the costs of production
of domestic producers are either constant of increasing. The assumption
that all countries can in principle produce all goods, although they actually
specialize in the production of one or a few, is required to arrive at limits
to relative international price movements – limits which do not allow any
country to experience losses from trade. However, in reality colonization
deprived most developing countries of the possibility of self-sufficiency,
even in terms of basic items. The assumption that developing countries
have either constant or increasing costs is necessary to avoid the infant
industry argument where there is a justification for the active promotion
of the growth of certain industries in order that they can reap the
benefits of lower costs.
Critics argue that in practice no present-day advanced country ever
practiced free trade during the early periods of their own development,

47
 nor do they practice it today with respect to their trade with developing
countries. An obvious example is the massive support given to agriculture
by both the US and Europe.
f) The liberalisation of international capital flows whereby there are no
restrictions on the type and conditions under which foreign capital would
flow into and out of a country and domestic capital would flow out. The
rationale for liberalised foreign capital flows is that it could serve to
augment domestic savings and improve the productivity of local
businesses as a result of the technology and skills which typically
accompany foreign investment inflows.
Critics argue that there is no evidence that many foreign capital flows
actually finance investment in developing countries.
Critics note that it is not the more liberalized developing countries which
actually attract foreign capital inflows.
g) Adherence to international intellectual property rights agreements such
as the TRIPs agreement concluded at the end of the Uruguay round of
multilateral trade negociations. The argument here is that such
adherence would encourage the further development of technology,
mostly in the advanced countries, and encourage foreigners to share
their technology with developing countries.
Critics note that the evidence shows what matters for the promotion of
rapid technological change is actually the absence of protection for
intellectual property rights.
Critics note that most advanced countries appropriated intellectual
property from other countries during their early development phases.
Critics argue that there is no logical reason to believe that advanced
countries are more likely to share their technology with those countries
who are more prepared to respect intellectual property rights.
h) The withdrawal of the state from most if not all economic activities and a
minimisation of its interference in the (economic) decision making of
private individuals. The argument is that many of the obstacles to rapid
growth in developing countries can be traced to the excessive
interference of the state, often in the form of so-called “rent-seeking”
behaviour.
Critics note that there is no evidence of a country growing rapidly
without the strong support of the government.
Critics argue that calls for the withdrawal of government from
supporting economic activity in developing countries are really calls to
allow the economy to be manipulated by international institutions, foreign
governments and foreign multinationals.
 With regard to increasing the supply of factor inputs into the process of
production, most emphasis is placed on increasing the supply of capital, or
savings, since it is assumed that both labour and land are plentiful in the
typical developing country. Indeed, developing economies are defined as
capital shortage economies. The proposed policies for raising savings are;

48
 increasing real interest rates, privatising and developing financial markets,
increasing public savings by cutting the budget deficit, increasing foreign
savings by encouraging foreign capital inflows.
Critics argue that most financing comes from either retained earnings of
companies or state banks. Little if any comes from the financial markets.
Critics argue that higher real interest rates actually lower profits and
therefore private savings.
Critics argue that cutting the budget deficit can actually damage private
savings and, eventually, government savings. Government expenditure
typically boosts private profits and output growth. Cut-backs in government
expenditure damage these and also cause government tax revenues to fall, as
a result of falling revenues of businesses and cut-backs in employment.
Critics argue that non-FDI capital inflows do not typically finance
investment, but rather finance speculative or non-productive activities.
 With regard to the demand for factor inputs the key emphasis is on labour
and land – since it is assumed that there is an abundant supply of these two
inputs. It is assumed that the demand for capital (or investment demand) is
less important than supply, but if there is a problem with demand it is
because capital is deemed to not be productive enough. Increases in the
productivity of capital are seen as coming from the acquisition of new
technology largely as a result of tax incentives (accelerated depreciation
charges, etc.), competitive pressures (as a result of breaking up large
domestic monopolies and increasing foreign competition in the domestic
market), access to increased private financing for the acquisition of modern
technology, and adherence to international intellectual property rights
agreements. With labour and land increases in demand are also argued to be
fundamentally related to improvements in productivity. Improvements in
labour productivity are deemed to result mostly from reform of the labour
incentive and education system. The incentive system refers to wage
differentials and tax policies which allegedly discourage harder work and the
acquisition of more skills. The educational system is criticised for failing to
meet the skills needs of the market. The problem is seen to be the state
domination of the educational system hence the reforms proposed are
typically those favouring the commercialisation or privatisation of education.
The demand for labour is also seen as crucially dependent upon the price of
labour or the real wage. Of importance here are government policies which
cause the real wage of labour to be higher than the market clearing level in
developing countries. Examples of such policies are minimum wages
legislation, enforced health care and pension provisions imposed on private
businesses, welfare payments to the poor and unemployed, etc. Land
productivity is seen as being enhanced by increasing land ownership of the
private sector and correspondingly well defined property rights, greater
access of farmers to private credit facilities (which also means privatising
state agricultural credit facilities), privatisation of agricultural distribution

49
 enterprises, and better access of agricultural producers to foreign markets
and foreign agricultural inputs.
Critics argue that demand for capital is fundamentally related to expected
profits and not simply the physical productivity of capital. The former is
related to actual profits, although can deviate from the latter at times.
Actual profits are given by an expansion of the market and a reduction in
costs. Capital productivity will contribute to an increase in the demand for
capital to the extent that it contributes to a reduction in costs – and the
latter contributes to a rise in profits.
Critics similarly argue that the demand for labour and land is not primarily
related to the physical productivity of both (or productivity and price in the
case of labour), although the latter will have some bearing on this demand.
Specifically, demand for labour and land will in the first instance depend on
the profitability of the activities using these two inputs. To the extent that
this demand depends on the productivity of the two inputs, it is argued that
the bases for the productivity increases are not for the most part
liberalisation of the markets for these factors or increased financing from
the private financial markets.
 Macroeconomic stabilisation fundamentally refers to the control of inflation
(and only secondarily to balancing the external payments situation). It is
argued that inflation damages output growth in two major ways; by damaging
private savings and by damaging relative price signals to economic agents. It
is of note that Neoclassicals argue that the source of inflation is a budget
deficit, which also implies lower aggregate savings, this time via the
government savings medium.
Critics note that there is little or no empirical evidence to support the view
that low inflation is conducive to economic growth.
Critics note that the inflation targeting strategies have, on the contrary,
damaged economic growth.
Critics note that there is no evidence to show that low inflation encourages
more investment financing or savings.

Heterodox approach
 In general Heterodox economists distinguish between growth and
development. Development is growth plus an increase in welfare. This means
development is not simply measured by increases in real GDP (or GDP at
constant prices) but rather by some composite index which includes physical
output and some index of welfare. One such measure is the UN’s Human
Development Index (HDI).
 Heterodox economists also consider environmental factors important in the
discussion of economic growth, and refer to the notion of “sustainable
development”. Sustainable development means a process of development
which does not impair the development of future generations through
environmental destruction and depletion of non-renewable resources.

50
 For Heterodox economists even economic growth, let alone development and
sustainable development, cannot be explained by economic factors alone.
Political and social factors are also considered to have an important bearing
on economic growth.
 The economic factors explaining long-term economic growth can be clustered
in a similar manner to those which were used to explain long-term economic
growth for Neoclassicals, namely; institutional factors, the supply of factor
inputs in the production process, the demand for these inputs, and
macroeconomic stability.
 It is of note that aggregate demand or expenditure is still fundamental to
the explanation of growth, but now when one looks at actual growth
processes in developing countries, as with the Neoclassicals, other factors
are brought into the picture.
 The correct institutional setting requires the following:
 Switch to manufacturing. Here the emphasis is on exports, but Heterodox
economists also favour import-substituting manufacturing production. The
promotion of export-oriented manufacturing activity is often referred to as
Export-Oriented Industrialisation (EOI) and import-substituting
manufacturing is referred to as Import-Substituting Industrialisation (ISI).
For both strategies an active involvement of the state is required. Instead
of free trade the strategy is one of export and import-substitution
promotion. The economic justification for the switch to manufacturing is
given by assumptions regarding the price and income elasticities of demand
and price elasticity of supply of manufactured products as opposed to
agricultural and raw material products.
 Control of the financial sector and its subordination to the needs of the
industrial (manufacturing) sector. The argument is that the private financial
sector is not needed for investment financing and, if allowed to get out of
control (in terms of control of the state machinery) will tend to damage
industrial development. One manifestation of the latter is excessively high
real rates of interest.
 An aggressive government supported domestic food production strategy.
The aim is to provide cheap and plentiful supplies of food for industrial
workers and those involved in manufacturing in order to keep wage costs
down (wage demands being linked to food prices) and give a country a
stronger bargaining power vis-à-vis foreign institutions and governments.
 Promotion of indigenous technology development based on the acquisition of
foreign technology and skills (either through FDI agreements, state financed
purchases of technology, or simply piracy) and its modification and use in
productive activities. Particular emphasis in this regard is placed on building
up technical education at the higher level and stopping the brain-drain.
 Improvement of welfare alongside economic growth.
 Strengthening the government machinery through an improvement of pay and
conditions of bureaucrats. Also important is a re-orientation of the
bureaucrats towards national policy goals.

51
 With regard to capital Heterodox economists stress both the supply
(savings) and the demand (investment). They argue the two are interlinked.
The supply is a direct function of profits while the demand is an indirect
function of profits (being a function of expected profit). Heterodox
economists argue that private profits in turn are a function of revenues or
markets and costs. With regard to markets Heterodox economists put most
emphasis on markets in the advanced countries (since this is where most of
the global purchasing power is located) and somewhat less importance on
securing domestic markets for local producers. That is to say, although
Heterodox economists see a role for both EOI and ISI strategies, they
place more emphasis nowadays on EOI strategies. State support for local
businesses is fundamental to both strategies. With regard to costs
Heterodox economists emphasise a) low food prices to stabilise wage costs,
b) low interest rates to minimise the cost of external funds (i.e., funds
coming from the private financial markets to fund working capital outlays), c)
low public utility costs (e.g., low costs of energy, water, sanitation, transport,
etc)., d) large-scale operations, and e) advanced technology and higher skill
levels to raise productivity of machines and the physical production process
in general. Profits can and should be augmented by state long-term
financing. This points to the importance of state development banks and
other long-term concessional financing institutions. It is denied that
foreign capital inflows are primarily important for financing of domestic
investment. Rather their importance lies in transfers of technology and
skills, as well as market access.
 Investment, or the demand for capital, is seen as also important for
Heterodox economists, and usually accompanying or even preceding savings or
increases in the financing of investment. Investment is seen as a function
of expected profits. As investment expands, it causes profits to rise
because it leads to an increase in demand in the system. The higher profits
causes savings or investment finance to rise and gives rise to even more
investment since businesses become more optimistic about the future due to
the present inflow of higher profits. Productivity of capital matters for
investment demand only to the extent it improves actual and expected
profits growth. Improvements in productivity of capital come from the use
of better technology. Heterodox economists see state financing and FDI
flows as extremely important in this process of acquiring advanced
technology by developing countries.
 Heterodox economists see both the supply and demand for labour as
important in the growth process. The demand for labour is again dependent
fundamentally on the markets for the products of labour. It is only
secondarily dependent on the wage cost and productivity of labour. With
regard to wage costs the problem is not minimum wages legislation and the
like, but high costs of food and other basics. With regard to the
productivity of labour Heterodox economists argue that of importance is not
pay differentials but the organisation of the production process – the failure

52
 to include labour in the decision making about, and responsibility for,
production. In this context, Heterodox economists tend to favour East
Asian cooperative labour organisations of production – with labour having a
sense of belonging to the company and the company looking after the welfare
of individuals and their families. With education, Heterodox economists
argue that commercialisation of education will tend to hurt the poor and
damage the social and long-term aspects of education. The private sector is
too focused on profit and the short-term. One implication of privatising
education is that it will fail to produce the skills which are required to
maintain the social fabric of a society, e.g., social workers, artists,
philosophers, etc. Heterodox economists see the supply as important
because they argue that industrialisation processes typically result in
shortages of industrial labour in the urban centres. Hence, there is a
requirement for labour migration from the agricultural to the urban centres
and the training of these migrants.
 In the case of land, again the starting point for Heterodox economists is
demand and investment in agricultural production. Investment will take place
if the market (prices) is (are) guaranteed by government. The key is
domestic food production. Heterodox economists do not favour privatisation
of agricultural lands, but rather the provision of long-term (99 year) tenure
rights. This is related to the food security strategy favoured by Heterodox
economists. They worry that agricultural lands will be appropriated by large
foreign agricultural companies producing for the external market, or
monopolistic local companies who will then monopolise local food production.
Heterodox economists see agricultural productivity as arising from such
property right changes as well as increases in state agricultural credit,
improved agricultural marketing, greater access to long- and medium-term
state agricultural credit, and state extension services (research and advice
on agricultural techniques and technologies).
 For Heterodox economists macroeconomic stabilisation means stabilising
economic growth – not allowing massive fluctuations in the growth rate.
Fluctuations are a disincentive for (long-term) investment. They tend to
favour financial market speculation. The source of the problem for many
Heterodox economists has been the government’s obsession with stabilising
inflation, even externally induced inflation. Typically the policies adopted
(mostly high interest rates, cuts in domestic credit, cuts in government
capital expenditure, etc.) tend to be detrimental to economic growth
Last update: Saturday, September 15, 2012

Lecture 10b: Inflation

Objectives of lecture
 To understand how inflation is defined and measured.

53
 The most important part of the lecture is to understand competing theories
of inflation as applied to developing countries; the Neoclassical and
Heterodox.
 Neither theory makes an issue of the distinction between trend inflation and
cyclical inflation.

Contents of lecture
Definition and measure
 Inflation is defined as an increase in the aggregate price level; that is, an
increase in the average money prices of all goods and services over a given
period of time – usually one year.
 Frequently distinctions are made between types of inflation; consumer, cost
and economy-wide.
 Consumer inflation refers to a rise in the money prices of a basic basket of
consumer goods. Typically consumer inflation is measured by increases in a
consumer price index.
 Cost inflation usually refers to increases in the money costs of production,
typically including wages, interest costs, building material costs, raw
materials and the like. Cost inflation is usually measured by some index of
business costs of production. However, since typical business costs tend to
vary from industry to industry, there is no agreed cost of production index
and governments do not usually compile and publish such an index.
 Economy-wide inflation refers to the rise in prices of all goods and services
in an economy. This is usually taken to be depicted by increases in the GDP
deflator, or the price component of the increase in GDP at market prices.

Neoclassical approach
 The Neoclassical approach to inflation argues that inflation is due to
excessive domestic expenditure (i.e., domestic expenditure which does not
result from an expansion in output).
 The Excessive domestic expenditure in turn results from an excessive
increase in money stock (i.e., growth of money stock in excess of the growth
of output).
 The money stock is typically defined as either narrow money, M1, or broad
money, M2. M1 comprises cash and non-interest bearing deposits with
commercial banks. Non-interest bearing deposits are demand or current
account deposits with commercial banks. M2 comprises M1 plus savings and
fixed interest deposits with commercial banks. Savings deposits are usually
deposit with commercial banks where the interest rate changes regularly.
Fixed interest deposits are sometimes called term-deposits because the
interest rate on the deposit is fixed for a certain period of time, usually 6
months, one year or two years. Some Neoclassicals use even broader
definitions of money stock.

54
 Increases in the money stock are argued to be due to increases in the cash
base of the system, so-called “high-powered” money or M0.
 Inflationary increases in the cash base of the system (an increase in the
cash base which causes the money stock to rise by more than the real
increase in output) can arise from a number of sources including central bank
reverse repurchase agreements with private banks (which provide
commercial banks with cash when they need it at a certain cost), inflows of
foreign exchange (central banks are obliged to purchase all foreign exchange
upon demand) and financing of the budget deficit. However, Neoclassicals
argue that inflationary increases in the cash base are largely due to the
third source of excess cash in the system – when central banks are forced to
finance the budget deficit (and not “sterilise” the resulting increases in cash
in the system by selling to the public the government debt it holds).

Heterodox approach
 The basic Heterodox explanation of inflation is that it is cost driven. This
comes from the microeconomic view of how prices are formed (cost plus a
mark-up). Since the mark-up is assumed to be fairly stable over long-periods
of time, most attention is paid to costs.
 In developing countries the key costs are seen as import costs and wage
costs, with most emphasis placed in the import prices due to the fact that
developing countries typically import so many of their inputs and basic
products.
 The import cost pressures comprise both increases in import prices arising
from increases in the dollar or foreign currency value of imports as well as
increases in import prices arising from currency depreciation.
 The wage cost pressures are seen as emanating primarily from food prices.
If food is imported then the exchange rate comes into the reckoning again.
 Money stock changes, particularly broad money stock, but also the cash base,
as seen as endogenous to the system; determined by the demand for money.
Heterodox economists deny that the authorities have much discretion over
the amount of money in a system, unless they are prepared to allow interest
rates to be high and extremely volatile.

Last update: Saturday, September 15, 2012

Lecture 10c: The Balance of Payments and Exchange

Rate
Objectives of lecture
 The basic aim of the lecture is to provide an understanding of competing
theories of the balance of payments and exchange rate as applied to
developing countries; the Neoclassical and Heterodox.

55
 It is of note that most attention in the standard theories the focus tends to
be on the current account, and particularly the trade account, of the balance
of payments.

Contents of lecture
Neoclassical approach
 The Neoclassical approach to explaining the balance of payments in
developing countries tends to focus on the trade balance.
 Inflows and outflows of money into an economy (whether through the trade
or other accounts) are typically explained by relative money stock to output
ratio changes between countries. That is to say, when the money stock of
one country in relation to its output increases relative to that of another
country then money will flow out of the country as a result of an increase in
import expenditure and a decrease in export earnings. Import expenditure
will increase as a result of increases in expenditure on all goods and services
due to excess money stock expansion, and the fall in export earnings will
result from a loss of competitiveness of exports resulting from inflation
(and an implied increase in the foreign currency prices of exports assuming
the exchange rate is fixed).
 Such imbalances arising from excess increases in money stock are deemed to
be automatically corrected if the exchange rate is allowed to float – to be
market determined. That is to say, the tendency for import expenditures to
rise and export earnings to fall due to an excessive increase in money stock
will be offset by the depreciation of the exchange rate and a corresponding
increase in the prices of imports and fall in prices of exports.
 This also means to say that in a floating exchange rate environment
Neoclassicals will explain the exchange rate in the same way they would
explain a payments imbalance (in a fixed exchange rate environment). That is
to say, currency depreciation is explained by an excessive growth of money
stock – usually M2.

Heterodox approach
 Heterodox economists distinguish first and foremost between, on the one
hand, current account flows, and on the other capital and financial account
flows, arguing that the distinction is important in the explanation of overall
balance of payments flows.
 Heterodox economists distinguish further between different flows
pertaining to the current, capital and financial accounts, arguing that these
distinctions are also important when explaining the flows of money into and
out of a country.
 Heterodox economists also distinguish between two types of developing
countries – on the one hand, raw material and agricultural exporters, and, on
the other manufacturing producers and exporters. They argue that this

56
 distinction is important for explaining balance of payments and exchange
rate phenomena.
 For many developing countries Heterodox economists also (like Neoclassicals)
focus most attention on the trade balance, but deny that this is in itself
enough to explain either the current account or the overall balance of
payments. Heterodox economists argue that long-term trends in the trade
balances of most raw material and agricultural producers are explained by
the terms of trade for these products – prices received by developing
countries for their exports in relation to the prices developing countries
have to pay for their imports. These terms of trade are in turn explained by
the nature of the products exported (and imported) and the structures of
the markets for these products. Heterodox economists deny that the
failure of the currency to adjust to the imbalances in inflows and outflows of
money has much of a bearing on the trade imbalances in these types of
developing countries.
 Heterodox economists argue that trade imbalances for most manufacturing
developing countries can be attributed to relative costs of production and
the value of the exchange rate – its relative competitiveness vis-à-vis other
competing developing country manufacturing-oriented export economies.
The lower the relative costs of production of an economy (and the more
competitive its exchange rate) the more it can export and the less it will
have to import.
 Heterodox economists argue that the current account imbalances of a
number of developing countries are explained not so much by trade
imbalances as negative income (and services) account balances. The negative
income account balances are due to excessive debt contraction.
 Heterodox economists note that in some cases positive current account
balances are due to aid inflows private remittances of migrant workers, and
have nothing to do with the trade performance of a country.
 Heterodox economists argue that sustained capital (especially FDI) inflows
are largely to be explained by relative profitability of countries. Short-term
FDI flows can be due to privatisation processes, but such inflows will not
continue unless there is a profits growth environment in a country.
 Heterodox economists too argue that in a market determined environment
the exchange rate will reflect inflows and outflows of money into an
economy. However, they deny that the exchange rate should reflect any and
all inflows and outflows of currencies, or that such a market determined
exchange rate will automatically adjust the balance of payments imbalance.
Rather, Heterodox economists argue that a floating exchange rate can
aggravate imbalances. Moreover, they argue that the government should
manage the exchange rate and that it should reflect, if anything, only
competitive flows – just the trade flows.

57