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Fifty major economists |
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FIFTY MAJOR ECONOMISTS
Fifty Major Economists provides a comprehensive and clear exposition of the ideas of those
individuals responsible for shaping the discipline of economics. Numerous examples help to
illustrate the key concepts and ideas of these economists. The book covers a wide range of
thinkers, spanning several centuries, beginning with Thomas Mun and Adam Smith, and
progressing to recent Nobel Prize winners such as Robert Lucas and Amartya Sen. Fifty Major
Economists contains brief biographical information about each economist, references to the
major works of each figure, guides to further reading and a glossary of economic terms used in
the book.
Steven Pressman is Professor of Economics and Finance at Monmouth University, New Jersey.
He is the author of Interactions in Political Economy: Malvern after ten years, also published
by Routledge, Quesnay’s Tableau Économique and Economics and its Discontents (edited with
Richard Holt). He also serves as co-editor of the Review of Political Economy.
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KEY CONCEPTS
In this series:
Fifty Major Philosophers
Diane Collinson
Fifty Key Contemporary Thinkers
John Lechte
Fifty Key Jewish Thinkers
Dahn Cohn-Sherbok
Forthcoming:
Fifty Key Thinkers in International Relations
Martin Griffiths
Fifty Contemporary Choreographers
Edited by Martha Bremser
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In memory of my mother, Phyllis Pressman (1926–95); a major figure
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FIFTY MAJOR
ECONOMISTS
Steven Pressman
London and New York
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First published 1999
by Routledge
11 New Fetter Lane, London EC4P 4EE
Simultaneously published in the USA and Canada
by Routledge
29 West 35th Street, New York, NY 10001
Routledge is an imprint of the Taylor & Francis Group
This edition published in the Taylor & Francis e-Library, 2002.
© 1999 Steven Pressman
All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any
electronic, mechanical, or other means, now known or hereafter invented, including photocopying and
recording, or in any information storage or retrieval system, without permission in writing from the publishers.
British Library Cataloguing in Publication Data
A catalogue record for this book is available from the British Library
Library of Congress Cataloging in Publication Data
Pressman, Steven
Fifty major economists: a reference guide/Steven Pressman.
p. cm.
Includes bibliographical references. 1. Economists—Biography. 2. Economics—History. I. Title.
HB76.P74 1999
330’.092’2–dc21
[b] 98–33133
CIP
ISBN 0-415-13480-3 (hbk)
ISBN 0-415-13481-1 (pbk)
SBN 0-203-02472-9 Master e-book ISBN
ISBN 0-203-20625-8 (Glassbook Format)
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CONTENTS
INTRODUCTION
ix
Thomas Mun (1571–1641)
1
William Petty (1623–1687)
4
John Locke (1632–1704)
7
Richard Cantillon (1687?–1734?)
10
François Quesnay (1694–1774)
13
David Hume (1711–76)
17
Adam Smith (1723–90)
20
Jeremy Bentham (1748–1832)
26
Thomas Robert Malthus (1766–1834)
29
Robert Owen (1771–1858)
33
David Ricardo (1772–1823)
35
Antoine Augustin Cournot (1801–77)
40
John Stuart Mill (1806–73)
44
Karl Marx (1818–83)
48
Léon Walras (1834–1910)
53
William Stanley Jevons (1835–82)
57
Carl Menger (1840–1921)
60
Alfred Marshall (1842–1924)
64
Francis Ysidro Edgeworth (1845–1926)
69
John Bates Clark (1847–1938)
73
Vilfredo Pareto (1848–1923)
77
Eugen von Böhm-Bawerk (1851–1914)
81
Knut Wicksell (1851–1926)
84
Thorstein Veblen (1857–1929)
88
Irving Fisher (1867–1947)
91
Arthur Cecil Pigou (1877–1959)
95
John Maynard Keynes (1883–1946)
99
Joseph Schumpeter (1883–1950)
105
Piero Sraffa (1898–1983)
109
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CONTENTS
Gunnar Myrdal (1898–1987)
112
Friedrich Hayek (1899–1992)
116
Simon Kuznets (1901–85)
120
John von Neumann (1903–57)
124
Joan Robinson (1903–83)
128
Jan Tinbergen (1903–)
132
John Hicks (1904–89)
136
Oskar Lange (1904–65)
141
Wassily Leontief (1906–)
145
Nicholas Kaldor (1908–86)
149
John Kenneth Galbraith (1908–)
153
Milton Friedman (1912–)
157
Paul Samuelson (1915–)
162
Franco Modigliani (1918–)
167
James M.Buchanan (1919–)
170
Douglass Cecil North (1920–)
174
Kenneth J.Arrow (1921–)
177
Barbara R.Bergmann (1927–)
181
Gary Becker (1930–)
185
Amartya Sen (1933–)
189
Robert E.Lucas, Jr. (1937–)
193
GLOSSARY
198
viii
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INTRODUCTION
“The ideas of economists and political philosophers, both when they are right and when they
are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by
little else. Practical men, who believe themselves to be quite exempt from any intellectual
influences, are usually the slaves of some defunct economist.” So wrote John Maynard Keynes
at the end of The General Theory of Employment, Interest and Money. Keynes was pointing
out that the key economic issues are generally argued within a context and framework that
was developed over many centuries. Not knowing that history results in less informal discussion
and also in worse economic policies. History counts not only because, as Santanyana remarked,
those who lack a knowledge of history are bound to repeat its mistakes. History also has value
for the perspective it bestows. Like other disciplines, economics was not developed in a vacuum.
To the contrary, economic ideas were developed by real people who were responding to the
important issues of their time. A sense of history is necessary to comprehend this noble function
of economics and to understand how great economists of the past responded to the problems
of their time. Finally, history is important because, in a sense, history is the arbitrator of what
has only fleeting importance and what has lasting interest and significance.
Unfortunately, at the end of the twentieth century the majority of the economics
profession has come to reject historical pursuits and perspectives. Most economists even
look down on those who study economics from an historical perspective. Part of the reason
for this is that over the past several decades economists have come to value technique
over ideas. Another reason economists ignore history is that they hold an outmoded view
of what counts as truth in the social sciences. Believing that we can come to know timeless
and universal economic truths, many economists ignore history; past ideas are thought to
be either imbedded in current economic knowledge or just plain wrong.
Historians of economic thought must also share some of the blame for the demise of
their area of specialization. They tend to present their field as a history of dead figures
whose ideas have little contemporary importance. Rarely do they explain how studying
the great figures from the past can help illuminate current issues, or how it can help us
understand how economics might help mitigate important contemporary problems. Even
less frequently do they study the ideas of economists who are still alive and who continue
to contribute to our knowledge of how economies work.
When Alan Jarvis of Routledge approached me about doing a book on the major figures
in economics I took his inquiry as an opportunity to remedy this situation, and also to
revitalize interest in the long and great history of economic ideas. All the key economic
figures from the past are contained in this volume. They are great figures for good reasons.
However, history does not end in the distant past; it continues up to the present and it
permeates much recent economic thought. Thus, this volume explicitly recognizes the
important contributions made by more recent economists.
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INTRODUCTION
Nonetheless, choosing which fifty economists to include in this volume quickly
became a daunting task. While the first forty or so were relatively easy decisions,
things soon became difficult. And as time went on, and as the number of figures I
selected approached fifty, it became more and more difficult to make the final
choices. My general guidelines for these decisions were the power of the ideas
developed by each economist, the breadth of their overall contributions, and of course,
the judgment of history. In the latter case I was guided by how history has viewed the
contributions of past and present figures and also by how I thought that history will
likely view their ideas in the future.
Of course, there can be considerable dispute concerning who should be included and
who should be excluded. In fact, “Who should be number fifty?” became an amusing
parlor game that I played with many colleagues over the past several years. Alas, this
parlor game led to little or no consensus. On the bright side, there was much heated and
enjoyable debate about the most important ideas and figures in the long history of
economics. I thank my many colleagues who humored me by playing this game, and by
so doing, for helping me to think about what is really important in economics and what
is really important about economic ideas. While I may not have gotten everything exactly
right, and while I am sure that people will point out many important figures who were
ignored, as the failure to find consensus around number fifty shows, there is probably
no right answer here. However, I am confident that I have pretty much gotten things
right. The fifty economists whose ideas I explain in this volume are all major figures
who have made important contributions. History is likely to view them as important
economic figures, worthy of continued study.
For each economist in this volume I have provided a short biography and a summary
of the several key ideas that they promulgated. I have also attempted to assess their
place in the history of the discipline. Towards this end, I have made some effort to let
the reader know where these figures rank according to the views of most economists. I
have also gone out on a limb and provided my own assessments of the rankings of these
figures. I know that my colleagues will dispute many of these rankings; and, of course,
these rankings will likely generate as much controversy as my decisions about who to
include in this volume. Again, although my assessments may not be perfectly right, I
think I have gotten things pretty much right in this regard.
Each entry ends with a bibliography containing the most important writings of each
figure and a few references to the most accessible and most important secondary literature.
These references should allow interested readers to pursue further the economic ideas of
these major figures. The volume closes with a glossary of key terms, so that frequently
mentioned concepts do not have to be continually defined and explained.
In all writing endeavors one incurs many obligations. This is especially so in a work
covering so many ideas, so much history, and so many figures. Many colleagues read
earlier drafts of this work and provided substantial comments in an attempt to correct
my mistakes. For their hard work I thank Nahid Aslanbeigui, Peter Boettke, Charley
Clark, Milton Friedman, John Henry, Sherry Kasper, Mary King, Roger Koppl, Franco
Modigliani, Laurence Moss, Douglass North, Susan Pashkoff, Alessandro Roncaglia,
Ruth Sample, Mario Seccareccia, John Smithin, Gale Summerfield and Naomi Zack.
Any errors, of course, remain my responsibility.
Several of my students at Monmouth University and the University of New Hampshire
read and commented on many individual chapters, thereby forcing me to make the ideas
of all fifty economists clear to someone who is not cursed by having a Ph.D. in
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INTRODUCTION
Economics. Special thanks here are due to Tad Langlois, Ivan Pabon, Lynn Van Buren,
Flavio Vilela Vieira and Sarah Youngclaus.
My editors at Routledge—Alan Jarvis and Alison Kirk—both provided
encouragement, ideas and suggestions at all stages of my writing this book. For all
their assistance and support I am very grateful.
But perhaps my greatest debt and gratitude goes to those people who typed the
numerous revisions to each chapter, as I tried to get the ideas of these fifty economists
exactly right and as I tried to make them intelligible to a broad audience. For their hard
work, and for their patience in putting up with my endless revisions, I thank Beth
Boyington, Nancy Palmer and Diana Prout.
xi
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THOMAS MUN
THOMAS MUN (1571–1641)
Thomas Mun is the best known and most
respected member of a group of seventeenth-
century British merchant-economists called
“the mercantilists.” This group proposed that
England run trade surpluses in order to prosper
economically. As set forth by Mun ([1664]
1954, p. 125),
The ordinary means…to increase our wealth
and treasure is by Forraign Trade, wherein
wee must ever observe this rule; to sell more
to strangers yearly than wee consume of theirs
in value. …[T]hat part of our stock which is
not returned to us in wares must necessarily
be brought home in treasure.
Little is known about the life of Mun. His
grandfather worked for the Royal Mint; his
father was a textile trader. Mun himself became
a merchant early in life, lived in Italy for many
years and quickly accumulated a great deal of
wealth. He later became involved with the East
India Company, a large British joint-stock
company that traded (primarily) in the Far East.
In 1615 Mun was elected to be a Director of
the East India Company, and he remained a
Director of the firm for the remainder of his
life. After Mun achieved wealth and social
status he was appointed to several British
committees and commissions. Most of these
commissions issued reports containing Mun’s
name as part of a long list of committee
members; but Mun himself wrote only two
economic tracts.
His first work (Mun 1621) defended the
East India Company against critics who
claimed that the firm was exporting gold and
silver to the Orient (in exchange for spices)
and that this loss of precious metals was
hurting the British economy. A Discourse of
Trade was rather unmercantilist in its
orientation. Rather than advocating a trade
surplus and the accumulation of gold, Mun
advanced any and all arguments he could
think up to support the East India Company.
He claimed that nations become wealthy
for the same reasons that families become
wealthy—by frugality and by making more
than they spend. Likewise, nations and
families become poor by spending too much
money. Thus, Mun reasoned, as long as the
East Indian Company made money it could
not make Britain poorer.
Mun also pointed out that food, clothing,
and munitions were necessities, so importing
these goods improved the welfare of
England. On the other hand, importing
luxury goods was harmful to the nation. Mun
then went on to argue that the East India
Company was importing only items
necessary for consumption.
Taking yet another line of defense, Mun
argued that trade with India provided a
market for English exports. In addition, trade
with India was good for Britain because it
eliminated trade with Turkey; had the same
goods been imported from Turkey, Mun
pointed out, the cost to Britain would have
been much greater.
Finally, Mun argued that not all luxury
imports were harmful; some imports were
improved by British firms and re-exported,
thus leading to a net influx of precious metals
into England. The goods imported by the
East India Company, Mun claimed, were
generally goods needed by British exporters.
While the Discourse made Mun an
apologist for the East Indian Company, his
second book, published posthumously (1664),
established Mun as an important early
economic thinker. What is most noteworthy
about England’s Treasure by Forraign Trade
is its much broader perspective. No longer does
Mun try to defend the East India Company;
rather he adopts the viewpoint of the nation as
a whole. He looks at trade in general, rather
than trade by the East India Company, and he
makes the case that foreign trade enriches a
nation whenever it leads to a trade surplus. Mun
also examines the factors that cause a country
to run trade surpluses. Finally, Mun advances
a set of proposals that British leaders could
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THOMAS MUN
implement if they wished to improve the
national trade position.
The trade balance is merely the difference
between what a nation exports and what it
imports. When a nation runs a trade surplus,
its exports exceed its imports. Sales abroad,
over and above what is bought from foreign
countries, must be paid for by foreigners. In
the seventeenth century these payments were
made with precious metals—gold and silver.
Trade surpluses thus enabled a nation to
accumulate wealth and enrich a country. In
contrast, domestic trade could not make
England wealthier because the gain in
precious metals by one citizen would equal
the loss of another citizen. To generate trade
surpluses, Mun noted, England must become
more self-sufficient and reduce its need for
foreign-made goods. Britain must also
become more frugal so that more goods were
available for export. Mun especially looked
down on and discouraged the consumption
of luxury goods.
With the domestic money supply rising
as a result of these trade surpluses, a
danger lurks that people might try to
purchase more goods. This would cause
domestic prices to increase and would
eventually lead to the loss of exports, since
domestically produced goods would
become too expensive to sell abroad. But
these consequences, Mun noted, could
easily be avoided. To make sure that the
inflow of money from abroad actually goes
to benefit a nation, all new money must be
re-invested. Reinvestment would also
create more goods to be exported in the
future. Here Mun recognized the
importance of capital investment, and he
viewed a positive trade balance as a way
to accumulate productive capital.
Besides explaining the benefits of trade
surpluses, Mun also explained what could
be done to encourage such surpluses. First,
there was price policy. Mun wanted exports
sold at the “best price”; that is, the price
that brings in the most revenue and wealth.
Where England had a monopoly in world
trade, or something close to a monopoly, her
goods should be sold at high prices. But
when foreign competition was great, British
goods should be priced as low as possible.
This would result in more sales for Britain
and help drive out foreign competitors.
When foreign competitors disappeared,
Mun recommended that prices be raised, but
not to the point that competitors are enticed
to come back into the market.
Second, Mun explained that higher
quality goods would be in greater demand
throughout the world and would also lead
to greater exports for Britain. He then
explained how the British government could
help improve product quality. Mun wanted
the government to regulate manufacturers
and to establish a council of trade (similar
to the functions now performed by the US
Department of Commerce) which would
advise the government in matters pertaining
to the regulation of trade and industrial
activity. These regulations on British
manufacturers should be quite strict in order
to ensure that Britain produced high quality
goods.
Finally, Mun explained how national tax
policy could help generate trade surpluses.
He recognized that (in opposition to the
national interest) some firms might want to
import luxury goods. In such a case,
government policies must bring private and
national interests into harmony. Mun looked
to taxation to achieve this end. Export duties
were to be discouraged because they would
cost Britain sales in foreign countries.
Import duties should be low on goods that
are subsequently exported and high on
goods that tend to be consumed by British
citizens. Excise or sales taxes, Mun argued,
did little harm. Although they raised the
price of food and clothing, Mun believed
that these taxes would lead to higher wages
and thus be shifted to employers. Although
Mun did not offer any explanation for this,
one possibility is that he had in mind a
subsistence theory of wages (see also
SMITH).
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THOMAS MUN
When higher prices for necessities lead
to higher wages, the standard of living for
British workers remains the same and the
excise tax is paid by the wealthy. In order
to avoid paying this tax the rich had only
two options—they could work longer and
harder, or they could reduce luxury
consumption. In either case, Mun argued,
the nation would benefit.
Mun, however, did not want the state to
collect tax revenues and then engage in lavish
or wasteful spending. Tax collections had to
be saved so that they were available for national
emergencies, such as wars. At the same time,
the state should not accumulate so much tax
revenue that the national supply of capital falls.
As a compromise, Mun proposed that each year
the state accumulate a surplus of taxes over
spending that was equal to the annual trade
surplus.
Mun and mercantilism came in for
sharp criticism from other economists
during the eighteenth and nineteenth
centuries. David Hume explained how
trade imbalances would correct
themselves automatically. François
Quesnay and Adam Smith both sharply
criticized the mercantilists, and argued
that less government restrictions on
businesses would spur domestic
production. Finally, David Ricardo
advanced a strong case for free trade. All
these anti-mercantilist views were quickly
taken to heart by most economists.
Mercantilist thinking, however,
experienced a revival of sorts in the twentieth
century. John Maynard Keynes praised the
mercantilists for recognizing that the demand
generated by trade surpluses would increase
economic growth. Chapter 23 of The General
Theory (Keynes 1936), entitled “Notes on
Mercantilism,” credits the mercantilists with
understanding that countries could create
jobs and incomes for its own citizens by
generating a trade surplus, while the influx
of money would increase business
investment.
But perhaps the strongest support for
mercantilist doctrines can be found in Asia.
The success of the Japanese economy in the
second half of the twentieth century was
achieved with the aid of economic policies
that were mercantilist in spirit, even if not
by intent. The Japanese government set high
product quality standards, which helped
Japan become a producer of high quality
consumer goods. Economic success was
also achieved by using tariffs and
protectionism to stem imports, while
encouraging domestic firms to export goods
(see Johnson 1982).
Although Mun is not highly regarded by
economists today, and although Mun did not
make any path-breaking discoveries, he did
leave his mark on the history of economics.
The idea that government economic policy
should be used to generate a trade surplus,
and the idea that the way to achieve
economic growth is through the growth of
exports, constitute his two lasting
contributions.
Works by Mun
A Discourse of Trade from England unto the East-
Indies (1621) in Early English Tracts on
Commerce, ed. John R.McCulloch,
Cambridge, Cambridge University Press, 1954
England’s Treasure by Forraign Trade (1664) in
Early English Tracts on Commerce, ed. John
R. McCulloch, Cambridge, Cambridge
University Press, 1954
Works about Mun
Buck, Philip W., The Politics of Mercantilism,
New York, Octagon Books, 1964
Johnson, E.A.J., Predecessors of Adam
Smith: The Growth of British Economic
Thought, New York, Augustus M.Kelley, 1965
Magnusson, Lars, Mercantilism: The Shaping of
an Economic Language, New York and
London, Routledge, 1994
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WILLIAM PETTY
Other references
Johnson, Chalmers, MITI and the Japanese
Miracle: The Growth of Industrial Policy,
Stanford University Press, 1982
Keynes, John Maynard, The General Theory of
Employment, Interest and Money (1936), New
York, Harcourt Brace & World, 1964
WILLIAM PETTY (1623–87)
William Petty was one of the very first people
to think and write systematically about
economics, and one of the first individuals to
apply economic principles to the real world.
His work provides insight into the nature of
rent and taxation. But Petty is best known for
his attempt to make economics a quantitative
and statistical science through what he called
“political arithmetic.”
Petty was born in 1623 to a poor cloth-
worker in the quiet market town of Hampshire,
on the river Test, in southern England. His
schooling consisted primarily of rote
memorization; it was a typical education for
the children of the lower classes at that time.
Nonetheless, Petty rose above his formal
schooling because he possessed great curiosity
and read widely in the areas of literature and
science.
At the age of 13 or 14 Petty left school and
found a job as a cabin boy on a ship that
continually crossed the English Channel.
During his first year at work, Petty broke his
leg. Since he was no longer useful to his
employer, he was left on the French side of the
Channel. Petty decided to stay in France and
to attend the Jesuit College in Caen. He left
Caen in 1640, spent three years in the navy,
and then went to Holland to study anatomy and
medicine.
In 1646 Petty returned to England to study
medicine at Oxford. After receiving his
doctorate in medicine, he was appointed
Professor of Anatomy at Oxford. Petty
established a name and reputation for himself
by supposedly raising from the dead a woman
who had been hanged (Strauss 1954, Ch. 3).
But within weeks of giving his first lecture, he
decided that the academic life was not right
for him and he left Oxford to become chief
physician of the Irish army. At the same time,
Petty became chief surveyor of Ireland, and he
used the knowledge he acquired in this job to
accumulate much land and great wealth. In the
1660s Petty helped establish the Royal Society
of London for the Improving of Natural
Knowledge. Its agenda was to follow the
scientific method of Francis Bacon—to use
observation and experimentation in order to
study the natural world and society.
Petty developed the method of political
arithmetic as a result of applying the Royal
Society research program to economic
phenomena. In the preface to his Political
Arithmetic, Petty ([1671] in Hull 1899)
announced that his goal was to refute popular
beliefs and show that England was suffering
from neither economic decline nor a decline
in trade. To the contrary, Petty claimed that
England was richer than ever. He then set about
to prove this thesis. Unfortunately, in
seventeenth-century England there were no
government agencies to report economic data
on a regular basis. Nor did newspapers provide
every economic and financial statistic that one
might care to know (as well as many that no
one cared about). Thus Petty assumed
responsibility for gathering the figures
necessary to make his case.
Essentially, the method of political
arithmetic was “to express myself in terms of
number, weight or measure; to use only
arguments of sense; and to consider only such
causes as have visible foundations in nature;
leaving those that depend upon the mutable
minds, opinions, appetites, and passions of
particular men, for the consideration of others”
(Hull 1899, p. 244). Political arithmetic
employed quantitative methods to analyze
economic and social phenomena. One aspect
of this new method was to use numbers and
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WILLIAM PETTY
measures to describe reality. Another aspect
was to use these numbers to draw inferences
about the way the world worked. For example,
by showing that A and B increased together
Petty would draw the conclusion that in order
to increase A it was necessary to increase B,
and in order to increase B it was necessary to
increase A. The final thrust of the political
arithmetic was an attempt to separate economic
analysis from the morals or beliefs held by
individuals, thereby making any study of the
economy more objective.
It is well known that the scientific or
experimental method is difficult to employ in
economics. A true controlled experiment would
require that we start with two identical
economies, or two identical groups of people,
placed in exactly the same situation. We would
then alter one condition for just one of these
two groups. Then we would observe how this
one change affected each group. Unfortunately,
in the real world it is virtually impossible to
create or find such an environment. Political
arithmetic attempted to substitute statistical
analysis for experimentation, believing this is
the best we can do in economics. This statistical
method continues to be used in economics,
although there have been recent attempts to
make economics more “scientific” by figuring
out how to run controlled experiments (Smith
1987, 1990; Burtless 1995).
To prove that London was wealthy and that
it had been expanding economically, Petty set
out to show that London had more people and
more homes than Paris. Petty first examined
the median number of burials in London and
in Paris over the prior three years (1683–5 for
London and 1682–4 for Paris), and found a
greater number of burials in London (22,337)
than in Paris (19,887). Assuming that death
rates were the same in both cities, Petty
concluded that the population of London was
greater than Paris and that London was
wealthier than Paris.
One key assumption in this analysis was that
national wealth depended on the population of
a nation. While this assumption may seem
bizarre in an era where poor countries tend to
be the most populous and whose populations
grow at the fastest rates, this was a reasonable
assumption when Petty was writing. In
seventeenth-century England there was no
direct way to measure wealth; some indirect
measurement was necessary. And Petty did
choose a reasonable indirect measure. Before
modern birth control methods came into
existence, population and population growth
depended primarily on the ability of children
to survive. This, in turn, required a greater
standard of living or greater national wealth.
Greater wealth did actually lead to more rapid
population growth; thus Petty’s analysis was
probably the best possible at the time.
Although Petty has been taken to be a
mercantilist (see also MUN) because he
frequently called for England to run trade
surpluses, Petty differed from the mercantilists
in many respects. Unlike the mercantilists,
Petty advocated trade surpluses to increase
employment rather than to accumulate wealth.
In addition, unlike the mercantilist writers,
Petty recognized a number of benefits to free
international trade. Finally, unlike the
mercantilists, Petty did not look towards
international trade to promote the economic
growth of England. Rather, Petty thought that
public finance, or government spending and tax
policy, was a more important determinant of
economic well-being than trade policy or
accumulating large trade surpluses.
In fact, Petty became a harsh critic of
English public finance, arguing that the English
tax system was a major force hindering national
economic growth. In seventeenth-century
England the cost of collecting taxes was high,
there was great uncertainty about the taxes that
people owed, and the many injustices
stemming from actual collection were
legendary. This all reduced the incentives that
people had to work hard and better themselves.
And when people lack such incentives,
economies stagnate.
But Petty was not opposed to all forms of
taxation. Nor did he think that taxes were
necessarily bad and hurt a nation. The problem
was with the actual English tax policy. Petty
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WILLIAM PETTY
(in Hull 1899, p. 64) condemned English poll
taxes because they were regressive in nature.
Petty also condemned state lotteries as a means
of raising revenues, which he regarded as “a
tax upon unfortunate self-conceited fools”
(Hull 1899, p. 64). Instead, he favored a
progressive tax where people pay according to
the “interest in the Public Peace; that is,
according to their Estates or Riches.” At times
he also supported a proportional tax on
consumption (Hull 1899, p. 91).
More important than how taxes were
collected, though, was how tax monies were
spent. According to Petty, taxation hurt the
economy only when tax revenues were removed
from circulation. If tax revenues were spent, they
had few harmful effects. Government spending
would return money to circulation and put
people back to work. This would compensate
for the loss of money in circulation and the loss
of jobs that arose from taxation.
Moreover, Petty recognized the possibility
that taxes could have positive effects.
Anticipating Nicholas Kaldor (see below),
Petty held that if taxation and spending
encouraged the consumption and production
of high productivity goods, this would increase
national output. In addition, tax monies spent
to assure that the economy functioned in an
orderly manner would promote national
wealth. Petty thus considered it the
responsibility of government to spend money
on things such as defense, justice, schools, poor
relief and public works including highways,
bridges and harbors (Hull 1899, p. 20). Finally,
Petty noted the importance of government
expenditure, even on useless items, in order to
create jobs and eliminate idleness.
Foreshadowing Keynes (see below), he wrote
the following about government spending: “’tis
no matter if it be employed to build a useless
pyramid upon Salisbury Plain, bring the stones
at Stonehenge to Tower Hill, or the like” (Hull
1899, p. 31). All that really mattered was that
spending of some sort be undertaken.
Despite his strong empirical and practical
orientation, Petty did make key theoretical
contributions to economics. He was the first
economist to define the notion of a surplus and
he was the first economist to explain land rents
based upon this notion of a surplus (Roncaglia
1985, Ch. 7). Although the view that rent is a
surplus has come to be known as the
Physiocratic theory of rent, the theory was
really due to Petty rather than to Quesnay.
To grasp the notion of a surplus, think of a
primitive agricultural economy that grows only
corn. During the year, corn will be both an input
into the production process and an economic
output. As an input, corn will be used as seed
and to feed workers. At the end of the year,
corn will be harvested, to be used next year as
food and seed. Petty defined the economic
surplus as the difference between the total
output of corn (at the annual harvest) and the
inputs of corn needed to produce that output.
Landowners, he thought, would tend to receive
rental payments equal to the surplus generated
on their land. No one would pay to rent land
for more than the surplus that can be obtained
from that land, since the renter would thereby
lose money. On the other hand, competition
among renters would push rents up to the level
of the surplus.
Despite his contributions to the study of
public finance, and despite his work on
defining and explaining the notion of a surplus,
Petty was an important figure mainly for his
emphasis on using numbers or data to
understand and explain how real world
economies work. Although he urged the
development of better and more regular
economic statistics to aid in this endeavor (see
Hull 1899, p. lxvi, note 4), it would take
another 250 years before reliable data became
readily available (see also KUZNETS).
Hutchison (1988, p. 37f.) is surely correct that
Petty was overconfident that governments
could collect reliable statistics in the
seventeenth century; but Petty was also right
that without any statistics it is virtually
impossible to understand how economies
change over time. Petty attempted to make such
measurements and he used them to try to
understand the British economy. This
constitutes his most important economic
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JOHN LOCKE
contribution and makes him the most important
economic figure of the seventeenth century.
Works by Petty
The Economic Writings of Sir William Petty, ed.
C.H.Hull, Cambridge, Cambridge University
Press, 1899
Works about Petty
Hutchison, Terence, Before Adam Smith: The
Emergence of Political Economy, 1662–1776,
Oxford, Basil Blackwell, 1988
Letwin, William, The Origins of Scientific
Economics: English Economic Thought 1660–
1776, London, Methuen & Co., 1963
Roncaglia, Alessandro, Petty, Armonk, New York,
M.E.Sharpe, 1985
Strauss, Erich, Sir William Petty: Portrait of a
Genius, London, Bodley Head, 1954
Other references
Burtless, Gary, “The Case for Randomized Field
Trials in Economic and Policy Research,”
Journal of Economic Perspectives, 9, 2 (Spring
1995), pp. 63–84
Smith, Vernon L., “Experimental Methods in
Economics,” in The New Palgrave: A
Dictionary of Economics, ed. John Eatwell,
Murray Milgate and Peter K.Newman, New
York, Stockton Press, 1987, 2, pp. 241–9
Smith, Vernon L. (ed.), Experimental Economics,
Aldershot, Edward Elgar 1990
JOHN LOCKE (1632–1704)
The contributions that John Locke made to
economics were primarily the contributions of
a philosopher. He provided the first justification
for private property and for limited state
involvement in economic activity. This helped
provide a philosophical foundation for the
capitalism developing in seventeenth-century
England, and helped win its acceptance in an
era dominated by religious concerns. Locke
also made several contributions to the theory
of money and interest rates.
Locke was born in Somerset, England in
1632 to a moderately well-off family. His father
was a country lawyer with considerable land
holdings; one of his best clients and closest
friends was Alexander Popham. Popham
became a member of Parliament in 1647 and
helped Locke gain admittance to the
Westminster School, one of the most influential
and best English public schools.
Locke did so well at Westminster that he
won a scholarship to Oxford University, and
entered Christ Church of Oxford in 1652. He
received a bachelor’s degree in 1656 and a
master’s degree in 1659. He then went on to
teach at Oxford—becoming a lecturer in Greek
in 1660 and a lecturer in Rhetoric in 1662.
Like many of his contemporaries, Locke
was fascinated by William Harvey’s discovery
that blood circulated throughout the body, and
he began to study medicine in his spare time.
He became personal physician to Lord Ashley,
who was Chancellor of the Exchequer, and
soon became his personal assistant. From his
relationship with Lord Ashley, Locke learned
about the important economic issues of the day,
such as trade with the British colonies and
interest rates.
Because of the knowledge and expertise he
developed about colonial problems, in 1673
Locke was made Secretary to the Council for
Trade and Plantations. Two years later he
returned to private life and to another love—
philosophy. Over the next few years Locke
worked on An Essay Concerning Human
Understanding (1690a) and Two Treatises on
Government (1690b). These two works
established his reputation as a great
philosopher. Nonetheless, Locke retained an
interest in economic issues, particularly
monetary matters, and continued to exert
political influence in England until his death.
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JOHN LOCKE
Locke made five contributions to
economics, three of a philosophical nature and
two that were more economic in nature. He
set forth philosophical justifications for
private property and for the state, and he
developed a methodology that helped make
economics “scientific.” This latter
contribution involved assuming that people
act rationally and respond to financial
incentives. Locke’s contributions to
economics concerned the theory of money and
interest. He argued against government
regulation of interest rates, and against a
government plan to devalue the British
currency, because such actions would have
bad economic consequences.
Probably the most important philosophical
contribution made by Locke was his
justification for an individual’s right to private
property. In seventeenth-century England
commercial activity was growing rapidly and
came into conflict with the dominant feudal
and religious institutions. It was generally
accepted that God gave the earth to all men in
common. To own the resources of the earth
meant that those resources were not available
for someone else. This made it hard to justify
private ownership.
Yet Locke provided such a justification. He
first set forth the rather uncontroversial
proposition that men had a right to their own
labor and the fruits of their labor. Men acquired
land as their lawful property by combining their
labor with the land. This was acceptable as long
as there remained an ample supply of land for
others, and as long as what someone took from
the land did not spoil before it was consumed
(Locke 1943, pp. 130ff.).
Locke then went from this limited defense
of property (based on what could be consumed)
to a more extensive defense of private property.
Money or capital, Locke recognized, was really
the product of past labor. Thus, ownership of
money could be justified because people had
to work in order to acquire it. Money also
allowed man to accumulate more and more
property, since money did not spoil before it
was consumed. The only constraint on
unlimited accumulation was the right of the
poor to enough income to be able to survive
whenever no land or jobs were available, and
whenever they were physically unable to
support themselves (Locke 1690b). In addition,
Locke argued that private property had practical
value, because when men were allowed to
accumulate property they were more
productive.
A second philosophical contribution made
by Locke provided a justification for the state
in economic society. In line with contemporary
beliefs, Locke held that natural law dictated that
the ultimate source of political rule was the
individual. The state could come into existence
only when a group of individuals agreed to turn
over some of their rights to a common ruler.
Locke viewed the state like a company whose
shareholders were men of property. Men put
themselves under the rule of government to
protect their life, liberty, and land. All citizens
(or at least those owning land and wealth)
therefore had an interest in joining civil society;
and presumably all citizens gave their tacit
consent to the rule of government. Rulers, in
turn, had to protect the interests of their citizens;
otherwise they would be removed from office
and replaced with someone who would uphold
the social contract (Macpherson 1962). Since
the state arose as a result of individual decisions
about laws and rules, the state could be justified
by appeals to natural law.
A final philosophical contribution made
by Locke involved the methodology of
economics, or how economics should be
done. Locke viewed people as rational self-
interested individuals, who responded to
economic incentives. This was quite
different from the prevailing religious view
that people were altruistic, or that they
primarily followed religious dictates.
Because people could be counted on to
behave in certain ways, economic laws and
principles could be developed. For example,
Locke recognized that when the price for
some goods increased, people would
substitute cheaper goods for the goods they
usually consumed; similarly, sellers would
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JOHN LOCKE
respond to greater profit opportunities by
producing and selling more (Locke 1968,
pp. 2–3, 46–68). As a result, economic laws
could be developed analogous to Boyles’
Law in chemistry and Newton’s laws of
motion in physics. Just as gases behaved
according to the mathematical expressions
contained within the law of chemistry and
physics, so too humans would behave
rationally when making economic decisions
(Vaughn 1980).
In the area of economics proper, Locke
made contributions to the theory of money and
the theory of interest. In the mid-seventeenth
century, Josiah Child held that the state should
limit interest rates to 4 percent (see Letwin
1963, p. 157), arguing that lower interest rates
would benefit merchants and others wanting
to borrow money for useful purposes, and thus
benefit the nation as a whole. The only people
who would be hurt by this policy, according to
Child, were lenders charging high interest rates.
Locke (1691) refuted this claim, and
made a case against government regulation
of interest rates. He argued that usury laws
merely redistribute the gains from trade
between the merchant and the lender; they
do not benefit the nation as a whole because
they do not increase borrowing and
investing. For example, if a merchant could
make 10 percent on borrowed money and
current interest rates were 5 percent, the
lender and the merchant split the gains from
trade 50–50. But if the government
prohibits loans at more than 4 percent, 60
percent of the gains from trade go to the
merchant and 40 percent go to the lender.
There would be no additional investment
and no net gain for the nation here. In fact,
there could be a net loss for the nation if
some people were unwilling to lend money
at a 4 percent rate. It would be better, Locke
concluded, if interest rates were allowed to
go to their natural level rather than be set
by government decree.
The natural rate of interest for Locke was
the free market interest rate, the rate
determined by the laws of supply and demand.
When money was in short supply, its price
(or the rate of interest) would rise because
lenders would know that they could charge
more. Behaving rationally, lenders would
charge higher interest rates and make more
money. Conversely, when there was more
money to lend than borrowers wanting this
money, the natural rate of interest would fall.
Rational borrowers would shop for good
deals, and only those lenders reducing their
rates would find someone who was willing to
borrow their money (Locke 1968, pp. 9–11).
Locke (1691) was also a prominent figure
in the recoinage question. In seventeenth-
century England, all coins were made of
precious metals. Because these metals had
value people began clipping or filing off the
edges of coins. These scraps would then be
melted down and sold as gold or silver.
Clippers thus accumulated wealth, while
clipped coins continued to circulate in
exchange for goods and services. This
behavior led Sir Thomas Gresham to
formulate one of the first economic
principles. Gre-sham’s Law simply states
that “bad money drives out good money.” By
this Gresham meant that rational people held
the best (least clipped) coins, and spent those
coins that were clipped the most and
contained the least amount of silver.
As early as 1690 the English
government proposed solving the problem
of clipped or depreciated coins by
reducing the weight of precious metals in
all coins, or essentially devaluing the
national currency. Locke opposed this
solution, and he argued against devaluing
and in favor of recoining with the
accustomed amount of precious metals.
Reducing the precious metal content in all
coins, he thought, would not help matters
because the value or purchasing power of
money was determined by its silver
content. This natural value of money
could not be set by public authorities or
by government laws (Letwin 1963, p.
171). Debasing the currency would
merely lead merchants to demand more
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coins (and thus the same silver content)
in exchange for goods. Although he
entered this debate at a rather late stage,
Locke helped to convince government
authorities not to devalue the British
currency and to recoin using the
accustomed silver content.
His argument that reducing the silver
content of each coin (and producing
more coins) would lead to higher
prices, makes Locke an important
forerunner of the quantity theory of
money (see also FISHER). However,
Locke has remained a key figure in
economics primarily for the important
philosophical contributions he made to
economics. His justifications for
private property, and for letting
economic activity take place without
outside interference by government,
have been accepted by most economists
throughout history—even up to today.
Works by Locke
An Essay Concerning Human Understanding
(1690a), 2 vols., Dover, 1959
Two Treatises of Government (1690b), 2nd ed.,
New York, Cambridge University Press, 1953
Some Considerations of the Consequences of the
Lowering of Interest and Raising the Value of
Money, 1691, in Locke 1696
Several Papers Relating to Money, Interest and
Trade (1696), New York, Augustus M.Kelley,
1968
Works about Locke
Letwin, W. The Origins of Scientific Economics,
London, Methuen, 1963
MacPherson, C.B. The Political Theory of
Possessive Individualism: Hobbes to Locke,
Oxford, Clarendon Press, 1962
Vaughn, K.I. John Locke: Economist and Social
Scientist, London, Athlone, 1980
RICHARD CANTILLON
(1687?–1734?)
Richard Cantillon (pronounced KAN-till-
LON) is a mysterious and fascinating figure.
Few details of his birth and youth are known,
and his financial activities as well as his death
remain shrouded in controversy. Despite
devoting most of his life to making money,
Cantillon wrote the first real economic treatise,
a study describing the interrelationships and
workings of the economic system. He also
contributed to monetary theory and was the first
person to explain the important economic role
played by the entrepreneur.
Cantillon was born into a Catholic family
in Ballyronan, a small town in Northwest
Ireland, sometime between 1680 and 1690. The
exact date of his birth remains uncertain
because parishes did not keep birth records in
Ireland during the seventeenth century. Brewer
(1992, p. 2) makes a plausible case for a birth
year of 1687 based on the fact that Cantillon
took French nationality in 1708, and he would
have had to be 21 to do this.
Little is known about Cantillon’s
upbringing or when he left Ireland. From 1711
to 1713 he was a clerk for the British Assistant
Paymaster General in Spain, who had the
responsibility for paying and outfitting British
troops fighting in Spain. In 1716, he went to
France to take over his cousin’s bank.
Cantillon made a small fortune in 1720 on
John Law’s Mississippi scheme, which
involved selling shares of stock to all the gold
and silver that were thought to be contained in
the Mississippi River area. Having accumulated
much wealth, he lent money to others who were
speculating on the value of Mississippi shares.
In order to get around French usury laws,
Cantillon disguised his loans as foreign
exchange transactions—he lent money to
others in one currency and demanded
repayment in another currency. As a result of
all his wheeling and dealing, Cantillon was
constantly involved in legal battles. In an
attempt to put an end to them, he decided to
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RICHARD CANTILLON
return to England and live a life of luxury with
the vast wealth he had made from his investing
and lending activities.
If some mystery surrounds his birth, the
death of Cantillon is downright confusing. On
the night of 14 May 1734, shortly after his
return to England, a fire engulfed Cantillon’s
home on Albermarle Street in London. At the
time it was thought the fire was an accident or
that Cantillon had been murdered. But Murphy
(1986) argues that Cantillon was not in the
house at the time of the fire. He thinks Cantillon
fabricated his own death to end all the litigation
arising from the fortune he amassed. In support
of this view, Murphy notes that Cantillon
withdrew £10,000 the day before the fire, that
a neighbor reported seeing what was supposed
to be Cantillon’s burnt corpse without a head,
and that Cantillon’s personal papers were
found many years later in the Dutch colony of
Surinam in South America. It is surely hard to
believe a thief would take valueless personal
papers and hard to understand how these papers
turned up in Surinam —unless, of course,
Cantillon himself took them there.
Cantillon wrote only one surviving work in
economics, his Essay on the Nature of
Commerce (Cantillon 1755). This book was
published more than twenty years after the fire
that engulfed his London home. A statistical
supplement, which is referred to in the text,
has never been found. There are reports of other
writings by Cantillon; but these too have never
been found.
Divided into three books or parts, the Essay
sets forth a simple set of overarching principles
that explain how economies work. The first part
describes how the real economy operates, or
the principles according to which goods are
produced and people get hired to produce those
goods. Book Two focuses on the monetary
system, and explains how money and the real
economy are related. Finally, international
trade and foreign exchange are brought into the
picture in Book Three.
Book One of the Essay depicts the economy
as an interconnected system, or a circular flow
of money and goods. It also explains how the
different parts of this system interact with one
another. Cantillon breaks into the circle of
production and exchange by focusing on the
money that gets spent by landowners. This
spending supports manufacturers in cities and
towns. It also supports agricultural workers in
rural areas, by creating jobs and incomes for
them. Manufacturing sector workers and
agricultural sector workers will need to buy
some manufactured goods, and they will need
to purchase a lot of agricultural goods. This
creates more jobs and more incomes for those
working in both these economic sectors.
Because the need for food and agricultural
goods is greater then the need for manufactured
goods, money tends to flow from the
manufacturing sector to the agricultural sector
in exchange for food. At some point
agricultural workers will have to pay
landowners for the use of their land, and so
money will find its way back into the pockets
of the landowners, ready to start a new cycle
of spending and production.
Within this framework, Cantillon ([1755]
1964, p. 53) observed that production in
different occupations is determined by the
demand for different goods. If landowners want
more manufactured goods and less food, people
and resources will flow from the agricultural
sector to the manufacturing sector; more
manufactured goods and fewer agricultural
goods will then be produced. In more modern
terms, if consumers want more running
sneakers and fewer shoes, shoe makers will do
less business. Some shoe makers will go
bankrupt and new businesses will start up that
produce running shoes. The same principle also
applies to different geographic regions within
a nation. If more labor is wanted in cities and
less labor is needed in rural areas, workers will
move from rural areas to urban areas.
Cantillon also analyzed the economic role
of the entrepreneur within this circular
production process. The term “entrepreneur”
goes back to ancient and medieval times,
when it referred to people who got things
done. Early eighteenth-century entrepreneurs
were contractors; in particular, they were
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RICHARD CANTILLON
people who had a contract with the
government. This was a rather riskless
occupation since governments generally paid
their bills. Cantillon borrowed this popular
term and redefined it. He made the
entrepreneur a risk taker, rather than
someone receiving a regular salary. Cantillon
recognized that the future was uncertain and
that all economic activity was inherently
risky. However, someone must take risks now
in the hope of making a profit later. If not,
no production would take place. The risk-
taking entrepreneur was thus essential for the
circular production process to operate well
and for economies to prosper.
Book Two of the Essay looked at how
money affected this circular process. By
analyzing the economic impact of money,
Cantillon can legitimately be regarded as
the founder of classical monetary theory
(Bordo 1983). Money in the eighteenth
century meant gold and silver coins; it could
be created in either of two ways—by mining
gold and silver or by selling goods to other
nations. When miners or traders had more
money their demand for goods and services
increased, and so employment and output
would expand in other industries or sectors.
Greater demand would also raise prices, but
not necessarily in proportion to the
increased supply of money (Cantillon 1755,
Book II, Chs. 6, 7), since higher prices
induce increases in output, and since
sometimes there can be more money but not
more spending of the additional money.
Economists now describe this uncertain
impact of money as the Cantillon Effect.
The economic effect of new money is
uncertain because it depends on who gets
the money and what they do with it. If the
money goes primarily to merchants and
exporters there will be more money saved
and more investment. With more
production, rather than more spending,
prices will not tend to rise. But if the money
goes to landlords who revel in luxury
consumption, there will be a greater
increase in prices and luxury goods will
tend to go up in price the most.
At some point, Cantillon thought, the
greater prosperity due to more money would
be likely to come to an end. It is primarily
through the effect of money on international
trade that this occurs. Rising prices will
make exports less competitive in
international markets at the same time that
imports become relatively cheap and
attractive to domestic consumers. A trade
deficit will result, meaning that gold will
be shipped abroad in order to pay for all
the imported goods flowing into the
country. With gold going abroad, the
domestic money supply is reduced and
domestic production stagnates. Cantillon
thus discovered the specie flow mechanism
(see also HUME).
Book Three of the Essay discusses trade
policy, and pretty much follows the
recommendations of the mercantilists (see
also MUN). Cantillon favored
protectionism, and supported running trade
surpluses in manufacturing. However, he
advocated these policies more for military
purposes than for economic reasons.
Protectionist mercantilist policies, Cantillon
thought, would increase the population of
Britain. A trade surplus in manufacturing
would allow Britain to import food, and this
food could then support a larger population
and make Britain a stronger nation.
Cantillon has been a much neglected
figure in economics. He is known primarily
for his influence on Quesnay and the
Physiocrats, and for developing the notion
that money flows connect the different
sectors of the economy. Yet the place of
Cantillon in history is more important than
this. His Essay can legitimately be regarded
as the first real economic treatise. It
envisioned the economy as an interrelated
system, and explained how that system
worked. For this reason, Cantillon probably
deserves to be regarded as the first real
economist.
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Works by Cantillon
Essai sur la nature du commerce en général
(1755), translated by Henry Higgs, New York,
Augustus Kelley, 1964
Works about Cantillon
Bordo, Michael “Some Aspects of the Monetary
Economics of Richard Cantillon,” Journal of
Monetary Economics, 12 (1983), pp. 235–58
Brewer, Anthony, Richard Cantillon: Pioneer of
Economic Theory, London and New York,
Routledge, 1992
Murphy, Antoin, Richard Cantillon: Entrepreneur
and Economist, Oxford, Clarendon Press,
1986
Spengler, Joseph, “Richard Cantillon: First of the
Moderns I,” Journal of Political Economy, 62,
4 (August 1954), pp. 281–95
Spengler, Joseph, “Richard Cantillon: First of the
Moderns II,” Journal of Political Economy,
62, 5 (November 1954), pp. 406–24
Tarascio, Vincent, “Cantillon’s Theory of
Population Size and Distribution,” Atlantic
Economic Journal, 9, 2 (July 1981), pp. 12–18
FRANÇOIS QUESNAY (1694–1774)
François Quesnay (pronounced KEN-nay) is
best known as the creator of the first economic
model ever developed, the Tableau
Economique, and as leader of the Physiocrats,
the first school of economic thought. However,
Quesnay has been admired for many other
things—his laissez-faire policy proposals, his
analysis of the generation and distribution of
an economic surplus, and his vision of the
economy as a closely integrated set of
interdependent parts.
Quesnay was born in 1694 in the village of
Méré, around 15 miles west of Versailles. His
father was a peasant fanner and shopkeeper,
and so Quesnay received little formal
schooling. But Quesnay was enamored with
books, and would often walk to Paris to
purchase secondhand copies of Plato and
Aristotle (Beer 1939, p. 101).
At age 17 Quesnay decided to become a
surgeon. Although dissatisfied with his medical
training, which included bleeding patients,
Quesnay continued with his studies. In 1717
he passed his medical examinations, obtained
a license, and opened a practice in the village
of Mantes, just south of Paris. After publishing
several books on medical subjects, his
reputation as a surgeon grew. In 1735 Quesnay
was asked to serve as personal physician to the
Duke of Villeroy. In 1744 he received a
doctorate in medicine and became a member
of the French Academy of Sciences. Five years
later he settled in Versailles to become personal
physician to Madame de Pompadour, the
powerful mistress of Louis XV, as well as a
medical consultant to the king.
At this point in his life (age 55) Quesnay
became interested in economics and
mathematics. His broad interests, and his
connections with those in high places, brought
him an invitation to write several articles for
Diderot’s Encyclopedia. The articles he wrote
earned him great fame and a large following.
His disciples called themselves “Physiocrats,”
from the French term Physiocrate, meaning
rule of nature.
The Encyclopedia articles all analyzed
economic processes as a circular flow of
money, goods, and people from one sector of
the economy to another, akin to the flow of
blood through the human body. “Corn” (in
Meek 1963) was the most important
Encyclopedia article because it first set forth
the doctrine that only the agricultural sector of
the French economy was productive. That is,
only in agriculture could a surplus be
generated, or only in agriculture does output
exceed the inputs needed to produce that
output. Quesnay thought that this surplus arose
from the natural, generative properties of the
land. This idea was important because it
emphasized that wealth was generated in the
process of production rather than through
exchange or trade as the mercantilists had
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FRANÇOIS QUESNAY
claimed. Another consequence of this view, one
that resulted in much criticism, was that
manufacturing activities were not productive
because they did not create a surplus.
Cantillon, as we have seen, had already
described the workings of an economy as a set
of circular flows or economic
interrelationships. Quesnay developed this idea
further, and quantified the various relations
between parts of the economy in greater detail
in his Tableau Économique. The Tableau was
thus the first attempt to mathematically model
an entire economy, and to actually show the
relationships between its various parts.
Quesnay began with the assumption that the
economy could be best described in terms of
three different classes or sectors. First, there is
an agricultural sector that produces food, raw
materials, and other agricultural goods. Second,
a manufacturing sector produces manufactured
goods like clothing and shelter as well as the
tools needed by both agricultural and
manufacturing workers. The manufacturing
sector for Quesnay also includes what we today
call the service sector, since it is responsible
for facilitating domestic and international trade.
Third, a class of landowners produces nothing
of economic value; but these landowners have
claims on the surplus output produced in
agriculture. These rents represent payment of
the surplus to landowners, and this view has
become known as the Physiocratic theory of
rent.
Following his position in “Corn,” Quesnay
assumed that only agricultural production was
productive. Most Tableaux showed that inputs
employed in agriculture yield twice the amount
of output; however, Quesnay was aware that
this assumption about the relationship between
inputs and outputs depends upon the
techniques of production employed in the
agricultural sector. Some of his important
policy proposals (see below) involve attempts
to increase productivity in the agricultural
sector.
Finally, Quesnay assumed that all income
was spent, and that spending was divided
equally between agricultural goods and
manufactured goods. These assumptions lead
Quesnay to his famous zig-zag model of the
economy, shown in Figure 1.
According to this model, landowners take
their $1,000 rental payments and spend one-
half of it on manufactured goods and the other
half on agricultural goods. These two sectors
now each have $500 in money income. Those
employed in these two sectors spend half
their new income on goods produced by the
other sector. This spending leads to incomes
of $250 for each producing sector. Again,
half of this additional income gets spent on
the goods of the other producing class. This
Figure 1 The Tableau Économique
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FRANÇOIS QUESNAY
process continues until the amount of
additional spending gets to be very, very
small. We can then add up all the spending
on agricultural goods and all the spending
that takes place on manufactured goods. As
Figure 1 shows, these both total $1,000.
What happens within each sector is
probably more important than what happens
across the different sectors because it is
within each sector that production takes
place, and it is within sectors that an
economic surplus gets generated. So let us
look more closely at each sector (for more
details see Pressman 1994).
Proprietors buy and consume $1,000
worth of goods—$500 food and $500 worth
of manufactured goods. During the year they
produce nothing. They thus subsist on the
output of the two producing classes or
sectors. In particular, they receive rental
payments from agricultural farmers equal to
the agricultural surplus, and use these
payments to buy and consume goods.
The other sectors take their initial $500
income and use it to buy necessary inputs so
that more food and manufactured goods can
be produced in the next year. The
manufacturing sector buys $500 of
agricultural goods through the zig-zags of
Figure 1 and has $500 in cash. It uses this
$500 in cash to buy more inputs from the
agricultural sector and then takes its $1,000
of inputs to produce $1,000 worth of
manufactured goods.
The agricultural sector has produced
$2,000 worth of goods, but has sold only
$1,000 to the proprietors and the
manufacturing class. In addition, it has
bought $500 worth of manufactured goods,
as depicted in the zig-zag diagram of Figure
1, and it sold another $500 worth of goods
to the manufacturing sector, as described in
the previous paragraph. These two
transactions balance each other out, and
leave the agricultural sector with $1,000
worth of inputs. It also has the $1,000 in cash
needed to pay the proprietors their rents and
start a new production distribution cycle.
Since inputs yield double the amount of
output, the agricultural sector will produce
another $2,000 worth of agricultural goods
in the next production period. This process
will continue from year to year, barring some
outside factor disturbing the reproduction
process.
Like the mercantilists, the Physiocrats
viewed economic theory as a means to
appropriate economic policy rather than as
an end unto itself. The purpose of the
Tableau was not just to explain the principles
by which economies reproduce and grow, but
to set forth policies to help stimulate
economic growth. Moreover, Quesnay the
physician tended to look upon the economy
as if it were a sick patient in need of help.
Towards these policy ends, Quesnay
usually presented two Tableaux, a sort of
controlled experiment. One Tableau would
be the control case, showing the present state
of affairs in France. The other Tableau would
show the effects of introducing various
policy changes into the French economy. A
good policy, Quesnay was able to show,
would lead to economic growth; the French
economy would prosper. This would be
demonstrated by increased output of
agricultural and manufactured goods. A poor
policy, in contrast, would cause the French
economy to decline and stagnate. In line with
the name they adopted for themselves, the
Physiocrats believed that all correct
economic policies were consistent with the
rules of nature.
One important policy conclusion of the
Tableau was that taxes should be placed only
on landlords. Taxes could not be placed on
the manufacturing sector because they
produced no surplus to tax. Any attempt to
tax this sector would tax away the inputs
used in producing manufactured goods.
Since inputs exactly equals output in
manufacturing, any reduction in inputs
would lead to lower manufacturing output
and therefore would result in the decline of
the manufacturing sector. To the extent that
the agricultural sector required goods
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FRANÇOIS QUESNAY
produced by the manufacturing sector, it too
would experience economic decline.
Similarly, any tax placed on the
agricultural sector would reduce the inputs
available in this sector and lead to its decline.
Since agricultural advances double during
production, each tax dollar imposed on
agriculture would lower national output by
two dollars. This outcome is even worse than
taxing the manufacturing sector.
If neither the manufacturing nor the
agriculture could be taxed without harming
the economy, taxes had to fall on the
landowners, the class that produced nothing.
Since a tax on landowners does not reduce
the inputs available in either manufacturing
or agriculture, it would not lead to economic
decline.
A second important policy conclusion of
the Tableau was that the French agricultural
system had to be restructured. Two important
changes were especially needed. First,
agriculture had to be modernized. Small plots
of land, farmed with outdated technology,
were terribly inefficient. By expanding the
size of French land holdings, new cultivation
methods could be employed that would only
be feasible if done on a large scale. Investment
in new technology, Quesnay recognized,
would only be profitable and would only take
place if its costs were spread out over many
acres and many agricultural goods. Second,
agriculture had to become more capitalist in
nature, following the example of English
agriculture. Quesnay argued that these
reforms would improve agricultural
productivity, or the surplus generated in
agriculture, by providing greater economic
incentives for successful farmers; and he
argued that with more food produced, all of
France would prosper.
A third policy prescription following from
Quesnay’s model was that saving, or hoarding
money, was bad for the economy because it
interrupted the circular flow of money and
goods. Any lack of demand would lead to a
reduction in national output and cause the
French economy to stagnate. In this respect,
Quesnay was an important forerunner of John
Maynard Keynes.
Finally, in contrast to the mercantilists,
Quesnay supported free trade of goods
among nations. For the Physiocrats, wealth
depended upon the total output of goods
produced rather than the precious metals
that a nation accumulated. More goods, in
turn, required greater agricultural
production. Quesnay thought that free
international trade would increase the
demand for French agricultural goods, and
shift economic resources or inputs from the
unproductive manufacturing sector to the
productive agricultural sector. As a result
of more inputs and greater production in
the agricultural sector, the economic
surplus generated within France would
increase and the country would prosper
(see Pressman 1993).
In one sense, history has not been kind to
Quesnay. He has as much right as Smith to
be regarded as the father of economics. But
while “Adam Smith” has become a
household name, Quesnay is virtually
unknown outside the society of professional
economists. Economists also parrot the
criticism, first made by Smith, that Quesnay
went wrong by assuming that manufacturing
is unproductive. Finally, the Tableau has
been harshly criticized for being extremely
difficult to follow and understand.
Yet, in another respect, history has been
good to Quesnay. Virtually all economists,
regardless of their orientation, think highly
of him (no small feat!). Mathematically-
minded economists look favorably upon
Quesnay for his role as a pioneer in
economic modeling. Leontief (1941, p. 2)
claimed that the Tableau was an important
precursor of his input —output analysis.
Conservative economists value his laissez-
faire policy proposals and his opposition to
placing taxes on the productive sectors of
the economy. More liberal economists have
been attracted by his Keynesian vision of
spending as an important determinant of
economic growth and decline. Even Marx
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(1954) lavished praise on Quesnay for
recognizing the importance of an economic
surplus arising in production, and for
showing how this surplus enables capitalist
economies to reproduce and grow. Quesnay
is truly an economist for all seasons.
Works by Quesnay
L’Ami des Hommes, 5 vols., Avignon, 1762 with
Victor de Riquetti, Marquis de Mirabeau
Philosophic Rurale 5 vols., Amersterdam, Chez
Les Libraries Associes, 1764
The Economical Table, New York, Bergman
Publishers, 1968
Quesnay’s Tableau Économique, ed. Marguerita
Kuczynski and Ronald L.Meek, New York,
Augustus M.Kelley, 1972
Works about Quesnay
Beer, Max, An Inquiry Into Physiocracy, London,
George Allen & Unwin, 1939
Higgs, Henry, The Physiocrats, London,
Macmillan, 1897
Meek, Ronald, The Economics of Physiocracy:
Essays and Translations, Cambridge, Harvard
University Press, 1963
Pressman, Steven, “Quesnay’s Theory of
Economic Growth and Decline,” in Economics
as Worldly Philosophy, ed. Ron Blackwell,
Jaspal Chatha and Edward J.Nell, London,
Macmillan, 1993, pp. 305–21
Pressman, Steven, Quesnay’s Tableau
Économique: A Critique and Reassessment,
Fairfield, New Jersey, Augustus Kelley, 1994
Vaggi, Gianni, The Economics of François
Quesnay, Durham, North Carolina, Duke
University Press, 1987
Other references
Leontief, Wassily, The Structure of the American
Economy, 1919–1929, Cambridge,
Massachusetts, Harvard University Press, 1941
Marx, Karl Theories of Surplus Value, 3 vols.,
Moscow, Foreign Language Publishing House,
1954
DAVID HUME (1711–76)
David Hume was a world famous philosopher
who argued that knowledge could arise only
from experience. But he also made several
contributions to economics when the
discipline was just developing. These involved
analyzing the impact of money on an
economy, and on the trade that takes place
between nations.
Hume was born in Edinburgh, Scotland in
1711. His father, a country gentleman, died
when Hume was very young, so Hume was
raised by his mother. However, his father left
plenty of money to the family. This allowed
Hume to receive an excellent education,
primarily by private tutors at home. He then
enrolled at the University of Edinburgh
intending to study the classics. But Hume
quickly became dissatisfied with the
education he was receiving, and he decided
to drop out of school, go to France and
become a great philosopher.
Despite having written several books that
are now regarded as philosophical classics,
Hume could not support himself as a
philosopher. Unable to get a teaching job at
any Scottish University, he agreed to tutor the
Marquis of Annandale in 1745. Several years
later he accepted a position as secretary to an
army general. These jobs provided Hume with
enough money that he soon achieved financial
independence and could spend most of his
time reading and writing.
In 1752 Hume was hired as a librarian at
the Advocates Library in Edinburgh. This
provided him with additional income as well
as ready access to a large number of books.
The result was a prodigious outpouring of
philosophical works as well as a six volume
History of England (Hume 1757–62). In
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1763 Hume became secretary of the British
embassy in Paris, and in 1767 he became
undersecretary of the foreign office. Two
years later he resettled in Edinburgh, where
he died in 1776.
As an economist, Hume made several
contributions to the theory of money and the
theory of international trade. He analyzed the
impact of money on interest rates, on
economic activity, and on prices. He also
explained how and why countries would not
be able to experience trade imbalances for
long periods of time. Finally, Hume
addressed the important question: “What
happens when rich countries trade with poor
countries?”. His answer was that
international trade would benefit both rich
countries and poor countries.
In mid eighteenth-century England, the
mercantilists were proposing that
government policies be enacted to support
the meritorious merchant (see MUN). But
they provided no justification for their
program. Hume filled this void by explaining
the economic function of the businessman.
For Hume, the merchant was praiseworthy
because he was frugal. Businessmen tend to
save their income and accumulate capital.
More capital lowers interest rates and tempts
other businesses to borrow and expand their
operations, thereby increasing competition
and lowering profit rates. In contrast to the
merchant, wealthy landowners typically
borrow money in order to consume more
goods. They, therefore, reduce the stock of
productive capital and push up interest rates
on loans.
This analysis not only explains the
functions of the merchant or businessman;
it also provides a theory of interest, now
called the “loanable funds theory”.
According to Hume, interest rates are
determined by the supply of savings and the
demand for savings. Greater savings lowers
interest rates and also allows more money to
be borrowed. Less savings has the reverse
effect—it increases interest rates and
discourages borrowing. Moreover, Hume’s
analysis of saving and investment provides
a justification for savings. Savings are
needed for new investment, and thus savings
is needed for economic growth.
Hume also analyzed the economic effects
of changes in the money supply. Hume
explained the positive effects of more money
on the economy and then explained how, in
the long run, the entire effect of more money
would be to raise prices, leaving output and
employment unchanged. Finally, Hume
analyzed the economic effects of money
leaving one country and going to another
country. This analysis of the international
flows of money has been called the specie
flow mechanism. Although historically this
transmission mechanism was first identified
by Cantillon, Hume is the first person to have
published something on this process and is
usually given credit for its discovery. With
his discovery of the specie flow mechanism,
Hume took one large step away from
mercantilist thinking and one large step
toward the classical macroeconomic theory
that was to develop in England during the
late eighteenth and early nineteenth
centuries.
The short-run effects of money were a
consequence of the fact that prices did not
immediately change. In fact, Hume (1875:
314) thought that prices would be sticky over
a rather long period, one lasting several
years. When gold and silver is mined,
according to Hume, it is put into circulation
by being spent. Money thus gets
concentrated in the hands of a few merchants.
As these merchants spend the money for
investment purposes, industry begins to
expand and employment begins to rise. Even
if prices rise a bit, this inflation is a good
thing because it increases business profits,
which further stimulates economic
expansion.
At some point, however, the rise in
employment will lead to higher wages. Also,
at some point in the process of money being
spent and dispersed throughout the economy,
businesses will not be able to keep up with
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demand and their inventories will start to fall.
These two effects alter the money
transmission mechanism. Rather than
leading to greater output and employment,
the additional money creating now increases
prices. As time goes on, the entire impact of
mining more money will be felt on the price
side, and there will be no more production
or employment than we had originally.
Hume next analyzed the impact of
additional money on foreign trade. This led
Hume (1955:60–77) to develop the specie
flow mechanism, which explained how
economic forces automatically lead to a
position of balanced trade for all countries.
It also explained how economic forces would
establish a natural distribution of money
throughout the world economy.
Consider again what happens to a nation
when gold is discovered and mined. We saw
above that this increase in the domestic
supply of money eventually causes a rise in
prices. But this price increase has further
economic consequences. Higher prices will
make a country’s goods more expensive
abroad, and so it will export less. Conversely,
with higher domestic prices, goods produced
abroad will be relatively less expensive. As
a result, more goods will be purchased that
were made in other countries. Both declining
exports and rising imports will worsen the
national trade balance. More money will go
abroad to buy foreign goods than comes back
through selling goods to other countries. This
will lead to a loss of money from the
domestic economy. In the long run, with less
money and less spending, the domestic price
level will tend to decline somewhat.
One important consequence of this
analysis is that trade imbalances cannot be
maintained for long periods of time.
Countries running trade surpluses will see
their money supply rise and will experience
inflation; this will tend to reduce their trade
surplus. Countries running trade deficits, in
contrast, will see their money supply decline
and their prices fall. This will tend to reduce
their trade deficit. A further consequence of
this analysis is that the amount of gold in a
country will remain the same, or reach an
equilibrium level, whenever its imports equal
its exports.
Although many economists regard Hume
as a mercantilist thinker, the specie flow
mechanism raises considerable doubt about
this interpretation. One fundamental tenet of
mercantilism was that countries should strive
for trade surpluses and that governments
should assist national businessmen in this
endeavor. But the logic of the specie flow
mechanism makes this goal an impossible
dream. Any trade surplus will lead to an
influx of precious metals and higher
domestic prices. This will tend to eliminate
the surplus. What the mercantilists desired
could not be achieved according to the logic
of the specie flow mechanism. And Hume,
to his credit, did not push for mercantilist
economic policies that would generate trade
surpluses.
Finally, Hume went on to examine the
question of what happens when poor
countries and rich countries trade with one
another. Many times since the eighteenth
century this issue has been the subject of
heated debate. It is an eternally important
question because it is closely related to the
issue of what causes economies to grow. At
the end of the twentieth century the debate
has focused on the economic consequences
of German unification, of bringing countries
like Greece and Spain into the European
Union, and of a North and South American
trading block.
For Hume (1955:60–77), trade helped
poor nations but did no harm to wealthier
nations. Trade enabled poor countries to
grow and develop; their standard of living
would converge with that of their wealthier
neighbors and trading partners. In contrast,
Gunnar Myrdal (see below) would later
argue that cumulative causation leads to a
divergence of world living standards, with
the rich getting richer at the expense of
poor countries.
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ADAM SMITH
One mechanism that Hume identified as
leading to converging living standards is the
transfer of technology from more advanced
to less advanced economies. As the recant
examples of South Korea, Malaysia, Taiwan
and Hong Kong show, advanced technology
allows the living standard of less developed
countries to rapidly approach that of more
developed nations. Later, Hume (1955: 78–
82) made the case that trade between unequals
also benefits wealthy countries because it
provides them with export markets. He then
used these arguments to support free trade and
oppose mercantilist restrictions on exchange
between nations (see Elmslie 1995).
Starting with the questions raised by the
mercantilists and the economic issues of the day,
Hume began to develop economic analysis by
showing the impact of money and trade on each
other and on economic growth. But his place in
the history of economics comes from more than
his attempts at economic analysis. Hume is an
important transitional figure between the
mercantilists and the British classical economists
who would follow on his heels.
Works by Hume
History of England (1757–62), London: T.Cadell
and W.Davies, 1802
Essays, Moral, Political, and Literary, ed. T.H.
Green and T.H.Grose, 2 vols, London:
Longmans, Green, 1875
Writings on Economics, ed. E.Rotwein, Madison,
WI: University of Wisconsin Press, 1955
Works about Hume
Cavendish, A.P., David Hume, New York: Dover,
1958 and Westport, CT: Greenwood Press,
1979
Elmslie, Bruce, “The Convergence Debate
Between David Hume and Josiah Tucker”,
Journal of Economic Perspectives 9 (Fall
1995): 207–16
Johnson, E.A.J., “Hume, the Synthetist” in
Predecessors of Adam Smith: The Growth of
British Economic Thought, New York:
Augustus Kelley, 1965, pp. 161–81
ADAM SMITH (1723–90)
Although others wrote about economic issues
and principles before him, Adam Smith is
regarded by most people as the father of
economics. This honor stems neither from the
originality of his ideas nor from the techniques
of economic analysis that he pioneered. Rather,
Smith is regarded as the father of economics
due to his vision of capitalism as an economic
system that makes everyone better off. Smith
was the first person to see the benefits
stemming from greater competition and to
argue for policies that promote greater
competition. This required both reduced
government involvements in the economy, and
also government actions to counter
monopolistic tendencies and practices.
Smith was born in 1723 in Kirkcaldy, a
small town near Edinburgh, Scotland. His
father, a lawyer and comptroller of customer
duties, died shortly before he was born; so
Smith was raised by his mother and by
guardians appointed in his father’s will (Ross
1995, p. 2).
Although he was a sickly child, Smith had
a great passion for books and was an avid
reader. At age 14, he was sent by his parents to
the University of Glasgow, where he studied
moral philosophy, mathematics, and political
economy. In 1740, he won a scholarship to
Oxford University and studied at Balliol
College for the next six years.
Smith found Oxford to be intellectually
stultifying. Little teaching took place and even
less learning occurred. Since so few of the
faculty actually lectured, Smith was able to
spend many hours in the library doing what he
liked best—reading, especially in the areas of
literature, philosophy and history. Smith’s
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ADAM SMITH
([1776] 1937, p. 717f.) suggestion that teachers
be paid based on the number of students in their
classes probably stems more from his bad
experience at Oxford than from a desire to spur
competition among faculty members.
In 1751 Smith was hired to fill the Chair of
Logic at the University of Glasgow. A year later
he took over the Chair of Moral Philosophy.
His lectures on ethics were well attended and
became his first literary success—The Theory
of Moral Sentiments (Smith 1759).
The Theory of Moral Sentiments tried to
explain how people acquired the moral feelings
that enabled them to distinguish right from
wrong. It found the answer in the ability people
had to put themselves in the position of an
impartial spectator. This allowed people to
judge actions not only from the viewpoint of
their own selfish interests, but also from the
perspective of an objective observer. Like the
conscience, this ability led people to act in
ways that were morally right.
When Charles Townshend read The Theory
of Moral Sentiments he decided that he could
do no better than to put his stepson, the Duke
of Buccleuch, under the tutorage of Smith. So
Townshend hired Smith, and Smith resigned
from his professorship at Glasgow to
accompany the young Duke to France. This
new job gave Smith lots of free time to read
and reflect, and by traveling to France, Smith
was able to meet the leading Physiocrats,
including François Quesnay. In early 1764,
Smith began writing a book “to pass away the
time” (Rae 1895, p. 178), as he noted in a letter
to his friend David Hume.
After traveling around France for three
years, Smith returned to Kirkcaldy and then
spent the next decade finishing his book. The
Wealth of Nations was published in 1776, and
it brought Smith both fame and fortune. In
contrast to The Theory of Moral Sentiments,
The Wealth of Nations assumed that people act
according to their own self-interest. Yet, The
Wealth of Nations argues that individual acts
of selfishness contribute to the public good. In
a famous passage, Smith ([1776] 1937, p. 423)
describes this process: when each individual
works, “he…intends only his own gain…[but]
is…led by an invisible hand to promote an end
which was no part of his intention.” That
unintended end was economic growth and
improved living standards for the nation as a
whole.
The Wealth of Nations set out to analyze
what caused the national standard of living to
rise, and to show how self-interest and
competition contributed to economic growth.
It also examined how governments affect
economic performance. These studies of the
principles of economics also led to an attack
on the economic theories and policies of the
mercantilists (see also MUN).
According to Smith it was the process of
mechanization and the division of labor that
enabled economic growth to take place.
Living at the onset of the industrial
revolution in England, Smith saw first-hand
the economic consequences of technological
innovation. In the 1730s the flying shuttle
was invented, which was more efficient than
the handloom and thus made the weaving
process go much faster. In 1769 the spinning
jenny was invented, which allowed one
person to spin several threads
simultaneously. These, and many other new
technological innovations, allowed
individual workers to be many times more
productive than they would have been
without the aid of machinery.
The Wealth of Nations begins by pointing
out how the division of labor enabled the
productivity of workers to increase. Smith
([1776] 1937, p. 4) describes the production
process in a pin factory:
The way in which this business is now carried
on…it is divided into a number of branches,
of which the greater part are likewise peculiar
trades. One man draws out the wire, another
straightens it, a third cuts it, a fourth points it,
a fifth grinds it at the top for receiving the head;
to make the head requires two or three distinct
operations…and the important business of
making a pin is, in this manner, divided into
about eighteen distinct operations.
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Smith reports that he saw pin factories
where ten people divided up all these tasks and
produced more than 48,000 pins per day. Yet,
if these people had to work separately and
independently, Smith claimed, they would not
be able to produce much more than 20 pins
per day. The division of labor thus yielded a
2000-fold increase in the number of pins
produced.
By dividing up the tasks, workers become
more productive for a number of reasons. First,
by concentrating on only one task, the skill and
dexterity of the individual worker improves,
and workers can perform their task more
quickly. Second, time is saved moving from
one task to another. Third, when focusing all
their attention on just one job, workers are more
likely to come up with labor-saving devices that
allow them to produce more with less effort.
Smith felt that the natural tendency of
people to buy and sell goods, and the natural
tendency of people to improve their material
condition (i.e. self-interest), were the driving
forces behind the division of labor and the
resulting improvements in productivity.
However, Smith did recognize one important
limit to the division of labor. If firms could not
sell the additional pins they manufactured,
there would be no incentive for them to divide
up the many production tasks, employ more
machinery, and increase the number of pins
produced. It was, therefore, critical to expand
the market for British goods.
Towards this end, Smith supported free
international trade among nations. Free trade
would allow British firms to sell their goods in
an international arena rather than only within
Britain. Moreover, Smith argued that free trade
would benefit Britain because it would allow
firms to obtain goods more cheaply from
abroad. This would lower the cost of producing
goods for exports.
The case for free trade naturally developed
into a critique of mercantilism. Because the
mercantilists wanted to limit trade in goods,
their policies would limit the market for
domestic producers and keep British living
standards from rising. The mercantilists were
also wrong about the gains accruing from
English colonies in the New World, according
to Smith. England did not gain because it could
sell goods to America and obtain gold in
exchange. Rather, England gained because it
could sell more goods, further divide up the
tasks done by workers, and produce more
goods with the same work force.
Smith, however, did not give his unqualified
support to free trade. Because national defense
was more important than national wealth,
Smith ([1776] 1937, p. 429) opposed trade
whenever it increased the military might of
countries other than Britain or reduced the
military strength of Britain. Smith thus
supported the English Navigation Acts. These
laws forced American ships to stop in England
and transfer their cargoes to British ships before
the goods moved on to their final European
destination. Smith reasoned that this policy
would increase both the number of British ships
and the number of trained British seamen; in
times of war these two assets would be
important for the defense of an island nation
like Britain.
On the other hand, Smith opposed
retaliatory tariffs on those countries placing
restrictions on the sale of British goods; he
claimed that one bad policy did not warrant
another bad policy. Smith thought that any
British worker who lost a job due to free trade
would soon find another job at a better wage
as long as guild restraints and apprenticeship
rules did not keep labor from moving to new
areas and more productive uses. Realizing that
this would not occur quickly in the real world,
Smith advocated a gradual lowering of
protective tariffs, rather than their immediate
elimination, so that the transition process could
take place slowly and smoothly.
Smith also rejected the popular infant
industry argument for protective tariffs. This
was that the claim protectionism was necessary
for a country just beginning to develop a
particular industry. Since new domestic firms
would be less experienced and knowledgeable
in producing goods than already-established
foreign firms, domestic firms would face a
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competitive disadvantage compared to their
foreign rivals. If, the argument runs, a nation
is to develop production expertise in a new
industry, domestic firms must receive
protection until they obtain the requisite
experience. Smith ([1776] 1937, p. 425)
opposed the infant industry argument because
it created inefficient monopolies and diverted
scarce capital resources to these monopolies.
Monopoly was another enemy of free trade,
of expanding the market for British goods, and
of rapid economic growth. Smith identified
four negative effects of monopolistic practices.
First, monopolies led to higher prices for
consumers, and thus made consumers worse
off. Smith ([1776] 1937, p. 128) noted that
businessmen had a penchant for getting
together and devising schemes to raise the price
of their goods and services. The fewer the
number of firms and the larger their size, the
easier it would be for firms to conspire against
the public by raising prices.
Second, Smith ([1776] 1937, p. 147) held
that monopolies were “a great enemy to good
management.” Competition, he believed,
forced managers to operate as efficiently as
possible and to seek out ways to improve the
efficiency of their operations. With
competition, if your firm did not become as
efficient as possible, other firms surely would,
or new firms would start up that operated more
efficiently. Poorly run firms would then be
driven out of business by their more
competitive rivals.
Third, Smith held that monopolies were
more likely than competitive firms to pressure
government to support their monopoly
position, and were more likely to be successful
in this endeavor. This would result in bad and
oppressive laws being passed. One example
that Smith gives ([1776] 1937, p. 612f.)
involves prohibitions on the export of sheep.
Draconian laws against selling British sheep
were passed by Parliament in order to maintain
the monopoly power of woolen cloth
manufacturers. Without British sheep exports,
other countries could not produce woolen
goods for sale in England.
Finally, Smith noted that monopolies led to
a misallocation of resources. Because of the
high prices they could charge, monopolists
would make huge profits. This would stimulate
production. Resources would thus go to
making goods not because people want those
goods most and not because there were many
possibilities for improving the division of labor
and reducing costs, but only because a
monopoly existed.
This critique of monopolies also turned into
a critique of mercantilism. Because mercantilist
policies kept out foreign competition these
policies helped to promote national monopolies
([1776] 1937, p. 595). They thus hurt
consumers and severely hampered national
economic growth.
While generally regarded as the patron saint
of laissez-faire economics and an opponent of
government, Smith did not really oppose all
government intervention into economic affairs.
In fact, he recognized four important functions
for government. The first, preventing monopoly
or guaranteeing a competitive environment, has
just been discussed.
Second, Smith recognized that only
governments could provide for the defense of
the entire nation against outside threats. It is
for this reason that Smith supported the
Navigation Acts and large government
expenditures on defense. Third, government
had to provide for internal order and defense;
that is, it had to protect all members of society
from every other member of society.
Government was thus responsible for setting
up a police force and a judicial system. Finally,
Smith opened a door that Milton Friedman
(1977) and other conservative thinkers were
later to bemoan, by approving government
provision of public goods in cases with large
externalities.
For most economic transactions, all the
costs of production are paid for by the person
who buys and consumes the good. Likewise,
all the benefits of production go to the
consumer of the good. However, in some
situations, many outsiders gain or lose
significantly from economic transactions.
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These gains and losses imposed on those
outside the market transaction are referred to
as “externalities.” One good example of a
negative externality is pollution. In this case,
some production costs (a less clean
environment) will fall on people living near the
polluting plant who do not buy the good
produced in the plant. Education is a good
example of a positive externality. Everyone
benefits from a better-educated labor force,
since it leads to higher productivity and more
goods. Here, those people who do not spend
more time in school gain from the greater
education of others. Under such circumstances,
there is less incentive for me to spend time and
money on my own education, since I receive
the benefits of a high living standard due to
other people’s efforts. But when everyone
reasons in this manner we get too little
education and everyone loses. The moral in this
case is that too little will be spent on education
unless education is provided by the
government.
In addition to explaining how economies
grow, Smith also attempted to explain how
incomes were divided up from producing
goods and services. As the first economist who
attempted to explain the principles determining
income distribution, Smith made several
contributions. These centered around his
analysis of what determined the price of goods
and what determined the returns going to those
who produce goods.
Smith began by distinguishing the market
price of a good from the natural price of a good.
The market price was the price that people paid
in their everyday economic transactions. Market
prices were determined by the fixed quantity of
goods brought to market as well as by the
demand for those goods. In contrast, the natural
price of a good was an equilibrium price, or the
price towards which market prices moved or
gravitated (Smith [1776] 1937, p. 55).
Smith thought that an automatic mechanism
would bring the natural price and the market
price into equality. If market price exceeded
natural price for some good, then landowners
and employers would shift their land and
capital to produce more of this good. This
would tend to reduce market price and move
the market price closer to the natural price. On
the other hand, if market price were below the
natural price, landowners and employers would
seek some other good to produce, or some other
use for their land or capital. This would reduce
the supply of this good, increase its market
price, and move the market price towards its
natural price.
Smith next tried to explain what determines
the natural price of each good. He adopted a
cost of production theory of price, where
natural price was the sum of the costs of paying
land, labor and capital for their role in
production. Each of these factors was to be paid
their natural rates, and so Smith needed to
explain what determined these natural rates.
His remarks about natural rents were quite
confusing. At times Smith ([1776] 1937, p. 145)
regarded rent as a monopoly price, which results
from land being a very scarce resource. At other
times he ([1776] 1937, p. 146) provided a
Physiocratic theory of rent (see also
QUESNAY), regarding rent as a payment for
the surplus output obtained from using land to
grow things. And at yet other times Smith
([1776] 1937, p. 147) hints of a differential
theory of rent (see also RICARDO), where rent
is a payment to the owners of more productive
land.
Smith’s theory of natural profits is even less
satisfactory than his theory of natural rent.
Smith says that natural profits are a return to
capital, which results from savings. But this is
merely a definition of natural profits; it does
not explain what determines the level of natural
profits.
To explain natural wages, Smith developed
the subsistence theory of wages, a doctrine that
was to dominate economic analysis for the
century following publication of The Wealth of
Nations. On this view, the natural wage was the
rate that just allowed workers to survive and
reproduce. If wages fell below subsistence
levels, workers would die; and with fewer
workers offering their services, wage rates would
have to go up. On the other hand, if wages rose
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above subsistence levels, higher living standards
would mean that few workers died and more of
their children would survive. Here the increased
number of workers would eventually force
wages down to subsistence levels.
Whether or not Smith was indeed the father
of economics, he was no doubt father of the
field within economics known as “public
finance.” As we saw earlier, The Wealth of
Nations described the proper role for
government in a thriving economy. It also
discussed how governments could best raise
revenues.
Given public expenditure decisions, funds
had to be raised through taxation to pay for
this spending. Smith laid down four rules or
maxims for taxing the public. First, he held that
taxes should be proportional, meaning that
everyone should pay about the same percentage
of their income in taxes. While today many
taxes (like the individual income tax) are
progressive in their incidence, taking larger
fractions of income from the rich than the poor,
when Smith was writing most taxes were
regressive, taking larger bites from the income
of poor families than from wealthy families. A
proportional tax therefore would have reduced
the tax burden on low-income families and
increased the tax burden on those with large
incomes and wealth.
Second, Smith held that taxpayers should
not be kept in the dark about their taxes. They
should know in advance how much they owe
and when their tax payments were due.
Moreover, tax laws should not be changed
radically from year to year, which would
make tax payments each year arbitrary rather
than certain.
A third principle of taxation was that taxes
should be levied at a time, and in a manner,
that is most convenient for people to pay. The
current practice of taxing capital gains when
they are realized, rather than when they accrue,
provides a good example of this maxim in
practice. If capital gains taxes were imposed
every year on the appreciation of assets that
each person owns, people might be forced to
sell their assets just to pay the taxes they owe
on their gains. Taxing gains only when assets
are sold makes it easier for people to pay their
taxes.
Fourth, Smith maintained that the best tax
was the one that was least costly to collect.
Taxation should not require great numbers of
tax collectors; it should not damage economic
incentives or create excessive efforts to evade
taxes (for example, smuggling goods so that
taxes don’t have to be paid on imports); and it
should not impose penalties that are so severe
that they will ruin tax evaders. All these
principles were designed to generate the
greatest growth, or to have taxes do the least
amount of damage to economic growth.
With Marx and Keynes, Smith ranks as one
of the three most important figures in all of
economics. His vision was of self-interest and
the national interest in perfect harmony, leading
to continued economic growth and prosperity.
The only potential problems were government
intervention in the free market, monopolistic
practices by businesses, or bad tax policies.
Thus Smith argued against mercantilist
restraints on trade, and wanted the British
government to control monopolies and observe
care in the manner by which it taxed its citizens.
The vision of Smith was an optimistic one
of competitive capitalism increasing living
standards and making everyone better off. In
the time since The Wealth of Nations was
published, this vision has, to a large extent,
come to pass. But it was not a quick passage.
Nor was it an easy one. What Smith did not
live long enough to see was the set of the
serious and deep problems that would
accompany economic growth—
unemployment, pollution, the poverty of
British workers, and the deterioration of
industrial British cities. These were the
problems that Smith’s successors were forced
to grapple with.
Works by Smith
The Theory of Moral Sentiments (1759), New
York, Augustus M.Kelley, 1966
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Lectures on Justice, Police, Revenue and Arms
(notes taken by a student in 1763), New York,
Augustus M.Kelley, 1964
An Inquiry into the Nature and Causes of the
Wealth of Nations (1776), New York, Modern
Library, 1937
Works about Smith
Friedman, Milton, “Adam Smith’s Relevance for
Today,” Challenge, 20, 2, (March-April 1977),
pp. 6–12
Hetzel, Robert, The Relevance of Adam Smith,
Richmond, Virginia, Federal Reserve Bank of
Richmond, 1977
Hollander, Samuel, The Economics of Adam
Smith, Toronto, University of Toronto Press,
1973
Rae, John, The Life of Adam Smith, London,
Macmillan, 1895
Ross, Ian Simpson, The Life of Adam Smith,
Oxford, Clarendon Press, 1995
JEREMY BENTHAM (1748–1832)
Jeremy Bentham is known primarily as a
philosopher and social reformer, and it is as a
philosopher that Bentham made his main
contribution to economics. This involved
introducing the notion of utility into economic
analysis.
Bentham was born in London in 1748. His
father was a prosperous attorney who was able
to provide an excellent education for his
children. Like many of the major figures in
economics, Bentham was somewhat of a child
prodigy. Everett (1931, p. 5) reports that he
knew the alphabet even before he could speak.
Bentham was educated at the Westminster
School in London. He enrolled at Queen’s
College, Oxford, aged 12. He received a
bachelor’s degree in 1767 and then went on to
study law, first at Lincoln’s Inn in London and
then at Oxford. Admitted to the Bar in 1769,
Bentham never practiced law. In part this was
because he disliked the law. But a more
important consideration was that Bentham
wanted to change the world, or at least improve
things in England. So instead of following in
his father’s footsteps, Bentham began to read
widely in philosophy and political theory. He
also assumed the role of social reformer,
attempting to persuade political leaders and the
public to adopt his many schemes to improve
life in England.
Some of the more noteworthy reform
proposals advanced by Bentham were birth
control, adult suffrage (including women), the
legalization of unions, and the development of
a civil service. But his pet project was always
prison and penal code reform. In the 1790s
Bentham launched a campaign to construct a
model prison, the Panopticon Penitentiary,
which he envisioned as “a mill for grinding
rogues honest, and idle men industrious”
(quoted in Mitchell 1950, p. 194). While this
plan was never implemented in England, a
Panopticon was built in St Petersburg in the
early nineteenth century (Halevy 1949, p. 296).
These many reform proposals gained
Bentham considerable fame and numerous
followers, and he soon became the leader of a
group of British reformers known as “the
philosophical radicals.” They earned this title
because their proposals were radical by the
standards of late eighteenth-century England
and were justified by the philosophical doctrine
of utilitarianism, or the view that all actions
should promote the greatest happiness for the
greatest number of people.
The only significant contribution Bentham
made to economics proper was his badly
mistitled Defence of Usury, which was
published in 1787 (in Stark 1952–4, Vol. 1, pp.
124–207). Since the Middle Ages, heated
disputes have raged over whether limits should
be placed on interest rates. In centuries past
the issue was primarily whether it was moral
to charge any interest at all on loans. In the
late twentieth century, the issue became
whether interest rate ceilings should be placed
on credit cards and consumer loans. But while
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the focus of the debate has shifted somewhat,
the main positions have not. On one side of
the debate is the argument that borrowers are
poor people who desperately need money; thus
charging interest or charging high rates of
interest takes advantage of the weak and
destitute. On the other side it is argued that
lending money involves some risk.
Compensation is thus required for the many
times one lends money but does not get repaid.
Adam Smith (1776, p. 339) supported
public regulation of interest rates through the
establishment of interest rate ceilings. Bentham
thought this was inconsistent with Smith’s
laissez-faire principles, and he pointed out that
there was “no more reason for fixing the price
of the use of money than the price of goods”
(Stark 1952–4, Vol. 1, p. 125). Bentham also
argued that since one party had agreed to pay
high interest rates it was hard to consider usury
an offense that should be prohibited by
legislation.
But the main case against laws regulating
interest rates was the negative economic
consequences that would follow. First, people
would not lend money if they could not earn
interest on their loan. Anti-usury laws, designed
to help people in need, would actually hurt the
poor by making it more difficult for them to
borrow the money they needed. Second, usury
laws kept innovative businessmen, as well as
the poor, from borrowing money. This hurt
everyone’s standard of living, the poor as well
as the affluent. Third, Bentham argued that if
the poor could not borrow the money they
needed to survive they would find other, less
socially desirable, ways to secure the funds.
Fourth, Bentham held that making usury illegal
led to the rise of a black market for loans at
even higher rates of interest. Again, anti-usury
laws would only hurt those people the laws
were supposed to help. Finally, anticipating
new institutional economics (see also NORTH)
to some degree, Bentham held that any law as
bad as usury prohibition would cause people
to disrespect all laws and thereby harm social
relationships as well as economic relationships.
After reading Bentham’s book, Adam Smith
was persuaded that his support of usury laws
was in error, and that there should be no
government regulations on interest.
Bentham’s main contribution to economics
was not his case against government
regulations on interest rates, but his work on
developing the notion of utility and bringing
considerations of utility-maximization into
economic analysis. Contemporaries of
Bentham had been employing the term “utility”
in legal, political, moral, and economic
discussions. But their use of this notion was
vague and imprecise. It was not clear what this
term actually meant, how utility could be
measured, or how different utilities could be
compared. Attempting to put the social or
human sciences on a par with the natural
sciences, Bentham wrestled with these issues.
His hope was that through these efforts he
would become the Isaac Newton of the moral
world (Mitchell 1950, p. 180).
Bentham began his Introduction to the
Principles of Morals and Legislation (1948, p.
1) with the following bold and often quoted
statement regarding human behavior: “Nature
has placed mankind under the governance of
two sovereign masters, pain and pleasure.” He
then went on to define the principle of utility
as a moral principle— considerations about
pleasure and pain determine “what we ought
to do,” and the right thing to do will always be
whatever maximizes net pleasure, or total
pleasure minus total pain.
This implies that individuals could measure
their pleasures and pains. Bentham held that
such measurements were made by each
individual and involved considering seven
dimensions of pleasure: (1) its intensity, (2) its
duration, (3) its certainty, (4) its propinquity,
(5) its fecundity, (6) its purity, and (7) the
number of individuals to whom it extends.
Bentham enumerated fourteen simple
pleasures, including wealth, skill, power, a
good name, memory, imagination,
benevolence, and malevolence; and twelve
simple pains including disappointment, regret,
and desire. He also identified various factors
that influenced pleasure and pain such as
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health, gender, age, education, and firmness of
mind. Thus, while his contemporaries talked
in general terms, Bentham spoke concretely
and tried to be precise and specific about
measuring utility.
Bentham argued that all pleasures were
equal, regardless of their source. The
pleasures from watching television counted
as much as the pleasures received from
reading a book on economics or
philosophy; and the pleasures received by
the poor counted as much as the pleasures
enjoyed by the very rich. Since the pleasure
of one person counts no more than anyone
else’s pleasure, economic and social
policies should not favor the rich, as most
policies did at the time Bentham was
writing.
A further implication of utilitarianism
was that education and legislation were
needed to promote the maximum amount
of happiness within the nation. Education
was important because it enables people to
do a better job of adding up and comparing
the pleasures and pains that result from
different actions. Legislation was
necessary to penalize acts that did not
maximize happiness and also to provide
incentives for people to act morally, or in
ways that contribute to the maximum
happiness of the population. Government,
for Bentham, became a mechanism for
helping to increase the net happiness of its
citizens.
The doctrine of utilitarianism also
provides a means for evaluating
government policies and legislation.
Government acts were good that increased
net utility in the nation, while government
action that decreased net utility in the
nation was bad. As such, the utilitarian
calculation is an important forerunner of
contemporary cost-benefit analysis. In fact,
Bentham’s Manual of Political Economy
contains the first use of cost-benefit
considerations to justify public
expenditure. Bentham proposes that public
spending should be evaluated by
comparing the benefits from that
expenditure with the costs produced by the
“most vexations and burthensome tax”
(Stark 1952–4, Vol. 2, p. 202). He argued
that if the benefits from government
spending exceed the costs produced from
having to tax citizens, the spending should
take place. On the other hand, if the costs
arising from additional taxation were
greater than the benefits of the public
expenditure, the spending should not take
place and taxes should not be imposed for
this purpose.
Despite its usefulness as a moral guide
and a policy tool, utilitarianism also gave
rise to numerous problems that would
greatly perplex later economists. First,
although Bentham struggled to make the
notion of utility concrete, it is not clear
how someone could, in practice, measure
this elusive notion. It is also not clear how
we could go about comparing, let alone
adding up, the pleasures and pains
experienced by different people. Second,
many people have criticized utilitarianism
for being an immoral doctrine, since it
ignored the notion of justice or fairness as
a means of judging government and
individual actions. For example, under
utilitarianism, discrimination would be
justified if it led to maximum happiness
in the nation. Finally, there is a curious
conflict between Bentham’s view of human
nature and his view of morality. If people
by nature are always under the domination
of pleasure and pain, and if they always
act to maximize their net pleasure, then
people cannot behave any differently than
they actually behave. Under such
circumstances, it is hard to talk about right
and wrong actions, or to hold people
responsible for their actions.
To be fair, Bentham was aware of these
problems with his theory. His response
was that, despite such problems, his
system was the best one available for
organizing society and for running a
government. The only alternative would
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be to have everyone pick their own
standard for how government and society
should be run; and this alternative,
according to Bentham, could only lead to
chaos and anarchy.
By providing a detailed explanation of
the principle of utility, as well as a
concerted argument for using this notion
in economic analysis, Bentham earned the
title “father of utilitarianism.” He also
became a philosophical guiding spirit for
the many generations of economists that
were to follow him.
Works by Bentham
Economic Writings, ed. W.Stark, 3 vols., London,
Allen & Unwin, 1952–4
Manual of Political Economy, in Bentham 1952–
4, Vol. 2
Introduction to the Principles of Morals and
Legislation, Riverside, New Jersey, Hafner,
1948
Works about Bentham
Everett, C.W. The Education of Jeremy
Bentham, New York, Columbia University
Press, 1931
Halevy, Elie, The Growth of Philosophical
Radicalism, New York, Augustus Kelley,
1949
Mitchell, Wesley C., “Bentham’s Felicific
Calculus,” Political Science Quarterly, 33
(June 1918), pp. 161–83. Reprinted in The
Backward Art of Spending Money and Other
Essays, New York, Augustus M.Kelley,
1950, pp.177–202
Other references
Smith, Adam, The Wealth of Nations (1776), New
York, Modern Library, 1937
THOMAS ROBERT MALTHUS
(1766–1834)
Thomas Robert Malthus (pronounced Mal-
THISS) is one of the most controversial figures
in the history of economics. He achieved fame
chiefly from the population doctrine that is now
closely linked with his name. Contrary to late-
eighteenth-century views that it was possible
to improve people’s living standards, Malthus
held that any such improvements would cause
the population to grow and thereby reverse
these gains. Malthus also sparked controversy
with his contemporaries on issues of
methodology (by arguing that economics
should be an empirical rather than a deductive
science), over questions of theory (by holding
that economies can experience prolonged bouts
of high unemployment), and on policy issues
(by arguing against free trade and against
government assistance to the poor).
Malthus was born in 1766 in the town of
Wotton, in Surrey. His father was a well-to-do
country squire, who made sure that Malthus
received a good education. At first, Malthus
was instructed by his father and private tutors
in his home. Then he was sent off to excellent
private schools. At the age of 18 he enrolled at
Jesus College, Cambridge where he studied
mathematics and natural philosophy.
Although his father wanted him to become
a surveyor, Malthus decided to enter the church.
He was ordained in 1788, thus becoming
Reverend Malthus. In 1793 he became a fellow
of Jesus College and curate of Okewood, a little
chapel in Wotton.
While he was working at Wotton, Malthus
got into a heated argument with his father about
the ability to improve the economic well-being
of the average person. His father thought this
was possible; Malthus remained skeptical. The
dispute prompted Malthus to do some reading,
and then some writing, on the topic. The
outcome was his Essay on Population, which
was first published in 1798.
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THOMAS ROBERT MALTHUS
The population essay brought Malthus
instant fame, and then (in 1805) a job as
Professor of History, Politics, Commerce, and
Finance at the New East India College near
London. The college was primarily a training
school for employees of the East India
Company who were about to take
administrative posts in India. The teaching
position made Malthus one of the first
academic economists. And, as is true of many
teaching jobs, it required little time and effort.
This left Malthus much free time to socialize,
to correspond with his many friends (especially
David Ricardo), and to stir up controversies
regarding economic principles and policies. In
addition to the controversies surrounding his
principle of population, Malthus became
embroiled in important debates with Ricardo
over the British Poor Laws and Corn Laws, the
benefits of free trade, and the possibility of
gluts or insufficient demand for goods.
In mid-eighteenth-century England the
industrial revolution was in full swing.
However, workers lived near the level of
physical subsistence, and their condition
worsened in the latter half of the eighteenth
century. Monotony and repetition characterized
factory work; the tyranny of the factory clock
and the pace of the assembly line were beyond
the control of all workers. The division of labor,
praised by Adam Smith in The Wealth of
Nations as the means to productivity growth
and rising living standards, made work so
routine that women and children could perform
jobs just as easily as men. Business owners
logically preferred such workers because they
could be hired for less.
These circumstances gave rise to numerous
champions of the working class. Among the
best known were the Marquis de Condorcet,
Robert Owen and William Godwin. Condorcet
(1795) argued that greater economic equality
and more security for workers would improve
their material well-being. Towards this end he
advocated two reforms —a welfare system to
provide security for the working poor, and
government regulation of credit to keep down
interest rates so that needy families could
borrow money at lower cost. Owen (see below)
attempted to develop utopian communities in
industrial towns that would improve both the
economic and social conditions of working
class families. Godwin (1793) was even more
radical in his analysis and his policy proposals.
He blamed the capitalist system for the poverty
of workers. He then demanded that property
be taken from its owners and given to those
whom it would benefit the most. This, Godwin
claimed, would end all poverty, injustice, and
human suffering in the world.
The Essay on Population (Malthus 1798)
was inspired by these men; yet it was written
to refute their arguments about the possibility
of improving economic conditions. Malthus
thought that human betterment was impossible
because poverty and misery were the inevitable
lot of the majority of people in every society.
Moreover, he argued that all attempts to
alleviate poverty and suffering, no matter how
well-intentioned and no matter how well
thought out, would only worsen things. It is
this position that led Thomas Carlisle to call
economics “the dismal science,” an appellation
that has stuck for more than two centuries.
Malthus held that the human condition
could not be improved for two reasons. First,
he believed that people were driven by an
insatiable desire for sexual pleasure. This led
to population increases which, if left
unchecked, would grow geometrically—1, 2,
4, 8, 16, etc. Second, Malthus believed that
diminishing returns operated in agriculture;
that is, as more and more land was brought into
cultivation, each new plot of land would be able
to grow less food than the previous plot. For
this reason, food production could at best
increase in arithmetical proportions— 1, 2, 3,
4, 5 etc. Since population was growing more
rapidly than the food supply, at some point the
population would exceed the food that could
be grown to feed everyone. Starvation would
ensue if there were no other checks on
population growth.
In the first edition of the Essay on
Population Malthus allowed only “positive
checks” on a growing population. These were
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THOMAS ROBERT MALTHUS
factors that raised death rates—famine, natural
catastrophe, plague, and war. But in the second
and subsequent editions of the Essay Malthus
added a set of “preventive checks”—sexual
abstinence, birth control, and delayed marriage.
These had the effect of lowering birth rates and
population growth. Allowing preventive checks
on population growth also toned down the
pessimistic nature of the economic forecast.
But Malthus still held that because of the strong
human desire for sexual pleasure, population
growth could not be reduced very much by
preventive checks; the conclusion therefore still
followed that it was impossible to improve
overall economic well-being.
The case against Condorcet, Owen, and
Godwin followed simply from this analysis.
If wealth and income were distributed more
equally, as Godwin advocated, or if the poor
were made better off through various social
reforms, as Condorcet and Owen suggested,
working families would respond by having
so many children that they would shortly find
themselves impoverished again. It is for
these reasons that Malthus opposed every
attempt to legislate relief for the poor, and
was opposed to granting charity to the poor.
This, he thought, would only lead to more
poor people. Contemporary Malthusians (for
example, Murray 1984) make similar
arguments, maintaining that government aid
merely causes welfare recipients to have
more children, thus worsening their
economic plight.
Several years later, in a pamphlet entitled
An Investigation of the Cause of the Present
High Price of Provisions (in Malthus 1970),
Malthus went even further in arguing against
relief for the poor. This work argued that poor
relief would also lead to increases in the price
of corn in England. Thus, not only would poor
relief hurt the poor, but by raising the price of
necessities, poor relief would also hurt all
British citizens.
Although best known for his population
doctrine, Malthus also made several theoretical
and policy contributions to economics.
At the theoretical level, Malthus provided
a justification for profits (see the Essay on Rents
in Malthus 1970). As we saw earlier, Adam
Smith really had no theory of profits and could
not explain what determined the level of profits.
Malthus filled in this gap left by Smith. For
Malthus, profits were a return to the capitalist
for his part in producing goods. Workers who
had tools and machinery were more productive
than workers lacking this capital equipment.
By allowing such capital to be employed in the
production process, capitalists contributed to
production and deserved to be remunerated
based on this contribution.
The Essay on Rents, also developed the
differential theory of rent (see also RICARDO).
According to this doctrine, rents existed
because of differences in soil fertility and
because landlords made improvements on their
land. Economic progress meant that the
demand for agricultural goods would increase
and less fertile lands would have to be used to
feed people. Differences in land fertility would
therefore rise and so would rents. In contrast
to Ricardo, for Malthus high rents were the
result of economic prosperity and a measure
of prosperity.
At the policy level, Malthus (1820)
attempted to explain why economies were
subject to periodic depressions or gluts— times
when businesses could not sell goods and when
unemployment remained very high. The
answer Malthus gave was that gluts were due
to insufficient demand or too little spending.
Conversely, Malthus’ explanation for rising
prices was too much spending taking place in
the economy. It is for this reason that Keynes
(1964, pp. 362ff.) has cited Malthus as an
important precursor of his theory of the
business cycles.
Just as Malthus (1820) was writing his
Principles of Political Economy, Great Britain
suffered a major Depression. The cause of this
problem, according to Malthus, was that as
capitalism developed there was a tendency for
capitalists to receive too much income. In fact,
he argued that capitalists got more income than
they could profitably invest. There were two
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THOMAS ROBERT MALTHUS
reasons for this. First, new machinery requires
new workers. While it is easy to build new
machinery in a short period of time, to get more
workers requires 15 years or more. During this
time there will be a shortage of labor; wages
will rise, profits will fall, and capitalists will
prefer to hold their income as cash rather than
investing. Second, Malthus held that new
machinery increases the productivity of labor
and reduces the need for workers. Because
capitalist received more income than they could
profitably invest they wound up saving too
much. Private virtue thus became public vice—
too little spending leads to a surplus of goods
and reduces the need for workers.
The solution that Malthus proposed for
the problem of gluts followed directly from
his analysis; he wanted the state to alter the
distribution of income so that capitalists
received less income and landowners
received more income. Malthus believed
that landowners spent almost all their
income; if they received more income they
would consume it by hiring more servants
and engaging in luxury consumption. For
this reason Malthus supported the British
Corn Laws (which were passed in 1815 and
then repealed in 1846). This legislation
prohibited the import of grain into Britain
until certain price levels were reached. With
fewer grain imports, Malthus reasoned,
more land would be used in Britain for
growing food. This would increase
(differential) rents due to diminishing
returns in agriculture and provide more
money to landowners. In addition, Malthus
believed that wages would rise in proportion
to the increased price of corn due to trade
restrictions. The losers would be capitalists,
whose savings would fall as their income
declined.
Despite his many theoretical
contributions, and despite being an
important forerunner of Keynesian
economics, Malthus remains an important
figure in economics primarily because of his
population doctrine. The term “Malthusian”
will always connote pessimism about the
ability of mankind to improve its economic
well-being.
Works by Malthus
An Essay on the Principle of Population as it
Affects the Future Improvement of Society, with
Remarks on the Speculations of Mr. Godwin,
M.Condorcet, and other Writers, first edition
1798. A paperback edition of the Essay is
published by Penguin.
The Principles of Political Economy Considered
with a View to their Practical Application,
London, Murray, 1820
The Pamphlets of Thomas Robert Malthus, New
York, Augustus M.Kelley, 1970
Works about Malthus
Bonar, J.R., Malthus and His Work, New York,
Augustus M.Kelley, 1966
Grampp, William D., “Malthus and His
Contemporaries,” History of Political
Economy, 6, 3 (1974), pp. 278–304
James, Patricia, Population Malthus: His Life and
Times, London, Routledge & Kegan Paul, 1979
Keynes, John Maynard, “Malthus,” in Essays
in Biography, New York, Norton, 1951, pp.
81–124
Other references
de Cariat, Jean-Antoine-Nicholas, Marquis de
Condorcet, Outlines of an Historical View of
the Progress of the Human Mind, London, J.
Johnson, 1795
Godwin, William, An Enquiry Concerning
Political Justice (1793), New York, Woodstock
Books, 1992
Keynes, John Maynard, The General Theory of
Employment, Interest and Money (1936), New
York, Harcourt Brace, 1964
Murray, Charles, Losing Ground: American
Social Policy, 1950–1980, New York, Basic
Books, 1984
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ROBERT OWEN
ROBERT OWEN (1771–1858)
Robert Owen was a pioneer of British
socialism and a leading figure of the utopian
socialist movement during the early nineteenth
century. Owen was also a practical social and
economic reformer. As manager and part owner
of a number of manufacturing plants and
communities, he tried to humanize factory
conditions in nineteenth-century England and
improve the living standard of those working
there. As an economic and social thinker, Owen
argued for economic policy changes that would
improve the performance of the British
economy and the lives of British workers.
Owen was born in Newtown, a remote little
town in central Wales, in 1771. His father was
a common tradesman, and so Owen received
an ordinary education in the village school.
This meant he could read, write legibly, and
understand basic arithmetic. Since he was
poorly taught at school, Owen fell back on his
own resources—he read widely and thought
carefully about everything that he read.
At the age of 10 Owen left Wales for
London to live with his brother and seek
fame and fortune in the world. He worked
as a draper’s apprentice, a retail clerk, a
manufacturer of “mules” for spinning
cotton, and manager of a large cotton mill.
Then Owen and a number of rich business
partners bought New Lanark, primitive mills
in the Scottish lowlands, from his wife’s
father for £60,000. Like many mills at the
time, New Lanark was located far from any
town. Mill owners therefore had to offer
their workers food, lodging and other
benefits. This system gave the owners
control over not just the work of their
employees, but their entire lives.
While his partners desired the greatest
possible profit, as manager of New Lanark,
Owen looked upon the mills as a laboratory
for social experiments in educational and
industrial reform. The changes that Owen made
at New Lanark developed his reputation as a
social reformer.
When Owen took over New Lanark, the
town contained around 1,500 family members.
In addition, around 500 pauper children were
brought from the closest large town to live and
work there (Johnson 1929, p. 61). Families
were housed in small one-room shacks, with
no sanitary arrangements, that were owned by
the firm. Drunkenness and thievery were both
common. The working conditions in the mills
were as bad as the living conditions outside
the mills. Hours were long and hard, wages
were low, and benefits such as health care were
unknown (Owen 1813–14).
Owen began by building a second storey
on every house so that each family could have
two rooms. He built streets, started regular
garbage pick-ups, and set up worker
committees to improve cleanliness inside
homes. Then he bought up all the shops in town
that were privately owned. By purchasing food,
fuel, and other goods in large quantity, and by
forgoing any profit, Owen was able to charge
workers low prices for all necessities. This
action alone increased the standard of living
of his employees by 25 percent. Owen also
established a general community fund. All
workers contributed one-sixth of their wages
to the fund, and the fund provided free medical
care to all residents of New Lanark.
But his main efforts were directed at the
children of Lanark. This was because Owen
believed that it was necessary to provide the right
environment for people early in life, when their
character and personality were most malleable.
He totally opposed employing young children.
His first decision as manager of New Lanark
was to stop importing paupers as apprentices
and to stop employing children under 10 years
old. At this time, children as young as 6 or 7
were working full-time in England’s factories.
Owen also built parks and playgrounds so that
children could have places to play.
Most important of all was education. All
children at New Lanark between the ages
of 1 and 10 were provided with free
schooling. Today, when universal education
is taken for granted, it is hard to realize how
radical Owen’s proposal was. In early
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nineteenth-century England, most people
believed that education was only for the
upper class and was not necessary for the
children of the working poor. Those few
reformers who advocated educating
children of the working class limited their
proposals to simple computations, writing,
and reading the Bible. Owen, however,
wanted all children to learn, to think, to
dance and sing, and to understand how the
world works. He believed that education
was the basis for character formation and
that it had the power to reconcile class
differences and unite the world.
Over the course of several years Owen
managed to turn New Lanark into a model
community. Working conditions were good, the
quality of the output was high, profits were good,
and the workers were content and idolized
Owen. But Owen wanted to do even more for
the residents of New Lanark. However, he was
constrained by the demands of his co-owners
for greater profits and by pressure from his
competitors who insisted on squeezing
everything possible out of their workers to
reduce production costs. Owen came to realize
that his reforms had to be made universal, so
that no employer could gain a competitive
advantage by using cheap child labor,
mistreating their workers, or not educating the
children of their employees. Owen (1815) thus
began reporting on the deplorable condition of
manufacturing plants in Britain, and argued that
the factory system should be judged by its effects
on character and health as well as on the wealth
it creates. He also pressed for legislation that
would prohibit child labor and mandate
education for young children.
The first Factory Act was passed in 1819.
It limited child labor slightly, but only in
certain types of manufacturing plants. This
watered down and ineffective law dissuaded
Owen from further pursuing a political route
to the reforms he thought necessary.
Although the Factory Act fell far short of
what Owen wanted and what he was
advocating, an important principle had been
established—for the first time government
regulated the way factory owners did
business and the state assumed responsibility
for protecting those too weak to protect
themselves.
The failure of a political solution to the
problem of child labor, as well as deteriorating
economic circumstances, led Owen to change
the focus of his efforts. With the end of the
Napoleonic War in 1815, the British
government no longer needed goods to fight
France. Reduced demand led to an oversupply
of farms and an oversupply of goods that piled
up in warehouses. Farm servants and
manufacturing labor were discharged at the
same time that the army was discharging a
large number of men In addition, machinery
was increasing production and reducing the
demand for labor. As more people lost their
jobs, sales fell and economic problems grew
even worse—agricultural wages fell by 50
percent and close to 50 percent of the
population were paupers.
Owen (1821) saw only three possible
outcomes to the problem of unemployment
and poverty: (1) to stop using machinery, (2)
to let the millions of people who could not
find work starve, or (3) to find jobs and
income for the poor and unemployed. He
argued that instead of unemployment
insurance, the government should set aside
capital to develop small villages of around
1,200 people. People in these communities
or “villages of Co-operation” would provide
goods for their own subsistence, buying as
little as possible from the outside. Any
surplus they produced would be used to trade
with the outside world for any necessities
that could not be produced within the
community.
Owen held that the poor in England could
produce wealth for the nation and could escape
poverty if they were given a chance to work and
a decent environment in which to live. However,
his plan was greeted with ridicule on the one
hand and outright rejection on the other hand.
And like his attempt at getting factory legislation
passed, his call for co-operatives failed to spark
any significant legislation in England.
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Hoping that the New World would be more
receptive to his ideas, Owen came to the United
States in 1824. He set up a cooperative
community in New Harmony, Indiana according
to the principles he had been advocating for
years. But life in New Harmony was not the
socialist utopia Owen envisioned. The
community could not produce enough to meet
its material needs; there was constant shirking
of work by community members; and people
could not get along with each other. As a result
of this experience Owen became even more
disillusioned and pessimistic; and in the last
years of his life he even lost the optimistic spirit
that he had as a young man.
Owen discovered no economic relationships;
no theories, modes of analysis, or techniques
bear his name. His focus was primarily on policy
issues, and it is here that Owen was a pioneer.
All contemporary labor legislation—such as
limiting the use of child labor, and establishing
minimum wages and decent working
conditions—goes back to Owen. The view that
eradicating poverty requires education and
developing human capital (see also BECKER)
also goes back to Owen. But perhaps the most
important contribution of Owen was his utopian
vision. It is the vision of a capitalist system
producing horrible problems in addition to great
wealth, and the possibility of fixing these
problems with intelligent policies.
Works by Owen
A New View of Society (1813–14), New York,
Cassell, 1991
Observations on the Effect of the Manufacturing
System, London, 1815
Report to the County of Lanark of a Plan for
relieving Public Distress and Removing
Discontent by Giving Permanent Productive
Employment to the Poor and Working Classes
(1821), New York, AMS Press, n.d.
The Book of the New Moral World in Selected
Works of Robert Owen, ed. Gregory Claeys
(1836–44), London, Pickering, 1993
The Marriage System of the New World, Leeds, J.
Hobson, 1838
The Life of Robert Owen, 2 vols . (1857–8), New
York, Gordon Press, 1973
Works about Owen
Cole, G.D.H., The Life of Robert Owen, London,
Frank Cass & Co., 1925
Cole, Margaret, Robert Owen of New Lanark,
London, Batchworth Press, 1953
Johnson, D.C., Pioneers of Reform, New York,
Burt Franklin, 1929
DAVID RICARDO (1772–1823)
David Ricardo was interested first and foremost
in issues concerning income distribution and
economic growth. He sought to understand
how the economic pie was divided up among
rent, wages, and profits; and he sought to
understand the principles causing economies
to grow and decline. Ricardo saw free
international trade as one important force
leading to greater economic growth. But he saw
diminishing returns in agriculture as a
counterforce, one which tended to squeeze
profits and slow down economic growth.
Ricardo was born in London, in 1772, to a
prosperous Jewish family. His education
prepared him to follow his father into the world
of trade and finance. True to plan, at 14 Ricardo
entered his father’s brokerage firm. Rather
quickly he took to the business. He was
regarded as an extremely able negotiator, and
rather adept at difficult and arcane operations
such as currency arbitrage (see also
COURNOT).
Ricardo became estranged from his father
when he married a Quaker and converted to
Christianity. Penniless, and having to support
a family, Ricardo borrowed all the money he
could and began his own brokerage firm. While
the first years were difficult, he quickly made
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a great fortune and became independently
wealthy by the age of 26. This allowed him
the leisure time to pursue his intellectual and
scientific interests. These included starting up
a laboratory, beginning a mineral collection,
and joining the Geological Society of Britain.
Ricardo came across a copy of The Wealth
of Nations in 1799 while on vacation with his
wife. According to legend, after reading Smith
he decided to spend his spare time studying
economics. Ricardo also joined a group of
distinguished economists who met regularly to
discuss economic issues. This group included
James Mill (the father of John Stuart Mill),
Bentham, and Malthus.
In 1819, Ricardo bought a seat in the House
of Commons. The seat was in the Irish borough
of Portarlington, an area that Ricardo never
visited. To be fair, at the time it was not
uncommon for wealthy people to buy seats in
Parliament. As might be expected, Ricardo
quickly became a recognized expert in
Parliament on financial matters, and he spoke
up frequently on critical economic issues such
as currency and banking, tariffs, taxation, and
the agricultural depression.
Economists remember Ricardo primarily
for his theory of comparative advantage. This
theory provides the justification virtually
every economist uses to support free trade.
But Ricardo made several other lasting
contributions to economics. He explained how
national income got distributed among wages,
profits, and rents; how income distribution
changed over time; and what the
consequences of changing income distribution
were for Britain. He also developed the labor
theory of value.
In The Wealth of Nations, Adam Smith held
that a country would export goods to other
countries if it were more efficient at producing
these goods. Smith called this “absolute
advantage.” According to this view, if Japan
produced cars, computers, food, and clothing
more efficiently than the US, Japan would
export all these goods to the US. The US would
run a large trade deficit with Japan, giving it
money in exchange for these Japanese goods.
For Ricardo, there was no problem if one
country was less efficient at producing
everything. Trade, he contended, depended on
comparative advantage, or relative efficiency,
rather than on absolute efficiencies. Ricardo
then demonstrated that countries would tend
to sell those goods it was relatively more
efficient at producing, or that it was relatively
less inefficient at producing. Through
specialization each country would gain from
foreign trade.
A simple numerical example helps to make
this point. Suppose both Japan and the US each
produce two goods—automobiles and rice. In
the US, one worker can produce either one car
or one ton of rice in any given year. In Japan,
one agricultural worker can produce two tons
of rice in a year, and one manufacturing worker
can produce three cars in one year. For both
rice production and automobile manufacturing
Japanese workers are absolutely more
productive than American workers. However,
Japanese workers are relatively more efficient
at producing cars and US workers are relatively
less inefficient at producing rice. Japanese
workers are three times more efficient in
manufacturing cars, and US workers are only
half as efficient as the Japanese when it comes
to growing rice.
What Ricardo demonstrated is that both the
US and Japan will gain from specializing in
what it does relatively better at producing, and
then trading with each other. The argument runs
as follows. Suppose the US has 200 workers
and Japan has 100 workers, and that workers
are divided equally between car production and
rice production in each country. The US then
produces 100 cars and 100 tons of rice, while
Japan produces 150 cars and 100 tons of rice
for the year. Combined output for both
countries is 250 cars and 200 tons of rice.
Now consider what happens when Japan
specializes in car production and the US
specializes in rice production. In Japan 100
workers make 300 cars; in the US 200 workers
produce 200 tons of rice. World output has
gone up by 50 automobile due to
specialization.
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The next important question that must be
answered is who gets this extra output. Ricardo
noted that this depends on the rate of exchange
between the two goods. If Japan trades 100 cars
to the US for 100 tons of rice, Japan winds up
with 200 cars (the initial 300 produced less the
100 traded to the US) and 100 tons of rice,
while the US winds up with 100 cars and 100
tons of rice (the 200 produced domestically less
the 100 traded for cars). Here all the gains from
specialization and trade go to Japan. On the
other hand, if Japan trades 150 cars to the US
for 100 tons of rice, all the gains from
specialization (the 50 cars) go to the US.
Within these boundaries (1 ton of rice
trading for 1 car and 1 ton of rice trading for
1.5 cars) both countries will benefit from trade.
Moreover, because both countries can benefit
from economic specialization and trade only
if the rate of exchange falls within these
boundaries, both countries have strong
incentives to make sure that the exchange rate
between cars and rice will fall within this range
(or that the exchange rate between the US
dollar and the Japanese yen will put trade
within this range). Ricardo, unfortunately, did
not explain where actual exchange rates would
fall within this range, or how gains from trade
would actually get divided up between two
countries. That job was left for John Stuart Mill.
A second theoretical contribution of
Ricardo was the first concerted theory of
income distribution. Ricardo also drew out the
important practical consequences of his theory.
Ricardo’s theory of distribution had three
elements—a theory of rent, a theory to explain
wages and a theory of profits. His theory
showed how national income was divided up
into these three categories, and what happened
to rents, wages, and profits over time as
economies grew. In analyzing rent, Ricardo
followed Malthus (1970) in advancing a
differential theory of rent. According to the
differential theory, rents stem from the different
fertility of various plots of land. Whenever there
is an ample supply of rich and fertile land,
people will not pay for the use of this land and
there will be no rent on the land.
But usually there is a limited supply of good
land. When the most fertile land is used up,
the next most fertile plot of land has to be
cultivated. Gains immediately accrue to those
who own the most fertile land. If the most
fertile land yields ten bushels of corn per acre
and the second best land yields eight bushels
per acre, some farmer should be willing to pay
close to two bushels of corn for using the best
land rather than the second best land.
As worse and worse quality land gets
brought into use, differential rents will rise.
“When land of the third quality is taken into
cultivation, rent immediately rises on the
second, and is regulated…by the difference in
their productive powers. At the same time, the
rent of the first quality will rise” (Ricardo
1951–5, Vol. 1, p. 70). If the third best land
yields seven bushels per acre, rent on the best
land will rise to around three bushels per acre,
while the second best plot of land now
commands a rent of one bushel per acre.
Worker wages, Ricardo held, depend upon
subsistence requirements—the minimum that
workers would need to survive. Unlike Smith,
Ricardo interpreted this minimum in
conventional terms rather than in physical
terms; it “essentially depends on the habits and
customs of the people” (Ricardo 1951–5, Vol.
1, p. 97). As the general standard of living
improves, so too does the minimum wage that
can be paid to workers. The minimum income
needed to survive in late twentieth-century
America was not the same as the minimum
income needed in nineteenth-century America.
Indoor plumbing and private baths, while
uncommon in the nineteenth century, were
essential at the close of the twentieth century.
Wage levels in the late twentieth century must
therefore take account of the higher living
standards to which people have grown
accustomed.
Finally, Ricardo held that profits were a
residual, or what was left over for the capitalist
after paying workers their wages and
landowners their rents. Ricardo also held that
profit rates would be the same in every industry,
since if one industry received higher profits,
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more capital would enter that industry and push
down prices and profits. Similarly, capital
would leave industries earning low profits. This
would tend to raise prices and profits.
These theories of rent, wages, and profit
led Ricardo to a rather unhappy conclusion.
Over time, as a country grows, its population
will likewise grow. More people mean more
mouths to feed and more food that has to be
produced. Consequently, less fertile land must
be brought into use. This will raise the rent
on all land and increase the rents that must be
paid to well-off landowners. As the cost of
producing food rises (due to higher rent
payments), so too must the price of food. The
subsistence theory of wages maintains that
higher food prices must lead to an increase in
wages. Only with such a pay increase can
workers buy higher-priced food and maintain
their standard of living.
With both wages and rents rising, the profits
of the capitalist must get squeezed. Landowners
receive higher rents, wages rise to keep up with
rising food costs, and so profits must fall.
Moreover, as profits fall, the motivation for
accumulating capital disappears. At this point,
economic progress comes to an end and the
economy stagnates.
Ricardo made several suggestions for
dealing with this looming crisis. First, he
argued for a repeal of the British Corn Laws.
First passed in 1660, the initial goal of the
Corn Laws was to stabilize the price of grain
in England. High duties on imports and low
export duties were imposed when the
domestic supply was great. When the harvest
was bad, import fees were removed, thereby
allowing more grain to come into England,
and export duties were imposed. This initially
helped exert a downward pressure on grain
prices in times of shortages. But over time the
legislation did not work as intended. By the
early 1800s, the Corn Laws were not
stabilizing prices. Rather, they were keeping
up grain prices and protecting the incomes of
landowners who gained from the high prices
of corn grown on their land.
Ricardo saw that a repeal of the Corn
Laws would increase imports of foreign grain
into Britain. This would have two beneficial
effects on profits. By keeping down the price
of food, grain imports would keep down
wages and stop the squeeze of wages on
profits. Greater grain imports would also
mean that Britain itself would need to
produce less grain. This would reduce the
amount of land used domestically to grow
food. Since the least fertile land would be
taken out of cultivation, and since rents were
a differential, rents in Britain would fall and
reduce the squeeze on profits.
A second policy reform advocated by
Ricardo was greater capital accumulation.
More capital equipment would improve the
productivity of land. If all land were
improved equally, there would be no change
in differential rents. And with wages
determined by habitual subsistence
requirements, wages would not be affected
by greater productivity. Thus the gains from
capital accumulation would go primarily to
business profits. Moreover, this increase in
profits would generate greater investment in
the future, the hiring of more workers, and
even greater productivity growth.
Ricardo eventually came to entertain
considerable doubt that capital
accumulation could improve British living
standards. The third edition of his
Principles of Political Economy (Ricardo
1951–5, Vol. 1) added a chapter entitled
“On Machinery.” This chapter discusses
the possibility that new machinery would
harm workers by displacing labor. Before
Ricardo, virtually all economists agreed
with Adam Smith that machinery assisted
the division of labor and thus contributed
to economic growth. In addition, following
Smith, most economists thought that the
introduction of machinery would not lead
businesses to lay off workers. Early
editions of the Principles concurred in this
view, and claimed that greater use of
machinery would lower the price of goods
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DAVID RICARDO
rather than displacing labor. Thus all
society would benefit.
But after reading a pamphlet by John
Barton (1817) entitled Observations on the
Condition of the Labouring Classes,
Ricardo changed his mind. With the aid of
numerical examples, Barton showed how
capitalists might make more money by
hiring fewer workers and employing more
machines. Based on these examples,
Ricardo concluded that workers were right
to fear and oppose the introduction of new
machinery on the grounds that it would
likely lead to what we now call
“technological unemployment.”
One consequence of the new machinery
chapter was that Ricardo came to agree
with Malthus that continued high
unemployment was possible. Another
consequence was that it made Ricardian
economics even more pessimistic. With
technological unemployment looming on
the horizon, not even capital accumulation
could be counted on to improve the welfare
of society (see Hicks 1969).
Finally, no summary of the
contributions made by Ricardo would be
complete without mentioning his theory of
value. Ricardo’s theory of value began
with observation that “commodities derive
their exchange value from two sources:
from their scarcity and from the quantity
of labor required to obtain them” (Ricardo
1951–5, Vol. 1, p. 12). Scarcity was only
important in determining the value of those
goods that cannot be reproduced—things
like rare paintings, books, coins, and wine.
These goods were not important in
Ricardo’s opinion. The vast majority of
goods were reproducible, and what was
important in determining their value was
the amount of labor needed to produce
them. Two sorts of labor were necessary—
direct labor and indirect labor. Direct labor
is the amount of work time or the number
of workers needed. Indirect labor is the
machinery used in the production process.
Since machinery is a reproducible good,
its value gets determined by the direct and
indirect labor needed to produce it. By
going all the way back, the value of every
good could reduce to the amount of labor
needed to produce it directly and the
amount of labor needed to produce the
machinery required in the production
process.
Ricardo held that reproducible goods
would exchange at rates that mainly
depended on the amount of labor (direct
plus indirect) needed to produce them. If
it took twice as much labor to produce a
boat as it took to produce a car, a boat
would be twice as expensive as the car. But
if it took three times as much labor to
produce a boat, a boat would cost three
times what it cost to buy a car. One
important implication of this theory of
value is that (relative) prices depend
exclusively on production and technology.
Demand for cars and boats is irrelevant. All
that matters is the way that cars and boats
each get produced, in particular how much
labor is required to make each good.
Ricardo did not hold a total labor theory
of value. He recognized that different capital
structures might be required to produce
different goods. Thus if two goods both
require 1,000 hours of labor, but one good
uses all direct labor and the other requires a
good deal of machinery, the two goods may
not cost about the same amount. The reason
for the cost differences in this case is
essentially the interest cost on the earlier
labor used to produce machinery. Such
interest does not need to be paid when
producing some good by using only direct
(i.e. current) labor. But interest does need to
get taken into account when using past labor,
or machines. Ricardo (1951–5, Vol. 1, p. 36)
thought that the amount of capital and labor
employed in producing every good was
roughly the same. Hence, the quantity of
labor needed to produce a good was a
reasonably good approximation of the value
of every good, but it was not a perfect
measure of relative prices (see Stigler 1958).
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ANTOINE AUGUSTIN COURNOT
With Smith and Marx, Ricardo was one
of three giant figures in classical economics,
the period stretching from the late
eighteenth century to the late nineteenth
century. He made several lasting and
important contributions to economics—the
labor theory of value and the theory of
comparative advantage being the most
prominent. Ricardo also developed the first
rigorous economic theory of distribution,
and drew out its consequences. Finally,
Ricardo had a vision of an economic system
where relative prices were determined
mainly by the costs of production, and
where demand and utility played little or no
role. This vision was subsequently adopted
and formalized by Piero Sraffa, and became
the basis of the neo-Ricardian or Sraffian
school of economic thought.
Chicago, University of Chicago Press, 1965,
pp. 326–42
Other references
Barton, John, Observations on the Circumstances
which Influence the Condition of the
Labouring Classes of Society, London, John
& Arthur Arch, 1817
Malthus, Thomas Robert, The Pamphlets of
Thomas Robert Malthus, New York, Augustus
M.Kelley, 1970
ANTOINE AUGUSTIN COURNOT
(1801–77)
Works by Ricardo
Works of David Ricardo, ed. Piero Sraffa, 10 vols.,
Cambridge University Press for the Royal
Economic Society, 1951–5
Works about Ricardo
Blaug, Mark, Ricardian Economics, New Haven,
Connecticut, Yale University Press, 1958
Hicks, John, “Ricardo on Machinery,” in A Theory
of Economic History, New York, Oxford
University Press, 1969, pp. 168–71
Hollander, Samuel, The Economics of David
Ricardo, Toronto, University of Toronto
Press, 1979
Stigler, George J., “The Ricardian Theory of
Value and Distribution,” Journal of Political
Economy, Vol. 60 (June 1952). Reprinted in
Essays in the History of Economics,
Chicago, University of Chicago Press, 1965,
pp. 156–97
Stigler, George J., “Ricardo and the 93 Per Cent
Labor Theory of Value,” American
Economic Review, 48 (June 1958). Reprinted
in Essays in the History of Economics,
Antoine Augustin Cournot (pronounced
CORE-KNOW) developed much of
contemporary microeconomics. He was the
first economist to draw a demand curve, he
explained how market structure affected prices,
and he provided the first analysis of how
markets reach equilibrium. But Cournot is best
known for his analysis of the process of
arbitrage and for his analysis of pricing
behavior in industries with only two firms
(duopolies).
Cournot was born in Gray, a small French
town east of Dijon, in 1801. He attended the
local high school until he was 15 and then spent
four years studying on his own. During this
time he primarily studied law and mathematics.
In 1821 Cournot was admitted to the École
Normale Supérieure in Paris, but when the
school was closed for political reasons he
transferred to the Sorbonne.
After graduating in 1823, Cournot spent ten
years helping a French marshal write his
memoirs. This job provided ample free time,
and Cournot used his time well. He wrote a
thesis in astronomy, a doctoral dissertation in
mechanics, and he obtained a law degree.
Cournot also began writing articles on
mathematics. These articles earned him
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ANTOINE AUGUSTIN COURNOT
substantial notoriety among distinguished
French mathematicians, and eventually a
position as professor of analysis and mechanics
at the University of Lyons.
Cournot turned out to be an excellent
administrator as well as an excellent
mathematician. He soon became Rector of the
Academy of Grenoble, and over the next
several decades he held many other
administrative posts. Cournot was Inspector
General of Education in Paris, served as
Commander of the Legion of Honor, and was
Rector of the University of Dijon.
In 1862 Cournot retired from administration
and returned to Paris in order to devote the last
years of his life to scholarly research and
publishing. Unfortunately, with his eyesight
deteriorating, Cournot was able to produce little
during his retirement.
Early in his professional career, Cournot
published mainly in the field of mathematics.
He then developed an interest in philosophy,
and wrote about the philosophy of history and
the theory of knowledge. Only later in life did
Cournot become interested in economics. His
major economic treatise, Researches into the
Mathematical Principles of the Theory of
Wealth (Cournot 1838), was the first work in
economics to bring the differential calculus into
economic analysis, and the first application of
calculus to the pricing behavior of the firm.
Surprisingly, Cournot’s contemporaries
showed no interest in this pioneering and
revolutionary approach to microeconomic
analysis. Many historians of economic
thought have speculated that Cournot was
ignored because other French economists
failed to understand the mathematics of the
calculus or what light the calculus could throw
on economic principles. However, Ekelund
and Hébert (1990) put some of the blame
directly on Cournot. They contend that
Cournot was ignored because he failed to
apply his mathematical economics to the main
issues of the day.
A quarter century after publication of his
Researches, Cournot took another stab at
economics. Hoping to reach a larger audience
he removed all the mathematics from his
treatise. But this book (Cournot 1863) also
made no impression on his contemporaries.
Cournot (1877) then made a third and final
attempt to simplify his theories. This work also
was ignored.
Although his contemporaries may have
failed to appreciate him, subsequent
economists have recognized the many
analytical advances due to Cournot. These
advances involve developing microeconomic
concepts and modes of analysis. The most
important microeconomic ideas due to
Cournot are his analysis of demand, his
analysis of firm costs and production
decisions, and his explanation of how an
arbitrage guaranteed that prices of goods
would be equal throughout the world.
Cournot (1960, Ch. 4) was the first
economist to describe and define the downward
sloping demand curve, noting that the quantity
demanded for any good, such as a bottle of
French wine, depended on the price of that
good. He noted that rising prices would reduce
the quantity of wine that people would buy,
while falling prices would increase the quantity
of wine demanded. Cournot then drew the first
demand curve relating prices and the amount
of wine consumers would purchase. Unlike the
demand diagrams of today, where price is put
on the vertical axis and quantity on the
horizontal axis (see also MARSHALL),
Cournot recognized that the quantity of goods
demanded by consumers was the dependent
variable in the relationship and that price was
the independent variable; so Cournot correctly
put quantities on the vertical axis and prices
on the horizontal axis.
Cournot (1960, p. 81) next showed that
an equilibrium price existed at the point
where demand and supply were equal. If
demand exceeded supply for some good, the
price of that good would rise. With demand
greater than supply, businesses would see
their inventories decline; this would be a
signal to the firm that it could charge higher
prices for each bottle of wine. At this higher
price, demand would be lower; thus demand
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ANTOINE AUGUSTIN COURNOT
would come to equal supply more closely.
Conversely, if supply exceeded demand,
sales would be sluggish and business
inventories would not get bought up. In this
case, firms would know that if they wanted
to sell their stock of wine they would have
to lower prices. This would increase demand,
thereby bringing it closer to supply.
Cournot also introduced several economic
concepts concerning business costs. He was
the first to distinguish variable costs from
fixed costs. Fixed or overhead costs, such as
insurance and the rent payments on a wine
bottling plant, stay constant as the firm
produces more and more wine. Variable costs
include expenses on raw materials, parts, and
labor. Expenditures on these items must rise
as output increases. To produce more wine,
firms require more grapes, more bottles and
corks, and more workers.
Cournot recognized the practical
importance to the firm of knowing whether
costs and revenues will rise or fall as
production changes. He defined marginal
cost as the cost of producing one more unit
of output (one more case of wine) and noted
that the marginal cost of producing one more
unit could be increasing, decreasing, or
constant as more goods were produced.
Similarly, he defined marginal revenue as the
additional revenue going to the firm as a
result of producing and selling one more unit
of output or case of wine.
Using these two notions, Cournot
explained how a monopolist should behave
in order to maximize its profits. He proved
that profits are at their maximum when the
firm produces at the level where marginal cost
equals marginal revenue, and then sets a price
based upon the demand for that quantity of
goods. If the last case of wine a monopolist
is considering producing has marginal cost
greater than its marginal revenue, the firm
should not produce that case for it loses
money by doing so. On the other hand, if the
marginal revenue from producing one more
case of wine exceeds the cost of producing
that wine, profits will rise and the firm should
produce that case of wine.
Once the firm compares marginal cost
and marginal revenue to determine how
much to produce, it must decide how much
to charge for what it produces. Here the
demand curve plays an important role.
Wanting to receive as much money as
possible, the firm looks to demand, which
shows the price that people are willing to
pay for that level of output, and it charges
the price indicated by that curve.
At the opposite end of the spectrum from
monopoly lies the market structure “perfect
competition.” Cournot defined the
characteristics of this type of industry.
Perfect competition requires large number of
small firms. It also requires no restrictions
on new firms entering the industry. Such
restrictions could be in the form of
government regulations or they could be the
high start-up costs for any new firm. Cournot
(1960, p. 90) noted that only with perfect
competition are sellers unable to alter market
price by varying the amount that they supply.
Cournot also analyzed the pricing
principles for duopoly, market which has two
sellers and two sellers only. For his analysis,
Cournot assumed that neither seller could set
prices. He also assumed that each seller knew
the demand for the product it produced, and
that costs were similar for both firms.
From these assumptions Cournot was able
to show how the decisions of each firm
affected the price in the market and thus the
output decisions of the other firm. If one firm
increased production in an attempt to raise
profits, that firm would have to lower its price
to sell the additional output. This would
require the second firm to also lower its price
if it is to remain competitive. Moreover, the
second firm faces similar decisions regarding
how much to produce. It too can attempt to
increase production and profits. Any decision
made by the second firm will affect the price
that the first firm could charge and the profit
it could make. When the second firm changes
production and prices, the first firm has new
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ANTOINE AUGUSTIN COURNOT
information, and might to make a new
decision about how much to produce and
what it can charge. This decision, in turn, will
affect the situation facing the second firm. It
too will have new information and will have
to make a new decision about production.
One might think that the process of each firm
altering its price and output decisions in
response to the decisions of its rival might
go on forever. But Cournot showed that this
would not be the case. Eventually a situation
would result where neither firm could
improve their position (make more profit) by
increasing or decreasing the amount of the
good that they produced. This was a duopoly
equilibrium (see Machlup 1962).
Finally, Cournot (1960, Ch. 3) turned his
attention to international prices or the price
of foreign currencies. Here he explained how
arbitrage guarantees an equilibrium set of
exchange rates among a number of different
currencies that will be totally consistent.
Arbitrage is merely the process of buying
and selling in different places and making
money on any price differences. For
example, if a bushel of corn goes for $1 in
Mexico and $1.10 in Canada, one can earn
profits buying corn in Mexico and then
reselling the corn in Canada. Moreover, this
activity will increase the demand for corn in
Mexico and thus push up its price. In Canada,
the greater supply of corn will tend to lower
prices. Thus, arbitrage pushes prices to the
same level all over the world.
What is true of buying and selling corn is
likewise true of trading foreign exchange—
arbitrage will equalize the price of foreign
currency throughout the world. In 1996, 100
yen cost around $1 in Japan, and the British
pound cost around $1.50 in England. For
exchange rates between the yen, the dollar
and the pound to be consistent, one British
pound had to equal 150 Japanese yen.
Arbitrage assures that this will be the case.
Consider what would happen if this were
not so—for example, suppose that in
England £1 traded for 200 yen. From an
American perspective 100 yen costs $1 in
Japan, but in England 100 yen costs only
75 cents, since 75 cents will buy half a
British pound and half a pound buys 100
yen. Arbitrage works here just like it did in
the corn example. Americans would make
money buying yen in England and selling
yen in Japan. These trades would push up
the price of yen in England (due to greater
demand) and reduce the price of yen in
Japan (due to the greater supply). This
process of arbitrage will continue until the
price of all three currencies were equal
throughout the world.
Cournot is surely one of the more
underrated figures in the history of
economics. Given the many important
conceptual and analytical advances he made,
and given the mathematical nature of these
advances, it is surprising that his reputation
has not been much greater. In part, this is
probably due to the fact that Cournot focused
too much on technique. Another likely
reason is that he had few disciples to
promulgate his ideas and his approach to
economics. Nonetheless, his many
contributions to microeconomic theory have
held up over time and they remain the heart
of microeconomic analysis.
Works by Cournot
Researches into the Mathematical Principles
of the Theory of Wealth (1838), trans.
Nathaniel T. Bacon , New York, Augustus
M.Kelley, 1960
Principes de la thèorie des richesses, Paris,
Hachette, 1863
Revue sommaire des doctrines économiques,
Paris, Hachette, 1877
Works about Cournot
Ekelund, Jr., Robert B. and Hébert, Robert F,
“Cournot and His Contemporaries: Is an
Obituary the Only Bad Review?,” Southern
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Economic Journal, 57, 1 (July 1990), pp. 139–
49
Machlup, Fritz, The Economics of Sellers’
Competition, Baltimore, Maryland, Johns
Hopkins Press, 1962
Moore, Henry Ludwell, “The Personality of
Antoine Augustin Cournot,” Quarterly Journal
of Economics, 19, 3 (1905), pp. 370–99
Plantz, Don V., “Cournot’s Recherches: Some
Insights on Its Influence Upon the
Development of Economic Thought,” Western
Economic Journal, 2 (1964), pp. 195–208
JOHN STUART MILL (1806–73)
John Stuart Mill was an important
transitional figure in economics. In some
ways he was part of the classical school that
included Smith, Malthus and Ricardo; but in
other respects Mill was an important
forerunner of the marginalist school that
began to arise in the late nineteenth century.
Mill was born in London in 1806. His
father, James Mill, was a prominent
historian. James Mill devoted considerable
time each day to teaching his children, and
he attempted to give them the best possible
education. The story of these efforts is quite
remarkable. Mill ([1873] 1957, p. 5) reports:
“I have no remembrance of the time when I
began to learn Greek. I have been told that it
was when I was three years old.” At 7 years
of age, Mill was reading the philosophical
dialogues of Plato. At 8 he began to learn
Latin. Over the next four years mathematics
was added to his studies. Mill learned
elementary geometry and algebra
thoroughly, as well as the differential
calculus and higher mathematics. On
reaching age 12, the advanced stage of his
education began with the study of logic and
philosophy. One year later Mill ([1873]
1957, p. 19) went through “a complete course
in political economy,” which included
attending many discussions between his
father and David Ricardo.
But it was the constant presence of
Bentham in the Mill household that had the
greatest impact on the young Mill.
Conversations with Bentham, and reading
his works, convinced Mill to follow in
Bentham’s footsteps and become a social
reformer. On reaching adulthood, Mill
sought to spread the gospel of Bentham
throughout the world. From 1834 to 1840
he edited the Westminster Review, a major
intellectual periodical in Britain and the
vehicle of communication for the
Philosophical Radicals (see also
BENTHAM). He then began publishing
books on economics, philosophy, politics,
and social theory. These works made Mill
one of the best known and most respected
figures in nineteenth-century England.
In his many books and articles Mill made
several important contributions to
economics. Some of these extended and
completed classical economic analysis;
others broke new ground by analyzing
economic phenomena as relationships and
trade-offs. Mill also made several
contributions to the broad area where
economics and philosophy overlap. These
explained the philosophical foundations of
economics, and set forth justifications for
individual freedom and limits on government
intervention in economic and social affairs.
The Principles of Political Economy (Mill
1848) was essentially a textbook
summarizing the economic wisdom
prevailing in mid-nineteenth-century
England. The book went through numerous
editions, and dominated economic teaching
in England for half a century (until the
publication of Marshall’s Principles).
One important contribution of the
Principles was its analysis of future
economic growth. Here Mill attempted to
find a middle path between Smith and
Malthus. As we have seen, Smith saw
societies becoming wealthier as a result of
greater freedom to trade, technological
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JOHN STUART MILL
innovation, and the division of labor and
capital investment. Malthus, on the other
hand, saw economic progress limited by the
press of people against fixed resources. Mill
saw both sets of forces operating at once.
Rather than predicting the ultimate outcome
of these conflicting forces, he (Mill 1848,
Book 4) set forth several possibilities or
scenarios for the future. As a result, Mill
deserves credit for being the first economist
to recognize that long-run trends or
outcomes cannot be forecast with certainty,
but depend on how various opposing forces
work themselves out over an extended time
period. A first scenario followed pretty
much along Malthusian lines—population
grew more quickly than capital and
technology could increase output. In this
case, as in Malthus, the result would be
lower wages and higher profits. The living
standard of the ordinary worker had to
decline.
A second scenario closely followed the
analysis of Smith—capital accumulation
increased faster than the population grew.
Here real wages rose, thus making the
average worker better off.
In a third scenario, the supply capital and
the population increased at the same rate,
but technology was relatively stable.
Because the supply of labor and the demand
for labor increased at the same rate there
would be no change in real wages. But since
technology did not improve, inferior land
had to be used to feed the growing
population because the most fertile land
would be used first (see also RICARDO).
This increased the cost of producing food.
With food prices and rents increasing,
profits had to fall. This is essentially the
Ricardian outcome.
Fourth, Mill noted that technological
advances might improve more rapidly than
capital and population grew. This would
make it easier to grow food, and would lower
both wages and rents. As a result profits
would rise, and the economy would prosper.
Mill thought that the third scenario was
the most likely of all the possible future
outcomes. Living in the middle of the
Industrial Revolution, and having no
experience with concerted, long-term
technological advance, it was somewhat
natural for Mill to believe technological
progress must come to an end. When this
happened, Mill argued, capital accumulation
and economic growth also would come to an
end, as Ricardo predicted.
Most classical economists feared the end
of economic growth. Mill, in contrast,
thought that the stationary state would have
many benefits. The most important benefit
of all was that the end of growth would end
the perpetual rat race of industrial life.
I am not charmed with the ideal of life held
out by those who think that the normal state
of human beings is that of struggling to get
on; that the trampling, crushing, elbowing, and
treading on each other’s heels.
(Mill 1848, p. 334)
Mill helped bring classical theory to
completion in other ways. One problem left
unanswered by the theory of comparative
advantage (see also RICARDO) was how
the gains from international trade get
divided up between countries. Mill
explained that most of the gains from trade
would go to that country with the lower
demand and the greater elasticity of
demand. If demand is elastic, a change in
price will yield a large change in quantities
bought by consumers. On the other hand, if
demand is inelastic, consumers will not be
swayed much by price changes.
Mill explained that if the US had less
need for Japanese automobiles and could
easily do without Japanese automobiles
(i.e., if our demand for Japanese
automobiles was relatively elastic), while
Japan could not do without American food
and had a great appetite for American
food, most of the gains from
specialization and trade would go to the
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JOHN STUART MILL
US. The US would sell food to Japan at a
high price and get their automobiles
cheaply. On the other hand, if Americans
are hooked on Japanese automobiles and
cannot get these goods elsewhere, while
Japan finds alternate sources of food,
most of the gains from trade will go to
Japan. In this case, the high and inelastic
demand for cars in the US means that
Americans pay high prices for Japanese
cars, while the low and inelastic demand
in Japan means that the Japanese get
American food cheaply.
Mill made his most lasting contributions
to economics not when he extended
classical economic analysis, but when he
began to think in new ways. He was the
first economist to speak of supply and
demand as schedules or relationships
(Stigler 1965). In the work of Smith,
Ricardo, and other classical economists,
supply and demand were treated as
quantities of goods brought to market and
as quantities of goods bought by
consumers. Mill recognized that quantities
responded to changes in price. As prices
increased businesses would bring forth
greater quantities of goods to the market,
and as prices fell consumers would
purchase greater quantities of the goods
provided by businesses.
Mill was also the first to formulate the
notion of opportunity cost. Any human
action involves giving up the opportunity
or ability to do something else. The
opportunity cost of any action includes
financial costs as well as non-financial
costs. Deciding to pursue a college
education requires spending money on
tuition, books, and other things. There are
opportunity costs involved since other
goods cannot be purchased because a
college education was bought. These other
goods are given up, or are lost
consumption opportunities. But there are
further costs of a college degree. When
going to school one is not earning money.
Thus one gives up the income that could
have been earned by not going to school.
The total opportunity cost of a college
education includes both the money spent
for schooling and the lost wages from
attending school.
Mill’s most important contribution to
economics may be his rejection of the
classical wage fund doctrine. This doctrine
holds that worker wages were a form of
capital and paid out of a fund that
businesses accumulated before producing
goods. On this view, the only way to
increase both wages and employment would
be for the entrepreneur to accumulate more
profits. Mill (1869b) argued that there was
no fixed amount that businesses had to pay
labor. The amount of money that firms
could pay as wages was flexible, and it was
determined by the willingness of employers
to pay workers more. Mill also noted that
business owners could always reduce their
own consumption of goods, for example
buying $5 million homes rather than $20
million homes. This would make more
money available for workers. Consequently,
there was no fixed wage fund. More money
was always available to increase wages or
to hire more workers; and business owners
and workers can always negotiate over
wages.
Mill achieved fame not only for his
economics, but also for his philosophical
and political writings, both of which dove-
tailed with his economic work. Mill (1863)
defended the utilitarian philosophy
developed by his father and Bentham, and
that had come to form the foundation for
much of economics.
More important, his “On the Definition
of Political Economy” (in Mill 1844) was
the first attempt by an economist to examine
the issue of economic method. Mill wanted
to know if the social, behavioral, and moral
sciences (such as economics) were like the
natural sciences. His answer was “no”
because controlled experiments were not
possible outside the natural sciences. It is
impossible to set up two economies,
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JOHN STUART MILL
identical in all respects except for the one
factor we wish to alter, in order to study its
overall impact. Since economic knowledge
could not come from experience, Mill
reasoned that it must come from
introspection. We know from examining
ourselves that people behave in ways that
attempt to maximize the pleasure they
received. And we know that all attempts to
maximize pleasure are constrained by
nature—we can only work so hard and so
long, and we can only produce so much in
any given year. Economics, for Mill, is thus
the science that deduces the consequences
of these assumptions, just like geometry is
a science that proves theorems about
triangles and circles after starting with
assumptions about points, lines, and angles.
Finally, On Liberty (Mill 1859)
discussed the limits of government and
societal restrictions on individual freedom.
Mill argued that the state and society had
a right to restrict individual freedom only
to keep one individual from harming
another individual. On Liberty was thus a
ringing endorsement of laissez-faire. In
contrast to Smith, who argued for laissez-
faire because it maximized material well-
being, for Mill laissez-faire was desirable
primarily because it resulted in the greatest
individual self-development. The
Subjection of Women (Mill 1869a) also
advocated equality for women on the
grounds of self-development. Mill argued
that the greatest obstacle to the liberation
of women was received opinion and
custom that relegated women to a
subordinate position in society. This
limited the development of half the
population. It also limited the ability of
society to progress. By allowing women to
compete with men for jobs and for all other
positions, society would gain by having the
best and most qualified person in every
position.
During his lifetime, Mill was regarded
as one of the two or three most prominent
economists. However, today Mill is not
counted among the very best and most
important economists. Part of the reason
for this is that while he added bits and
pieces to economic analysis, Mill made no
major advances. Moreover, as a transitional
figure, Mill left no school of followers to
further and continue his work. Yet another
factor is that there was no single area of
economics in which Mill specialized and
made major contributions. Rather, the work
of Mill encompassed numerous and
disparate areas —methodology, theory,
policy, labor economics, international
trade, and political theory.
Works by Mill
Essays on Some Unsettled Questions of Political
Economy (1844), New York, Kelley, 1968
Principles of Political Economy, 2 vols. (1848),
New York, Oxford University Press, 1994
On Liberty (1859), Indianapolis, Indiana,
Hackett, 1978
Utilitarianism (1863), Indianapolis, Indiana,
Bobbs Merrill, 1957
The Subjection of Women (1869a), Cambridge,
Massachusetts, MIT Press, 1970
“Thornton on Labour and It’s Claims,” Fortnightly
Review, 5, May 1869b, pp. 505–18. Reprinted
in Collected Works of John Stuart Mill,Vol. 5,
Essays on Economic and Society, London,
Routledge & Kegan Paul, 1967, pp. 631–68
Autobiography (1873), Indianapolis, Indiana,
Bobbs-Merrill, 1957
Works about Mill
Hollander, Samuel, The Economics of John
Stuart Mill, Toronto, University of Toronto
Press, 1985
Schwartz, Pedro, The New Political Economy of J.
S.Mill, Durham, Duke University Press, 1972
Stigler, George J., “The Nature and Role of
Originality in Scientific Progress,” in Essays
in the History of Economics, Chicago, Illinois,
University of Chicago Press, 1965, pp. 1–15
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KARL MARX
KARL MARX (1818–83)
Although the name Karl Marx is most closely
associated with socialist economic systems,
Marx actually wrote very little about socialism.
Rather, he studied the operation of capitalist
economies and analyzed the problems that arise
under capitalism. He then argued that these
problems could not be remedied by economic
policies, or by other actions to make the system
work better, because they were essential
characteristics of capitalism. These problems,
Marx thought, would continue to fester and
eventually destroy capitalist economies.
Marx was born into a middle-class Jewish
family in Trier, Germany in 1818. He was first
educated at home by his parents and Baron von
Westphalen, a close friend and neighbor of his
father. Marx then went on to attend high school
in Trier. Upon graduating, he decided to go to
the University of Bonn to study law, but shortly
after beginning his studies he became bored
with legal issues and developed an interest in
philosophy. In order to pursue this interest
Marx transferred to the University of Berlin,
which at the time was the hub of Hegelian
philosophy.
According to Hegel, human life was
constantly in flux; every idea and every force
generated an opposite force, and the tension
generated by these two opposing forces would
inevitably lead to change. Marx embraced the
Hegelian notion of change; and his idea of all
economic systems generating opposing forces
and then undergoing radical transformation
derives from the philosophy of Hegel. It should
go without saying that this vision threatened
political leaders, who preferred the status quo,
and business leaders, who saw Marx and his
followers as attempting to ruin their good thing.
In 1841 Marx received a Ph.D. in
Philosophy, and in 1843 he married the
daughter of the Baron von Westphalen. Unable
to get an academic job teaching philosophy,
and without many marketable skills, he worked
as editor of the liberal-left newspaper
Rheinische Zeitung. Within a year the paper
was banned by Prussian censors. Seeing no
future in Germany, Marx moved to Paris, where
he began to associate with numerous socialists
and communists. In Paris, Marx also met
Frederick Engels. Engels was the son of a
wealthy textile manufacturer and a well-known
economist in his own right. His classic, The
Condition of the Working Class in England
(Engels 1844), described the sad state of
working class families in the industrial towns
of northern England. Engels and Marx quickly
became friends and collaborators. Perhaps as
important, Engels provided financial support
to Marx during the rest of his life.
Because of his radicalism, Marx was
expelled from Paris after a short period of time.
He tried living in Brussels, but was soon
expelled from there as well. Finally, he moved
to London, where he was accepted by political
authorities, although not necessarily with open
arms. Marx lived the last 33 years of his life in
London, spending most of his time at the
British Museum, reading and writing
economics.
The economic writings of Marx attempt to
understand how capitalist economies work,
and where capitalism fits into the economic
history of mankind. Marx saw capitalism just
as one phase of an historic process that all
economies move through. Human economic
activity, Marx noted, began in hunting and
gathering societies. Then people settled down
and formed agricultural communities, which
shortly developed into feudal economies.
Under feudalism, landowners provided
protection for peasant fanners, and peasants
provided part of their output to the landowner.
Feudalism, in turn, was transformed into
capitalism due to the rise of businessmen who
engaged in small-scale manufacturing and
who traded goods both domestically and
internationally.
As was true of each economic epoch, Marx
recognized that capitalism possessed both
positive and negative aspects. Among its
positive attributes was the ability to increase
average living standards through the use of
more advanced technology and machinery (see
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KARL MARX
also SMITH), and the ability to attract workers
to towns and cities, and away from “the idiocy
of rural life.”
But the negative attributes of capitalism
dominated the positive ones, according to
Marx. Moreover, Marx saw these problems as
being essential parts of the capitalist system.
Reform efforts, which attempted to mitigate the
negative aspects of capitalism, could not really
solve the deep-seated problems, or save
capitalism from its ultimate fate. Indeed, in The
Communist Manifesto, Marx and Engels (1948,
Ch. 2) advocated a number of such reform
measures including free public libraries, free
education, the abolition of child factory labor,
a graduated income tax, the end to all
inheritances, government control of
communications and transportation networks,
and the establishment of a national bank. But
Marx saw these policies as band-aids to make
life more tolerable under capitalism; he did not
think they could fundamentally change the way
capitalism operated or keep it from self-
destructing. No matter what policies were put
into effect the capitalist system was destined
to collapse at some point under the weight of
the many problems that it created. Most of the
economic writings of Marx attempted to
identify and explain these problems.
One crucial characteristic of capitalism,
according to Marx, is that it exploits
individual workers. To understand the notion
of exploitation, it is necessary to understand
Marx’s analysis of the value of any good.
Following Ricardo, Marx adopted a labor
theory of value. This theory held that the
value of any good depended upon the amount
of labor spent producing it. This labor could
either be direct labor, which is current work
effort, or indirect labor, which is the amount
of labor that went into making the machinery
that was used in producing the good.
Marx then divided the value of all goods
into three categories—constant capital, variable
capital, and surplus value. Constant capital
referred to the machinery, plants, and
equipment used up in the production of a good;
this notion is similar to the notion of
depreciation that is familiar to all accounting
students. Variable capital refers to the current
wage bill, or what workers are paid to help
produce goods. Marx defined surplus value as
the value of a product over and above wage
and depreciation costs. It is similar to the more
familiar notion of profit. Marx provided a
second, and similar, perspective on surplus
value. He noted that the essence of capitalism
was to take money (M), use this money to buy
things (labor and machines) that could produce
some commodity, and then sell that commodity
for a greater amount of money (M’). Surplus
value could thus also be defined as the
difference between M’ and M.Marx held that
the appropriation of surplus value by the
owners of capital constitutes exploitation.
Exploitation was made possible by the fact
that workers had to offer their services or work
effort because they owned no capital and could
not support themselves in any other way.
Through their daily efforts, workers created
something of value. They produced goods, and
they produced machinery that could help
produce even more goods in the future. But
workers did not receive the full value of
everything they produced. Some of the value
they created was taken by their employer in
the form of surplus value. At the beginning of
the workday, workers produced enough goods
so that the sale of these items would pay for
their wages plus wear and tear on the
machinery used in production. For the rest of
the day, however, laborers worked to enrich
their employer.
Marx noted that capitalists had three
means at their disposal to increase surplus
value and thus the exploitation of workers.
First, they could increase the length of the
workday, so that during each day more
surplus value was created. Second, they
could increase the intensity of work effort,
so that workers produced more goods in a
given time period. One means of increasing
work intensity was to increase the speed of
the assembly line. Another was to increase
the monitoring and control of workers, so
that workers were less able to slack off.
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In these cases, workers produced more
during the day; and with variable and constant
capital fixed, more output would translate into
greater surplus value. Finally, capitalists could
increase surplus value by reducing the wage
bill. One obvious way to do this would be to
lower the wages of current employees.
Alternatively, women and children could be
hired to replace men and paid less. In the late
twentieth century we could look at firms
moving to less developed countries (where
labor costs are much lower than in developed
countries) as another way to reduce the wage
bill. These three strategies all have the same
effect—they lower wages and increase
exploitation or surplus value.
Marx did recognize that there were limits
to the exploitation of workers by these
methods—workers could physically endure
working just a certain number of hours each
day, technology and physical capabilities
limited the extent to which an employer might
speed up the assembly line, and families had
to be paid enough to buy the necessities that
would enable them to survive and work in the
future. Competition, however, forced firms to
maximize their exploitation of workers. In a
competitive environment, not every firm will
be profitable and thrive. Firms unable to do as
well as their many competitors will invariably
go out of business. Competition among firms
thus forces each firm to exploit its workers
more in order to lower costs, increase profits,
and remain in business. Only those firms
exploiting their workers to the fullest extent
possible will survive; other firms will cease to
exist because their costs of producing goods
will be too high. Competitive capitalism thus
guarantees that workers live on the edge of
subsistence and that they get exploited to the
maximum extent.
A second major problem with capitalism
that Marx noted is that it creates alienated
workers. Alienation had four aspects. First,
under capitalism workers become alienated
from how they produce. Marx thought that
human beings were naturally creative and
wanted to control and shape their environment.
But, contra Adam Smith, the division of labor
did not promote dexterity and skills; rather it
transformed the production process into
simple, monotonous tasks. Work became
boring and had no meaning except as a source
of income; it destroyed the creative, emotional,
aesthetic, and intellectual potential of the
worker (see Braverman 1974). Thus, rather
than work being an integral part of human life,
this aspect of alienation leads to the familiar
aphorism “life beginning when work ends.”
A second reason for alienation under
capitalism is that workers lose control over the
goods that they produce. The individual
craftsman, Marx noted, could take pride in
what he produced. For the assembly line
worker, however, this is not the case. These
workers are not responsible for producing the
final product and can take little pride for the
small part they play in producing it. In addition,
the capitalist system leads inexorably to the
production of cheap and shoddy merchandise.
Capitalists always seek to produce at the lowest
possible costs. Again, survival is at stake. One
way to cut costs is to cut corners. Thus quality
tends to suffer, and workers tend to turn out
cheap junk that they can take no pride in having
made. By losing control over the means of
production workers become alienated from
what they produce.
A third reason for alienation is that under
capitalism the surplus value created by workers
goes to enrich their employer. People work hard
all day long. But these efforts only improve
the absolute position of the capitalist; they do
not improve the absolute standard of living of
the individual worker who puts in all the effort.
Workers always and only receive subsistence
wages. This means that the relative position of
the worker worsens as a result of working hard.
The standard of living for workers remains at
the bare minimum necessary for survival, while
capitalists increasingly become richer and
richer. Marx believed that this characteristic of
capitalism stemmed from the fact that
capitalists monopolized the means of
production. Workers had to work in order to
earn enough money to eat and survive.
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Capitalists, in contrast, owned enough property
so that they could live well without working
or producing. Thus workers were at a great
disadvantage relative to capitalists and were
forced to accept subsistence wages.
Finally, Marx contended that under
capitalism the labor power of the worker
becomes the property of the capitalist
employer. The worker is thus alienated from
himself or herself. There is a loss of individual
freedom and self-respect; employment
becomes a form of slavery for the worker.
Alienation and exploitation of workers lead
inevitably to a class struggle between
capitalists, who own the means of production,
and workers, who do not. This struggle, Marx
thought, would lead to the destruction of the
capitalist system when the pressures on
workers became too great. And competition
among capitalists guaranteed that such
pressures would continue to rise and build.
Marx always placed his analysis of the class
struggle in an historical context, noting over
and over that capitalism arose out of a
predominantly agricultural and feudal society.
Capitalism destroyed feudal ties. It would
therefore not be surprising if capitalism were
replaced with another socio-economic system,
socialism, where workers owned the means of
production and made decisions regarding
working conditions, quality of output, prices,
wages, etc. Moreover the forces that would
eventually cause capitalism to self-destruct
were all integral parts of the capitalist system.
First, capitalism was about taking fortunes
and using them to create larger fortunes. Large
fortunes are needed because they bring power
and prestige. Also, each capitalist was always
under pressure from other capitalists. Anyone
trying to stand still would quickly be forced
out of business by competitors, lose prestige
and power, and have to seek employment as a
worker (i.e., be exploited and alienated).
Second, capitalism was characterized by an
unending drive towards monopoly and
economic concentration. Monopolists made
huge profits. In contrast, the firms in a
competitive environment tend to compete their
profits away. All firms, therefore, desire to
become large and all desire to be monopolies.
The process of competition crushes the weak
and the small, or they become absorbed by the
big and the strong. Furthermore, to remain
competitive a firm had to constantly improve
worker productivity; but technological
improvements required increasing amounts of
capital. Thus larger and larger firms were needed
to supply this rising capital requirement. These
tendencies towards monopoly meant that small
businesses would be bankrupted by large firms,
small businessmen and women would soon
become workers for these large monopolies, and
more and more people would come to resent
monopolies.
A final force leading to the demise of
capitalism was the tendency for profit rates to
fall. Capitalism is all about trying to
accumulate more and more wealth. To win at
the game, more and more efficient machinery
must be bought and used. As such, the
production process comes to rely on relatively
more capital and relatively less labor. The profit
rate though equals total profits divided by the
initial monies put out to produce goods. In
Marx’s terminology, the rate of profit equals
the ratio of surplus value to constant plus
variable capital. Since surplus value comes
from exploiting workers, using more
machinery and fewer workers can only reduce
surplus value and the rate of profit.
The tendency to replace labor with
machinery also increases unemployment. This
“reserve army” of the unemployed helps to
keep wages down and counters the tendency
of the rate of profit to fall. But at the same time,
higher unemployment and lower wages lead
to greater social unrest. And it is this, more than
anything else, that will help bring about the
end of capitalism.
These many pressures on the capitalist
system, Marx thought, would continue to build
until the system is finally destroyed. As Marx
(1957–62, Vol. 1, p. 929) writes:
the mass of misery, oppression, slavery,
degradation and exploitation grows; but with
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this there also grows the revolt of the working
class, a class constantly increasing in numbers,
and trained, united and organized by the very
mechanism of the capitalist process of
production…. The centralization of the means
of production and the socialization of labor
reach a point at which they become
incompatible with their capitalist integument.
The integument is burst asunder. The knell of
capitalist property sounds; the expropriators
are expropriated.
Marx had little to say about economic life
or the economic world after capitalism. He was
clear that workers rather than capitalists would
own the plants and factories used to produce
goods and services. This is the traditional
definition of a socialist economic system. It is
also clear that Marx envisioned a more equal
distribution of income and wealth under
socialism than existed under capitalism. But
beyond this, there is nothing in the work of
Marx. Yet, even without a clear vision of the
future, Marx continued to inspire nineteenth-
century workers to organize and to rebel against
capital oppression.
With Adam Smith and John Maynard
Keynes, Marx must be regarded as one of the
three greatest figures in the history of
economics. Unlike Smith, who primarily saw
the benefits that would accrue from a free
market capitalist economy, Marx saw the dark
side of capitalism and saw this as leading to
its ultimate demise. And unlike Keynes, who
looked towards rational government policy to
save capitalism, Marx thought capitalists
would buy out government officials.
Politicians, therefore, would not put into place
any policies such as unemployment insurance,
welfare systems, maximum hours or
minimum wages, that might improve the
condition of workers and keep class conflicts
from becoming violent and revolutionary.
Likewise, Marx did not think government
policy would be employed to keep
unemployment down, provide legal
recognition for labor, or help labor unions gain
bargaining power. Yet many social policies
were put into effect throughout the world in
the twentieth century, governments did assist
labor unions, and labor —management
conflicts were reduced to manageable
proportions.
In the end it seems that Marx
underestimated the flexibility of the capitalist
system and its ability to change in order to save
itself. He also seems to have underestimated
the ability of democratic governments to rise
above the capital-labor conflict, and to
implement policies that soften the harsh, and
sometimes brutal, aspects of capitalism. But
despite these flaws in his predictions, probably
no one has understood the dynamics of the
capitalist system and the tensions it creates
among its various participants better than Marx.
Works by Marx
The Communist Manifesto, New York,
International Publishers, 1948, (with Frederick
Engels) Capital, 3 vols., Moscow, Foreign
Languages Publishing House, 1957–62
Theories of Surplus Value, 3 vols., Moscow,
Foreign Language Press, 1963
Value, Price and Profits, New York, International
Publishers, 1976
Wage-Labor and Capital, New York, International
Publishers, 1976
Works about Marx
Heilbroner, Robert, Marxism: For and Against,
New York, Norton, 1980
McLellan, David, Karl Marx: His Life and
Thought, New York, Harper & Row, 1973
Robinson, Joan, An Essay on Marxian Economics,
London, Macmillan, 1960
Sweezy, Paul, The Theory of Capitalist
Development: Principles of Marxian Political
Economy, New York, Monthly Review Press,
1970
Wolff, Robert Paul, Understanding Marx: A
Reconstruction and Critique of ‘Capital’,
Princeton, New Jersey, Princeton University
Press, 1984
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Other references
Braverman, Harry, Labor and Monopoly Capital,
New York, Monthly Review Press, 1974
Engels, Frederick, The Condition of the Working
Class in England (1844), Moscow, Progress
Publishers, 1973
LÉON WALRAS (1834–1910)
Léon Walras (pronounced VOL-wras, with a
German W and the S enunciated) is known
primarily for developing general equilibrium
analysis. He took a very abstract and theoretical
problem about how all markets in an economy
are related, applied sophisticated mathematics
to the problem, and arrived at a solution. His
solution showed that all the markets in the
economy could simultaneously achieve
equilibrium.
Walras was born in Evreux, France (around
90 kilometers west of Paris) in 1834. His father,
a teacher and an economist, stressed that
mathematics would come to be used
increasingly in the social sciences. Walras
revered his father and wanted to live up to the
high expectations that his father set for him.
So after graduating from high school, Walras
applied to the prestigious École Polytechnique.
Ironically, he was turned down because he
lacked the necessary background in
mathematics and twice flunked the entrance
examination. As a result, Walras wound up at
the École des Mines studying engineering
rather than social science. Not really interested
in engineering, he spent his time reading
literature, philosophy, art, history, and the
social sciences. Eventually he dropped out of
school. Walras then started writing novels, but
he was not successful at this endeavor either.
In 1858, during an evening walk, his father
suggested that making the social sciences akin
to the natural sciences was one of the major
jobs remaining to be accomplished in the
nineteenth century. Walras promised his father
he would give up writing novels and devote
his life to developing a scientific economics.
Inspired by his reading of Cournot, as well as
by his father, he decided to make this scientific
economics a mathematical economics.
Progress towards this end, however, was
slow and hard. Walras wrote articles for
economics journals, but all he had to show for
his efforts was a pile of rejection letters.
Nonetheless, Walras learned more mathematics
and he continued to praise the virtues of
making economics more quantitative. During
the 1860s, while working on his mathematical
economics, Walras supported himself as a
newspaper columnist and as an administrator
for a railway company. Finally, his efforts
began to pay off. In 1870 he received a teaching
position with the law faculty of the Lausanne
Academy.
Walras was not happy teaching at Lausanne.
Neither his few students nor his law faculty
colleagues were especially interested in
mathematical economics. However, Walras
persevered and continued to write. He sent his
articles, free of charge, to others using the
inheritance he received following the death of
his mother. These articles helped Walras
achieve international recognition and numerous
awards for his contribution to economic
science. Towards the end of his life he was
made an honorary member of the American
Economic Association.
Walras made several important
contributions to economics. Along with Jevons
and Menger, he was one of several independent
discoverers of the notion of marginal utility.
He was one of the first and strongest advocates
of methodological individualism, the belief that
all explanations of economic phenomena
should be based upon individual acts of choice
(Hicks 1934, pp. 347f.). But Walras is best
known for constructing a general equilibrium
economic model, which views the economic
system as a set of interrelated mathematical
equations. Walras then explained how to solve
this set of equations for all prices and
quantities.
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The notion that different sectors of any
economy are related to each other has a long
history in economics; the idea goes back at
least as far as Cantillon and Quesnay. Walras
added two important things to this vision—
a mathematical representation of how all
markets were interrelated, and an argument
that economies would move towards
equilibrium in all markets.
Walras recognized that whenever one
market moved towards equilibrium, or
whenever one market was affected by outside
forces, these changes would upset the
markets for other goods. For example, in the
1970s when OPEC raised oil prices,
consumers wound up paying more for
gasoline and heating oil. With more
consumer dollars going to energy-related
products, less could be spent on other goods.
As a result, the producers of these other
goods had to cut back production and lay off
workers. These lay-offs, in turn, would
further reduce consumer spending, leading
to further production cutbacks and lay-offs.
In addition, the energy shock affected the
costs of producing goods. Even those goods
using little energy in production still require
energy when transported from where they get
produced to where consumers buy them.
Similarly, the parts required for production
have to be transported from elsewhere. On
the other hand, the lay-offs due to reduced
spending will push down wages.
Consequently, the rising cost of energy
should increase the price of some goods
(those using little labor and much energy)
and reduce the price of other goods (those
using little energy and much labor).
Consumers will tend to cut back their
spending on those goods whose prices rise,
and will buy more of those goods whose
prices fall or remain stable. But these
changes in consumer spending will change
the quantities of inputs (such as workers and
energy) that businesses want to hire. This
changed demand for inputs will, in turn,
change input prices. Again, when input
prices change, the cost of production will
change and so too will the final price of each
good.
The question raised by the notion of
general equilibrium is whether all these
changes tend to slow down and stabilize at
some point, so that all markets reach a point
where there are no more forces of change
affecting any good or input. Walras answered
this question with an unqualified “yes.” To
support this answer he set up a series of
mathematical equations representing the
market for every good and for every input in
the economy.
There were four sets of equations in his
economic model. The first set showed the
quantity of each good that consumers
demanded. Consumer demand was based
upon individual preferences and the price
of every good that consumers could
purchase. Each good sold to consumers
could be represented by a mathematical
equation relating the amount of the good
consumers wanted to their income and the
price of every good.
A second set of equations described what
determines the price of every good bought
by households. Walras assumed that all
markets were competitive and that firms
could not charge high prices based upon their
monopoly power. This enabled him to set the
price of each good equal to its cost of
production (the price of inputs times the
quantity of each input used).
These first two sets of equations dealt
only with product markets, or goods sold to
consumers. But another set of markets
operates in all economies. These are factor
or input markets. They are where
remuneration is determined for the factors
of production—the wages received by
workers, the rental payments received by
landlords, and the profits received by owners
of capital. Factor markets contribute two
more sets of equations. One set shows the
quantity of inputs or factors (land, labor, and
capital) offered to help produce goods.
Owners of factor inputs (workers,
landowners, and capitalists) determine the
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quantity of factors they wish to supply. This
decision will be based upon how
disagreeable it is to work or supply their
input into the production process, and also
on how much can be bought with the income
received from helping to produce goods. The
reward for working, in turn, depends on the
price of goods and the income received from
working.
A final set of equations show the quantity
of inputs or factors that businesses want to
buy. This depends on the final demand for
goods (how much consumers want to buy at
different prices), on production technology,
and on the cost of all inputs (enabling
businesses to figure out the least costly way
to produce things). For example, if
consumers decide to spend more money on
clothing, clothing manufacturers will need
to hire more workers and buy more
machinery. Alternatively, higher wage costs
or new labor-saving technology will reduce
the demand for labor and increase the
demand for machines.
So far we have four sets of equations—
one showing the quantity of goods
demanded, one relating price to costs of
production, one showing the quantity of
inputs supplied, and one showing the
quantity of inputs demanded. We also have
four sets of unknowns that we need to solve
for: (1) the price of each good, (2) the
quantity of each final good bought and sold,
(3) the price of each factor of production, and
(4) the quantity of each factor supplied and
bought by business firms.
But Walras adds one more equation to his
mathematical system. This equation
stipulates that all the money received by
various factors of production must be used
to buy something. This can be done either
directly by each household spending all their
income, or indirectly by some households
saving money and then lending this money
to other households.
This extra equation created a difficult
problem for Walras. As all students of
algebra learn, to solve a set of mathematical
equations it is necessary that the number of
equations equals the number of unknowns.
Walras now had one more equation than the
number of unknowns. To deal with this
problem Walras selected one good, G1,
arbitrarily; the prices of all other goods
would be determined relative to G1. The
price of G1 thus would be a standard of
comparison, or numéraire. Mathematically
the number of unknowns would now equal
the number of equations in the general
equilibrium representation of the economy.
The system could thus be solved for the price
of all goods relative to G1. The solution
could not explain the absolute level of prices,
or why a gallon of milk cost $2 rather than
$1 or $4. But it could explain why a gallon
of milk costs twice as much as a dozen eggs
and four times as much as the daily
newspaper.
This vision of the economic system as a
set of equations is quite abstract. One
question that naturally arises after working
through a mathematical proof for the
existence of general equilibrium is “what, if
anything, does this have to do with the real
world?” After all, in the real world things
change all the time; and in the real world
there is no master economist who solves a
large set of equations in order to determine
prices of each good and wages received by
each worker. Walras believed that his
mathematical solution to the system of
equations would be the same solution
reached by markets in the real world. But
how could the real world achieve equilibrium
without a master economist to solve the
many mathematical equations?
Walras devised an answer which he felt
showed that his abstract model and his
mathematical equations were good
depictions of actual reality. His answer was
two-fold. First, Walras held that all traders
wanted to maximize utility and that utility
maximization and competition moved the
whole economy to the set of equilibrium
prices ground out by his equations. Second,
Walras introduced the notions of the
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auctioneer and the tâtonnement (which
means groping) process.
Imagine a big auction, where producers
bring their goods to sell and where
consumers come to buy goods. Producers set
prices for their goods and these prices are
called out by the auctioneer. Of course, at
some prices, some goods will have too many
buyers and other goods will have too few
buyers. The auctioneer then notes these cases
of too many buyers and too few buyers, and
raises prices in the former case while
lowering prices in the latter case. Buyers and
sellers would then revise their offers to buy
and sell goods. Again, there may be
shortages of some goods while other goods
will find too few buyers. The auctioneer
would take this new information into account
and again revise prices accordingly. Through
successive iterations of this process, Walras
argued, the auctioneer would grope towards
the set of equilibrium prices for the whole
auction. Only then would exchange take
place and, at the set of equilibrium prices,
all markets would clear. Walras thought that
market prices naturally behaved the way that
the mythical auctioneer did. Market prices
rise when there are more buyers than sellers
and fall whenever there are more sellers than
buyers. In this way, the market system gropes
its way to a position of general equilibrium.
Unfortunately, the auctioneer and the
tâtonnement process do not fully solve the
problem of real world applicability. The
groping process seems as divorced from
reality as a set of mathematical equations
proving general equilibrium. In the real
world trades take place before the final set
of general equilibrium prices is reached
through the groping process. Also, the final
equilibrium will likely be affected by any
exchanges that take place before the whole
system balances (Hicks 1934).
Another problem with the tâtonnement
process is that in the real world suppliers
change prices rather than omniscient
auctioneers; and being human, they may
make mistakes and raise rather than lower
prices (or vice versa). Moreover, real world
suppliers set prices based upon expected
demand in the future rather than current
conditions.
Finally, as von Neumann (see below) was
quick to recognize, the mathematical
solution to a Walrasian set of equations could
conceivably contain negative prices. It could
also contain prices whose value is zero. Yet
in the real world this is impossible.
Businesses will not give away goods for free.
Nor will they produce goods and then pay
people to purchase them, which is what
would occur when we get negative prices
after we solve a set of Walrasian equations.
All these problems, however, do not
detract from the great achievement of Walras.
Walras forced economists to focus on the
interrelationships among different markets.
He formalized the notion of general
equilibrium, and showed economists how it
was possible to study an interrelated
economy as a set of mathematical equations.
He raised the important issues of
convergence to equilibrium and the stability
of economic equilibrium, and he attempted
to explain how economies could reach
general equilibrium. For these achievements,
Walras must certainly be regarded among the
half dozen most important figures in the
history of economics.
Works by Walras
Elements of Pure Economics (1874 and 1877),
Homewood, Illinois, Irwin, 1954
Correspondence of Léon Walras and Related
Papers, 3 vols., ed. W.Jaffé, Amerstam, North-
Holland, 1965
Works about Walras
Hicks, John R., “Léon Walras,” Econometrica, 2,
4, October 1934, pp. 338–48
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WILLIAM STANLEY JEVONS
Jaffé, William, Essays on Walras, ed. Donald A.
Walker, Cambridge, Cambridge University
Press, 1983
Jaffé, William, “The Antecedents and Early Life
of Léon Walras,” History of Political Economy,
16, 1 (1984), pp. 1–57
Schumpeter, Joseph, “Marie Esprit Léon Walras,”
in Ten Great Economists, New York, Oxford
University Press, 1951, pp. 74–9
WILLIAM STANLEY JEVONS
(1835–82)
William Stanley Jevons (pronounced Jev-ins,
with a soft e) is best known for developing a
theory of relative prices, or exchange values,
based upon the notion of marginal utility. In
contrast to early nineteenth-century classical
economists, who held that the costs of
production determined relative prices, Jevons
argued that relative prices depend upon
subjective assessments by people of the
satisfaction to be gained from purchasing
different goods. Jevons also made
contributions to growth theory and business
cycle theory.
Jevons was born into an upper middle
class family in Liverpool, England in 1835.
His father was an iron merchant and his
mother came from a prosperous family of
bankers and lawyers. The family wealth
enabled Jevons to receive an excellent
education. At first he was tutored at home;
then he attended private schools and
University College in London, where he
studied metallurgy and mathematics (with
the world-famous Augustus DeMorgan).
When the British railway boom ended,
the family iron business went bankrupt. To
help his family deal with their financial
problems Jevons abandoned his studies in
1854. He then trained as an assayer and took
a job at the Sydney Mint in Australia
(Könekamp 1962, pp. 255f).
A dispute over the funding of a railway
line for New South Wales initially sparked
his interest in economics; and Jevons was
soon reading the great classical economists,
especially Smith, Malthus, and John Stuart
Mill. A powerful desire to do good,
especially a wish to help nations grow and
prosper, prompted Jevons to continue his
education. Returning to England in 1859,
and to University College in 1860, Jevons
studied mathematics, political economy,
philosophy, and history. Although he was
disappointed with his political economy
courses and felt that he got more from
reading on his own than from attending
lectures, he continued with his studies and
received both an undergraduate and a
master’s degree in political economy from
University College.
Jevons then accepted a position at Owens
College in Manchester, where he taught for
the next 13 years. In 1876, Jevons left Owens
College to become Professor of Political
Economy at University College, London.
This appointment had light teaching and few
administrative duties, thus allowing Jevons
the time to pursue his own writing. But by
1880 Jevons again found it difficult to juggle
both his teaching duties and his writing
ambitions, so he resigned from University
College in order to focus more on writing.
Unfortunately, by that time his health had
deteriorated due to overwork, and two years
later he collapsed while swimming and
drowned.
The first book that Jevons (1865)
published, The Coal Question, was alarmist
and Malthusian. It forecast a severe energy
shortage for England. Jevons began by
estimating the existing supply of coal in
England. He then estimated the rate at which
coal consumption was increasing. Putting
these two estimates together, Jevons found a
continually increasing demand for a
depleting supply of coal reserves. The
consequences could only be sharply rising
coal prices. Even worse, at some point the
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WILLIAM STANLEY JEVONS
dwindling supply of coal would stop
economic growth in England.
Jevons was not optimistic that energy
substitutes for coal could be found. Nor did he
think conservation efforts could do anything
but push back slightly the date at which
economic growth would come to an end. More
surprisingly, Jevons ignored two obvious
policy solutions—a tax on coal and a
prohibition on British coal exports. Instead, he
advocated repaying the national debt so that
when the day of reckoning came, and the
existing supply of resources were exhausted,
there would be no other burdens on future
generations.
The Coal Question brought instant fame
to Jevons. Stories of the impending coal
shortage filled British newspapers. John
Stuart Mill praised Jevons in Parliament, and
a Royal Commission on Coal was
established to investigate the problem.
However, panic about an energy crisis was
premature. Jevons estimated that coal
consumption in Britain would be 2,607
million tons by 1961 (based on 1861 levels
of coal use and mid-nineteenth-century
annual growth rates of 3.5 percent). Yet in
1962, actual coal usage in England was
around 10 percent of his estimate—192 tons
(Black 1981, p. 16).
The primary reason Jevons was so far off
the mark is that he did not foresee the
development of coal substitutes such as
petroleum, natural gas, and hydroelectric
power. A personal disposition to fear what
the future had in store apparently also came
into play. Concerned about a shortage of
writing paper, Jevons purchased such large
stocks of paper that more than fifty years
after his death Jevons’ children had still not
used it all up (Keynes 1951).
Jevons’ lasting claim to fame, however,
stems not from his fears of energy
shortages, but from his efforts to bring
utility analysis into economics. Jevons,
J.B.Clark, and Menger, each independently,
discovered the notion of subjective utility
and the principle of diminishing marginal
utility. These were both important
discoveries, as they brought consumers and
consumer behavior into economic analysis
for the first time. But Jevons went even
further than Menger by drawing out the
implications and possible applications of
utility analysis.
The discovery of the principle of
diminishing marginal utility appears to have
taken place in the late 1850s while Jevons was
working in Australia. This idea is simply and
concisely encapsulated in a 1860 letter that he
wrote to his brother: “One of the most
important axioms is, that as the quantity of any
commodity, for instance, plain food, which a
man has to consume, increases, so the utility
or benefit derived from the last portion used
decreases in degree” (quoted in Keynes 1951,
p. 280).
Several years later Jevons (1871) set forth
more precisely the important distinction
between total utility and degree of utility or
marginal utility. This led to the development
of the modern theory of consumer behavior.
Jevons noted that as people consume more and
more of any good, the total utility they get from
consuming that good generally increases. But
as people consume more and more, the utility
they get from each additional quantity of the
good declines. Thus, the first beer to a thirsty
man provides more satisfaction than the second
or third beer. By the fifth or sixth glass the man
begins to get sick of beer and derives no
additional utility from another one.
According to subjective utility theory,
consumers buy those goods that provide them
with the greatest satisfaction. Going even
further, Jevons argued that each consumer was
in equilibrium whenever any further change in
his or her spending could not increase total
utility. Whenever the consumer can freely
switch purchases, buying more goods that give
a lot of utility and buying less of those things
providing little or negative utility, the consumer
will be better off.
This doctrine forms the basis for keeping
government from regulating the goods and
services that consumers can buy. For example,
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WILLIAM STANLEY JEVONS
if cigarettes or alcohol or drugs are freely
available, consumers will buy only the amount
of these goods that maximize their utility.
When governments prevent the sales of these
goods, or make their purchase difficult by
imposing regulations on producers or taxes
on these goods, consumer satisfaction or well-
being falls throughout the country. What is
true of cigarettes and alcohol is true of all
other goods.
Jevons next applied the notion of utility to
labor. By so doing, he helped show how wages
get determined and how labor markets work.
Jevons assumed that labor was disagreeable
and therefore involved negative utility or
disutility for the worker. On the other hand,
labor also yielded positive utility, since
workers were paid for their efforts and could
use this income to buy goods. Individuals thus
had to balance the disutility of work against
the utility of the goods that could be bought
with the fruits of one’s labor. As long as the
utility of consumption exceeded the disutility
of work, people would continue to work
(Jevons 1957, Ch. 5). At the point where the
disutility of work exceeded the utility of
consumption, people would stop working and
enjoy leisure time.
This application of utility analysis to the
labor market had several important
consequences. First, the distinction between
productive and unproductive labor, first set
forth by Quesnay, was shown to be mistaken.
All labor was productive in the sense that it
yielded utility to individual workers, who
could take their pay check and buy goods with
it. Second, bringing utility theory to a study
of labor cast doubt on the classical theory of
wages (see also MALTHUS). Humans were
not at the mercy of a subsistence wage; rather,
the labor supply depended upon the going
wage. If wages got too low workers would
withdraw from the market and enjoy leisure.
Third, in contrast to Ricardo and Marx, for
Jevons there is no opposition between labor
and capital. Labor makes its own decisions
about whether or not to work, carefully
balancing the gains and the losses from
employment. Capitalists also make similar
decisions when deciding whether or not to
invest and hire more workers.
Finally, no accounting of the economic
thought of Jevons would be complete without
mentioning his theory of the business cycle.
While doing extensive research on economic
growth, Jevons (1884) noted a close
relationship between sunspot activity and
economic activity. Between 1721 and 1878
business cycles had an average duration of
10.46 years, while sunspot activity showed a
periodicity of 10.45 years. Jevons felt that this
relationship was too close to be accidental.
He even set forth a few creative explanations
for this similarity. If sunspot activity affected
the weather, and the weather affected British
harvests, then sunspot activity should be
correlated with grain prices. A good harvest
would increase the supply of grain and lower
its price, while bad harvests would lead to
higher grain prices. Jevons also looked to
foreign trade to explain the similar solar and
economic cycles. A more active sun,
according to Jevons, influenced the rice
harvest in India. A good harvest in India led
to high demand for British manufactured
goods. This, in turn, caused the British
economy to expand. In contrast, less sunspot
activity meant poor Indian harvests, little
demand by India for British goods, and a
slumping British economy.
Few contemporaries of Jevons, and few
subsequent economists, have taken the
sunspot theory of business cycles seriously.
In addition, more recent data cast doubt on
the figures Jevons used; astronomers have
increased the solar sunspot cycle to 11.1
years, while economists have reduced the
length of the business cycle to 7 or 8 years
(Keynes 1951, p. 279). And in contrast to
Jevons, most economists in the late
twentieth century look towards the economy
itself, rather than outside forces, as the
cause of periodic turns in prosperity and
depression. Nevertheless, Jevons deserves
recognition as one of the originators of
business cycle theory.
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Despite his linkages to the future
through worries about the depletion of
energy resources, and despite his linkages
to the past as a business cycle historian,
the major contribution of Jevons to
economics remains his development of
marginal utility theory and his use of this
theory to explain consumption and work
decisions. In all his work, Jevons was a
pioneer, and the many advances due to
Jevons makes him one of the three or four
most important nineteenth-century
economists.
Works by Jevons
The Coal Question: An Inquiry Concerning the
Progress of the Nation, and the Probable
Exhaustion of Our Coal-Mines, London,
Macmillan, 1865
“Notice of a General Mathematical Theory of
Political Economy,” Statistical Journal, 29
(June 1866). Reprinted as an Appendix in
Jevons (1957), pp. 303–14
The Theory of Political Economy, (first edition,
1871) 5th edn., New York, Kelley & Millman,
1957
The Principles of Science: A Treatise on Logic
and Scientific Method (1874), London,
Macmillan
Investigations in Currency and Finance (1884),
ed. H.S.Foxwell, London, Macmillan
Works about Jevons
Collison Black, R.D., “W.S.Jevons, 1835–82,” in
Pioneers of Modern Economics in Britain, ed.
D.P.O’Brien and John R.Presley, London,
Macmillan, 1981, pp. 1–35
Keynes, John Maynard, “William Stanley Jevons
1835–1882,” in Essays in Biography, New
York, Norton, 1951, pp. 255–309
Könekamp, Rosamond, “William Stanley Jevons
(1835–1882): Some Biographical Notes,”
Manchester School of Economic and Social
Studies, 30, 3 (1962), pp. 251–73
Schabas, Margaret, A World Ruled by Number
William Stanley Jevons and the Rise of
Mathematical Economics, Princeton, New
Jersey, Princeton University Press, 1990
CARL MENGER (1840–1921)
Carl Menger (pronounced MEN-GIRR) is
regarded as the founding father of the
Austrian School of Economics. This is
because he is responsible for developing two
pillars of Austrian Economics. First, Menger
helped to establish a subjective theory of
value. Second, he argued that economic
knowledge can come only from deducing the
consequences of assumptions that are known
to be true.
Menger was born in 1840 in Neu-Sandec,
Galicia (then part of Austria but now part of
Poland). Very little is known about his
upbringing or his education. His father was
a lawyer, and Menger followed in his father’s
footsteps by studying law and political
science, first at the University of Vienna and
then at the University of Prague. In 1867 he
received a doctorate in law from Kracow
University.
After graduating, Menger worked first
as a financial journalist and then in the
press office of the Austrian Prime
Minister. It was during this time that he
worked on the Principles of Economics
(Menger 1871).
With his reputation growing due to the
Principles, Menger was appointed to a
lectureship in the Law Faculty at the
University of Vienna in 1873. Three
years later he was promoted to the
position of Professor Extraordinarius;
but he soon resigned this position in
order to tutor Crown Prince Rudolph and
travel with him throughout Europe. In
1879, Menger accepted a teaching
position in Vienna, and thereafter led the
life of an academic economist—devoting
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all his energy and efforts to teaching and
writing. Although he was made a member
of the upper chamber of the Austrian
Parliament in 1900, Menger preferred his
work in economics to taking part in any
political deliberations and debates
(Hayek 1934, p. 417).
Menger made two important
contributions to economics. One involved
value theory and the other concerned
economic methodology. Menger was one
of the first economists to discover the
marginal utility theory of value and the
principle of diminishing marginal utility,
and he was one of the earliest advocates
of a subjective theory of value. Menger was
also involved in a heated debate over the
nature of economics and the proper way
to do economic analysis.
During the late nineteenth century,
classical economics was held in low esteem
on the European continent. Especially
dissatisfying was the highly abstract and
theoretical nature of British economics.
Menger sought to bring economics back to
the real world. His starting point in this
endeavor was a recognition that goods have
value because they meet our needs.
In contrast to the classical British
economists, Menger argued that value was
determined by subjective factors (utility
or demand) rather than by objective
factors (the costs of production or
supply). Value, for Menger, comes from
the satisfaction of human needs. Human
needs create a demand for goods; they
become the driving force of economic
exchange and help determine prices.
Furthermore, Menger argued that since
human needs were greater than the goods
available to satisfy these needs, people
would choose rationally among all
alternative goods made available to them.
Menger (1985, p. 127) illustrated these
principles with a table, which is reproduced
here as Table 1. Each column in the table
represents a different type of good. The
numbers under the Roman numerals represent
how important a particular good is to some
individual, or the degree of satisfaction
obtained by consuming that good. Goods
must satisfy the subjective needs of
consumers, according to Menger, and
consumers must recognize this fact if goods
are to have any value.
Table 1
Menger also recognized that as one
purchases greater and greater quantities of a
good, each succeeding quantity purchased
will yield less satisfaction to the consumer.
That is, people experience diminishing
marginal utility when they consume more of
any good. Thus, Table 1 shows that the first
units consumed of any kind of good yield the
greatest utility and that each succeeding unit
yields less and less utility.
Unfortunately, Menger gave few examples
of the goods that belong in each category. He
stated that Category I goods are those that
preserve life; Category II goods preserve
health; Category III goods provide for
individual welfare (that is, future life and
health); and Category IV goods are various
types of diversions. Category I might thus
represent food; Category II medical care, and
Category IV entertainment.
Menger was also not clear about what the
numbers in his table actually measure. It is clear
however, that the numbers are supposed to
measure relative wants or the satisfaction
received from consuming different goods
(Menger 1985, pp. 163–76). Menger was also
clear about how individuals make decisions
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regarding what to consume or how to spend
their money. Since consumers have limited
income at their disposal, individuals will first
buy those goods that satisfy more important
needs. Goods with a subjective value of 10 will
get consumed before goods with a value of 9,
which in turn get consumed before goods
valued with an 8 or less.
One important consequence of this theory
of value is that all activities yielding subjective
satisfaction are productive activities. In contrast
to the British classical economists, trade was
productive according to Menger because people
would not trade unless they felt the goods that
they received would give them more utility than
the goods they gave up. And in contrast to
Quesnay, agriculture and manufacturing could
both be productive activities because the goods
produced by each of these economic sectors
yield satisfaction to consumers.
Another implication of the subjective theory
of value is that the classical labor theory of
value (see also RICARDO) had to be wrong.
As Menger (1985, p. 145) noted:
The determining factor in the value of a good,
then, is neither the quantity of labor or other
goods necessary for its production nor the
quantity necessary for its reproduction, but
rather the magnitude of importance of these
satisfactions with respect to which we are
conscious.
Since value comes from the individual,
according to Menger, economic analysis must
begin with studying the individual. This
position has come to be known as
methodological individualism.
Menger also recognized that factors of
production (land, labor, and capital) have value
because they satisfy wants indirectly; these
factors are needed to produce the goods that
people directly desire. To find the actual value
of a factor, Menger thought that we should
withdraw one unit of the factor (say one
worker) and observe the loss in output. The
value of this output is the value added by that
worker. It represents the consumer satisfaction
produced by that worker. The value created by
each factor of production thus depended upon
its marginal productivity; and the return or
payment to each factor used in producing goods
should depend on the anticipated value created
by that factor (Menger 1985, p. 124).
From 1875 to 1884 Menger was absorbed
in a heated methodological dispute with Gustav
Schmoller, a leader of the German Historical
School. Dispute might be a too euphemistic
description of what was more an exchange of
insults than a true scholarly debate. Moreover,
the exchange itself was quite strange
considering that Menger dedicated The
Principles to Roscher, another leader of the
Historical School.
According to the Historical School,
economic laws have to be found in historical
facts accumulated over long periods of time.
Until the facts were set forth, it would be
premature to develop any economic theories.
The right way to understand an economy was
to look at historical data, find regularities, and
then make inferences about how the economy
worked. The Historical School rejected the
abstract-deductive method of doing economics,
where economic principles were derived from
assumed characteristics of people and markets.
Instead, they accepted a relativism regarding
economic relations and economic policy. For the
Historical School the world worked differently
at different times and in different places.
In contrast, theory development took
precedence over data accumulation for
Menger. Menger thought that proper scientific
method involved the search for essential
characteristics of economic phenomena, or
necessary connections between economic
variables (such as the fact that lower prices
for some good causes people to buy more of
that good). Historical or empirical economics
could not do this, since sometimes prices fall
and people expect further price declines, so
they buy less now. Consequently, historical
economics could not yield definitive results.
Only introspection yields absolute and
necessary truths according to Menger. Trying
to refute laws of economics by pointing to
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CARL MENGER
contrary real world evidence was like trying
to refute the laws of geometry by measuring
the angles of a triangle to see if they equaled
180°—attempting to do this shows a
misunderstanding of geometry.
Menger’s Untersuchungen (1883) sought
to put economics on firm theoretical and
methodological foundations. In so doing,
Menger defended his method of doing
economics and argued against the method of
the Historical School. Menger strongly
emphasized the individualistic method of
analysis and the fact that economic knowledge
is derived a priori or before the experience of
real world economies. Studying economics
for Menger involved studying individual
preferences (or demand) and explaining how
these lead to observable phenomena like
different prices for different goods.
The Untersuchungen provoked hostile
attacks from members of the Historical
School, including Schmoller. These attacks
were responded to in kind by Menger’s
students and followers. Schmoller refused to
have any more books written by Menger
reviewed in his journal, and he announced
publicly that followers of Menger were not
fit to fill any teaching positions (Hayek 1934,
p. 407).
Eventually the debate ended, more as a
result of boredom than through a final
resolution of the issues. Menger’s method
became the accepted method of doing
economics, although there have been many
prominent critics of this methodology (see also
LEONTIEF). The major effect of the debate
has probably been to give economic
methodology, a study of the methods used to
obtain economic knowledge, a bad reputation.
As Schumpeter (1951) notes, most economists
have felt this debate to be a total waste of time
and from it they have generalized the lesson
that all methodological discussion in
economics is a waste of time. But this outcome
has probably hurt the economics profession,
for as Hutchinson (1973, p. 36) points out
“critical examination of the assumptions,
concepts and theories of economists…is
seldom, if ever, a waste of time.”
Major economists usually leave a legacy of
ideas and theories that come to be accepted by
most other economists and form part of the
economic wisdom taught to students of future
generations. A few make their mark because
they dared to step outside the mainstream and
were able to inspire a group of students or
followers. Menger is the rare figure who fits
into both categories. His emphasis on the
individual, and his argument that we must
explain the economic world as responses to
subjective individual assessments, make
Menger a founder of the Austrian School of
Economics (Alter 1990; Vaughn 1994). But
with his discovery of utility as a source of value
and his discovery of the principle of
diminishing marginal utility, Menger also fits
into the former category.
Works by Menger
The Collected Works of Carl Menger, ed. F.A.
Hayek, 4 vols., London, London School of
Economics and Political Science, 1934–6
Principles of Economics, trans. J.Dingwall and
B. F.Hoselitz (1871), New York and London,
New York University Press, 1985
Problems of Economics and Sociology, trans. F.J.
Nock (1883), Urbana, Illinois, University of
Illinois Press, 1963
Works about Menger
Alter, Max, Carl Menger and the Origins of
Austrian Economics, Boulder, Colorado,
Westview Press, 1990
Bloch, Henri-Simon, “Carl Menger: The Founder
of the Austrian School,” Journal of Political
Economy, 48, 3 (1940), pp. 428–33
Caldwell, Bruce J., (ed.) Carl Menger and His
Legacy in Economics, Durham & London,
Duke University Press, 1990
Hayek, F., “Carl Menger,” Economica, 1
(November 1934), pp. 393–420
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Hutchison, T.W., “Some Themes from
Investigations into Method” in Hicks and
Weber (eds) Carl Menger and the Austrian
School of Economics, Oxford, Clarendon
Press, 1973, pp. 15–37
Schumpeter, Joseph, “Carl Menger, 1840–1921,”
in Joseph Schumpeter, Ten Great Economists
From Marx to Keynes, New York, Oxford
University Press, 1951, pp. 80–90
Stigler, George, “The Economics of Carl
Menger,” Journal of Political Economy, 45
(April 1973), pp. 229–50
Vaughn, Karen I., Austrian Economics in America,
New York, Cambridge University Press, 1994
ALFRED MARSHALL (1842–1924)
Alfred Marshall is responsible for what Keynes
(1951, p. 157) called “diagrammatic
economics,” or the translation of economic
concepts into simple graphs. He is also
responsible for introducing many of these
concepts into economic analysis. Finally, more
than anyone else, Marshall helped make
economics a field of study in its own right.
Marshall was born in Bermondsey, a
working-class suburb of London, in 1842. His
father was a clerk at the Bank of England; his
mother was a butcher’s daughter. Although the
family was not well-to-do, they placed a high
value on education and sent Marshall to good
schools. Like John Stuart Mill, Marshall was
pushed hard by his father and forced to study
late into the night. Despite the fact his father
stressed the classics and languages (and
perhaps because of this) Marshall was drawn
to mathematics rather than the humanities.
With financial help from his uncle, Marshall
attended Cambridge University, where he
studied mathematics, philosophy, and political
economy. His interests in philosophy were
particularly strong. During frequent mountain
climbing excursions in the Alps, Marshall
would find a good spot for reading and
contemplation, and there he would study the
classic works in philosophy. However,
Marshall decided to specialize in economics.
One important factor in this decision was his
walks through “the poorest quarters of several
cities…looking at the faces of the poorest
people” (Keynes 1951, p. 137). After receiving
a degree in the moral sciences (there was no
economics degree at Cambridge at the time)
Marshall taught for nine years at St John’s
College in Cambridge. He then taught briefly
at Bristol and at Balliol College, Oxford. In
1885 he returned to Cambridge, where he
taught until his retirement in 1908.
Many of the notions and modes of analysis
introduced by Marshall still provide the basis
for undergraduate education in
microeconomics, particularly in introductory
microeconomics courses. Marshall studied
individual markets in isolation, pretty much
ignoring the impact that one market has on
other markets and that these other markets, in
turn, have on every market. This made Marshall
the founder of partial equilibrium analysis. In
contrast, Leon Walras studied the many
interrelationships among all markets in the
economy, or general equilibrium analysis.
While neither as complete and comprehensive
as general equilibrium analysis, partial
equilibrium analysis has the advantage of
focusing on the practical problems facing a
particular firm and industry.
In order to study individual markets
Marshall developed the tools of supply and
demand analysis. The upward sloping supply
curve demonstrated the law of supply—as
prices rise firms will produce more and bring
to market greater quantities of any good. The
downward sloping demand curve showed the
law of demand—as prices fall, consumers
buy greater quantities of a good. The “two
scissors” of supply and demand determined
the price for each good and the amount of
each good that would be produced. In
contrast to the demand-driven approach of
Jevons, and in contrast to the supply-driven
approach of Ricardo, Marshall emphasized
that supply and demand jointly determined
prices and production.
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Marshall argued that competition would
force actual prices towards the equilibrium
price. If prices were set above the
equilibrium level, firms would not be able
to sell what they produced and would see
their inventories pile up. This would signal
to the firm that it must lower prices and cut
production. On the other hand, if prices were
set below equilibrium, shortages would
result. People would line up to buy a limited
stock of goods and many consumers would
have to be told that some good was “sold
out.” Businesses would take this as a sign to
increase prices and production. As Figure 2
shows, only at the equilibrium point would
firms sell all they produced and tend to keep
their prices the same (barring any change in
either supply or demand).
Marshall recognized that his “two
blades” were complex constructions. He then
went on to analyze supply and demand in
Marshall (1920, p. 97) defined a change in
demand as the purchase of more (or less) of a
good by people at the same price. Changes in
the demand relationship, or shifts in the
demand curve could result from several
causes—changes in wealth, population
changes, changes in tastes, a change in the price
of other goods, or changed expectations about
future prices (Marshall 1920, Book 3, Ch. 4).
Greater wealth and a larger population would
increase demand, as shown in Figure 3. This
would push up prices. Advertising could
change consumer tastes and cause demand to
increase. Likewise, expectations of greater
prices in the future would push up demand and
prices since people would want to buy now,
before prices go up.
Figure 3 Shifts in demand
Figure 2 Supply, demand, and equilibrium
greater detail. Demand was governed by the
utility or satisfaction that people received
from consuming a particular good.
Consumers were forever attempting to get the
greatest utility from what they purchase and
consume. They would compare the
additional satisfaction from buying one good
with the additional satisfaction that would
result from alternative purchases. When a
good was priced highly, consumers could
buy very little of that good because they
could get more utility from using their money
to purchase many other goods.
The impact of a change in the price of other
goods is a bit more complicated to analyze.
Normally, when the price of some good, like
gasoline, increases, people buy less gasoline
and spend their money on other items. Thus
demand for goods other than gasoline should
rise. However, there are some cases when the
reverse is true. Complimentary goods are sets
of goods usually consumed together. Any good
consumed with gasoline, like automobiles
(especially gas guzzlers), would experience
reduced demand if the price of gasoline rose.
Supply, in contrast to demand, was
governed by the costs of production. Producers,
like consumers, were always trying to
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ALFRED MARSHALL
maximize; but the producer wanted to
maximize profits from production. Due to
diminishing returns and the rising cost of parts
and labor, greater output could be produced
only at rising costs. Businesses would therefore
only produce more goods if they received a
higher price. Hence the Marshallian supply
curve was positively sloped.
Like demand, the supply relationship could
shift. And like shifts in demand, a shift in
supply means more (or less) of the good gets
produced and sold at each price. The main
factor causing supply to shift is a change in
the costs of production. Higher wages, for
example, would raise the costs of production
—no matter how much was produced. Business
could make the same amount of profit only if
they pass these higher costs on to consumers
in the form of higher prices. An increase in
wages would therefore shift supply to the left,
as shown in Figure 4. The supply shift would
lead to higher prices. In contrast, improved
technology, by reducing the amount of labor
necessary to produce goods, would lower unit
costs, shift supply down (or to the right) and
lower prices (Marshall 1920, Book 5, Ch. 3).
Figure 4 Shifts in supply
One of Marshall’s most important
contributions to economics was his
formulation of the notion of elasticity.
Virtually all economic relationships are cause
and effect relationships. The notion of
elasticity attempts to ascertain how much of
an effect a given cause has. If some cause has
a large effect, the relationship is said to be
elastic; if the cause has a small effect the
relationship is inelastic. Marshall also
developed a mathematical formula to measure
exactly how elastic or inelastic any economic
relationship was.
The price elasticity of demand concerns how
much a given change in price alters the amount
of a good consumers would purchase (Marshall
1890, Book 3, Ch. 3). Marshall identified
several factors that determined whether the
demand for a particular good was likely to be
elastic or inelastic. One important factor was
the ease of substitution. If goods were
necessities and there were few alternatives, then
demand for the good was likely to be price
inelastic; consumers would have to keep
buying the good when its price increased
because they had no alternatives. During the
energy crisis of the 1970s, for example, despite
a quadrupling of gasoline prices, people still
needed to drive. So they paid the higher prices
and cut back very little on their consumption
of gasoline.
Marshall also explained why price itself was
an important determinant of demand elasticity.
For a container of salt, whose price is very low,
a large percentage change in price would have
little effect on consumption because the extra
money spent on salt due to a large price
increase would be rather trivial. In contrast,
whenever expensive items (such as
automobiles or a college education) increase
in price by a large percentage, consumers must
spend a good deal more of their income to buy
these goods. Thus they are less likely to
purchase them. Consequently, demand for
expensive goods tends to be elastic and demand
for inexpensive goods tends to be inelastic.
Finally, Marshall stressed that time was an
important factor in determining the elasticity
of demand, with demand becoming more
elastic over time. After the large increases in
gasoline prices in the 1970s people found it
difficult to cut back on their gasoline purchases.
But over time, they started buying more fuel
efficient cars, automobile manufacturers
produced cars that got better gas mileage, mass
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ALFRED MARSHALL
transit systems were improved and expanded,
and people learned to carpool. All of these
changes eventually helped to reduce the
amount of gasoline bought.
Marshall also applied the notion of price
elasticity to the supply relationship. The price
elasticity of supply measured how much more
businesses would produce and attempt to sell
in response to a given change in price. Here
too time was an important factor.
The shortest time period of all Marshall
called “the market period.” Everything that is
brought to market must be sold or it will spoil
and production does not respond to price
changes. In this case the supply curve will be
vertical, or nearly vertical, and demand
determines price.
In the short run, in response to higher prices
firms can work their current employees and
equipment for more hours. But equipment
cannot be expanded in the short run, and new
firms cannot enter an industry in the short run.
So there are limits to how many more goods
can be supplied. Any increase in demand will
lead to some increase in production; but most
of the impact will be on prices.
The long run is the period of time that
allows firms to expand their plants and
equipment. In addition, in the long run firms
can enter and exit the industry. Output can
therefore be readily expanded at more or less
constant cost, making the long-run supply
curve fairly flat. From this Marshall concluded
that over short time periods demand was the
more important determinant of price; but given
enough time, it was supply or the costs of
production that determined prices.
Since Marshall was drawn to economics by
moral considerations and a desire to help the
poor, it is not surprising that he was especially
concerned with the problems of income
distribution and poverty. Marshall traced the
problem of poverty to the labor market (Rima
1990). The labor market operated just like the
market for any good. The only difference was
that in the labor market businesses were doing
the demanding and households were doing the
supplying. For Marshall, the supply of
unskilled labor was determined by a
Malthusian population principle—in response
to higher wages, the population would increase
and so would the labor supply. The demand
for unskilled labor, however, was constantly
decreasing due to mechanization. These two
forces keep wages down for the unskilled and
kept them earning poverty-level incomes.
Marshall argued that individuals lacking
broad and extensive skills, and individuals
lacking any bargaining position in the labor
market, could only get low wages. This led to
poor health and poor education, which in turn
led to low productivity and low wages for their
children. Poverty persisted from generation to
generation because nothing was done to break
the cycle of poverty (Marshall 1890, Book 6,
Chs 4–6). Unfortunately, Marshall said little
about how to raise wages for those with few or
no skills, and even less about how to reduce
poverty. He refused to advocate either
minimum wages or trade unions. His only
suggestion was that the unskilled limit their
family size and that progressive taxation be
used to help the poor (Marshall 1920, p. 719;
1917, pp. 317–29). Ultimately, he looked to
education as a solution to the problem of
poverty (Marshall 1920, pp. 717f.).
Although most famous for his
contributions to microeconomics, Marshall
did make some macroeconomic
contributions as well. He (Marshall 1923)
employed the notion of purchasing power
parity to explain what determines exchange
rates between the currencies of two different
countries. The idea behind this notion is
rather simple and straightforward. Some
goods are sold virtually everywhere
throughout the world. By comparing the
cost of these goods from country to country
we can obtain a good measure of the relative
value of two different currencies. If a
McDonald’s hamburger sells for $1 in the
United States and for 100 yen in Japan, then
$1 and 100 yen should represent equivalent
incomes. According to the purchasing
power parity theory, regardless of the actual
exchange rate between the dollar and the
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ALFRED MARSHALL
yen, $1=100 yen should be used when
comparing incomes in the US and Japan,
since $1 and 100 yen have the same
purchasing power or can buy the same
things. Also, according to the purchasing
power parity theory, exchange rates between
the yen and the dollar will tend towards this
level. If goods are cheaper in Japan, those
holding US dollars will seek to buy
Japanese yen so that they can buy goods
more cheaply in Japan. This will push up
the value of the yen (and push down the
value of the dollar) until purchasing power
parity is reached. Conversely, if goods are
cheaper in the US, the Japanese will seek
to buy US dollars, thereby pushing up the
value of the dollar and moving us towards
purchasing power parity.
Despite the many new concepts
advanced by Marshall, his main
contribution to economics may have
been institutional rather than
substantive. Marshall, more than anyone
else, is responsible for establishing
economics as a separate subject and
discipline. When Marshall returned to
Cambridge University in 1885,
economics was still part of the
curriculum in the moral sciences and
history. It was merely one subject that
historians and philosophers were
required to take in order to get their
degree. Marshall set out to make
economics an independent field of study
that stood on its own, and that had
scientific standards as high as the
physical and biological sciences. Yet
Marshall also wanted economics to be a
practical science, aiding and assisting
government officials and business
leaders in making important decisions.
In 1903 Marshall succeeded in this
endeavor; a separate school and degree in
Economics was started at Cambridge
University. Other academic institutions
soon followed the lead of Cambridge, and
economics became a recognized
discipline throughout the world. As a
result, students throughout the world were
able to major in economics, and to study
the many notions introduced by Marshall.
For all these reasons Marshall was the
most eminent economist of his day, and
remains among the half dozen or so most
important figures in the long history of
economics.
Works by Marshall
Elements of Economics of Industry, London,
Macmillan, 1879
Principles of Economics (1890), London,
Macmillan, 8th edn., 1920
“National Taxation after the War,” in W.H.
Dawson (ed.) After-War Problems, London,
Allen & Unwin, 1917, pp. 313–45
Industry and Trade, London, Macmillan, 1919
Money, Credit and Commerce, London,
Macmillan, 1923
The Pure Theory of Foreign Trade, London,
London School of Economics and Political
Science, 1930
The Early Writings of Alfred Marshall, 1867–
1890, 2 vols., ed. John K.Whitaker, New York,
Free Press, 1975
Works about Marshall
Groenewegen, Peter, A Soaring Eagle: Alfred
Marshall 1842–1924, Brookfield, Vermont,
Edward Elgar, 1995
Keynes, John Maynard, “Alfred Marshall, 1842–
1924,” Economic Journal, 34 (September
1924), pp. 311–72. Reprinted in Essays in
Biography, New York, Norton, 1951, pp. 125–
217
Pigou, A.C., (ed.), Memorials of Alfred Marshall,
London, Macmillan, 1925
Reisman, David, The Economics of Alfred
Marshall, New York, St Martin’s Press, 1986
Reisman, David, Alfred Marshall’s Mission, New
York, St Martin’s Press, 1990
Rima, Ingrid, “Marshall’s Concern About Poverty:
A Hundredth Anniversary Retrospective,”
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Review of Social Economy, 48 (Winter 1990),
pp. 415–35
FRANCIS YSIDRO EDGEWORTH
(1845–1926)
Francis Edgeworth studied how economies
could achieve the best or optimal distribution
of its resources. His main contribution was to
apply advanced mathematical techniques in an
attempt to answer this question. In this
endeavor, Edgeworth developed many modern
tools of microeconomic analysis-utility
functions, indifference curves, contract curves
and the Edgeworth box.
Edgeworth was born in Edgeworthstown,
Ireland in 1845 into a famous and wealthy
family. His grandfather was Richard Lovell
Edgeworth, and his aunt was the novelist Maria
Edgeworth. Edgeworth received an excellent
classical and humanistic education at the hands
of private tutors. At the age of 17, he entered
Trinity College, Dublin to study languages.
Then, in 1867, Edgeworth went to Oxford
University to study the humanities. He obtained
an MA degree in 1877 and also published his
first book, a work on ethics (Edgeworth 1877)
that attempted to bring other moral theories
under the rubric of utilitarianism. Edgeworth
then began to study commercial law; he also
read and studied mathematics on his own.
In the late 1870s Edgeworth lectured at
Bedford College in London. His neighbor,
William Stanley Jevons, interested Edgeworth
in mathematics and statistics, and how they
could be applied to economics. Edgeworth
quickly saw that mathematics could aid
economic reasoning and could check the
arguments made in ordinary English (Creddy
1986, p. 15). He then began publishing articles
and books that employed mathematical
techniques to demonstrate economic principles.
These publications eventually earned him a
position as professor at King’s College in
London and then a highly-prized chair—the
Drummond Professor of Political Economy at
All Souls College, Oxford.
In 1891, Edgeworth became the first editor
of the Economic Journal. Over the next 35
years, Edgeworth molded and developed the
journal, making it into one of the most
distinguished and important economic journals
in the world. During this time period, he served
either as editor or joint editor (with Keynes).
In all his work, Edgeworth looked to the
differential calculus as a “master key” that
would unlock all the wisdom of economics.
Starting with clear definitions and
mathematically precise axioms, and proceeding
with rigorous demonstrations of his
conclusions, Edgeworth hoped to put
economics on the same footing as mathematics
and the hard sciences. Only then, he felt, could
questions of economic policy be adequately
addressed and solved. Edgeworth also felt
mathematics was aesthetically more elegant
than mere prose, was more precise than prose,
and was therefore philosophically superior to
the verbal arguments of Adam Smith and the
other classical economists. Ironically, his poor
prose and his convoluted mathematics make
Edgeworth difficult to read, even for those
economists who have specialized trained in
mathematical economics.
Edgeworth was primarily interested in the
issues of exchange and distribution; in
particular, he studied how the benefits of trade
or exchange get distributed between individuals
and between countries.
One important contribution due to
Edgeworth (and Pareto) concerned the notion
of much more utility, a concept that had
become popular among British economists due
to the influence of Bentham and Mill. Early
utilitarians relied upon the notion of cardinal
utility, which required that consumers know
how much more utility they received from good
A than they received from good B.Edgeworth
moved economists from focusing on cardinal
utility to focusing on ordinal utility, which
involved a rank ordering of consumer
preferences based upon the utility derived from
each good. Ordinal utility was less stringent
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FRANCIS YSIDRO EDGEWORTH
than cardinal utility because it required
consumers to know only that they preferred
good A to good B (or vice versa), or that they
were indifferent between the two goods (see
also PARETO).
Edgeworth then used the ordinal view of
utility to develop the notion of an indifference
curve. This curve is a set of points representing
combinations of two goods that provide the
same amount of utility to a particular
individual. This notion is easiest to understand
if we consider a simple case with just two
goods—pretzels and beer. To start, let us take
some combination of these goods, say three
beers and three bags of pretzels. If I have either
more beer or more pretzels, my utility should
increase since I have more things. For my
utility to remain at the same level, whenever I
have more beer then I must have fewer pretzels
(and vice versa). We can consider continually
increasing the quantity of one good and
Figure 5 The indifference curve
decreasing the quantity of the other to make
sure that utility stays the same for the consumer.
The set of all such points would be an
indifference curve for beer and pretzels. Such
acurve is shown in Figure 5.
Starting with more beer or more pretzels
we could trace out another indifference curve,
one yielding greater utility than our original
curve. This new curve would be to the
northeast of the indifference curve sketched
in Figure 5, and would include combinations
like 4 beers and 4 bags of pretzels. Since more
goods yield greater utility, this indifference
curve would represent more utility, or a better
situation for our consumer. Similarly, starting
with fewer beers or fewer pretzels would let
us trace out a new indifference curve yielding
less utility than our original indifference
curve. This would lie to the southwest of the
curve sketched in Figure 5.
Edgeworth assumed that indifference
curves would be convex to the origin, as
shown in Figure 5 , rather than a straight
line. This is because of diminishing
marginal utility. As I consume more and
more beer the extra utility I receive from
another beer declines. The first beer
quenches my thirst and helps me relax after
a hard day at work; the second beer also
helps me to relax. But the ninth beer
provides few additional benefits over and
above the eighth beer, and as cases of
extreme drunkenness and alcohol poisoning
show, may even provide negative utility.
What is true of beer is also true of pretzels.
A first bag satisfies my hunger, a second
and subsequent bags provide less utility,
while a tenth bag of pretzels is only likely
to make me sick.
Edgeworth next applied the tool of
indifference curves to analyze exchange.
Exchange can occur between two people
(barter), which is how Edgeworth thought
of it, or as trade between two countries,
which is how many contemporary
economists employ the Edgeworth analysis.
This theory of exchange constitutes the
main contribution to economics made by
Edgeworth. It shows diagrammatically how
exchange could benefit both parties, and
also shows how the final result of such
exchange was likely to be indeterminate.
Consider two countries (Germany and
Belgium), each of which produces two
goods (again, pretzels and beer). Each
country has their own set of indifference
curves, and each will want to maximize
their utility or reach their highest
indifference curve (the best combination of
the two goods as possible). With their own
national resources, Belgium finds its
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highest indifference curve, and produces
40 million cases of beer and 10 million
tons of pretzels. Likewise, Germany seeks
its highest indifference curve, producing
40 million cases of beer and 60 million
tons of pretzels. The Edgeworth Box is
constructed by flipping one country’s
indifference curve upside down and linking
it with the indifference curve for the other
country. In Figure 6 Germany is flipped
around, so that higher indifference curves
for Germany are further down or to the
southwest. Point A in Figure 6 shows the
optimal situation for the two countries
before any trade takes place. It should be
thought of as the best each country could
do on its own, without trade.
Edgeworth noted that both Belgium and
Germany could improve their well-being by
moving from point A to any point within the
ellipse or eyepiece formed by the intersection
of their two indifference curves. Points like B
and C lie on higher indifference curves for each
country, and make each country better off.
These points could be reached only if Germany
and Belgium trade with one another. Belgium
moves to a higher indifference curve by trading
beer to Germany for more pretzels; and
Germany moves to a higher indifference curve
by giving up pretzels in exchange for beer.
In contrast to this situation, consider what
happens as we move along the line segment
drawn between D and E.Belgium can become
better off only if Germany becomes worse off,
and Germany can become better off only if
Belgium becomes worse off. If Germany goes
to a higher indifference curve, then Belgium
must be on a lower indifference curve, and
vice versa.
Edgeworth called the set of points at which
the indifference curves of Germany and
Belgium can be tangent to each other (points
between D and E in Figure 6) the “contract
curve.” These points represent the best possible
trades for the two countries (starting at point
A). In reality, however, the curve is as much a
conflict curve as a contract curve. Each country
is better off when on the contract curve than
Figure 6 The Edgeworth Box
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FRANCIS YSIDRO EDGEWORTH
when they reject trade (and remain at point A);
yet once on the contract curve the two countries
are in conflict—one country gets more if the
other country gets less. At point E, Germany
goes to a much higher indifference curve and
receives all the gains from trade, while Belgium
is neither better off nor worse off. Conversely,
at point D, all the gains from trade go to
Belgium.
Edgeworth next sought to find out whether
there would be one unique solution in a
situation like this, or how the gains from trade
would actually get divided up between the two
parties. He discovered that there is not likely
to be just one trading equilibrium point. The
point on the contract curve that the two
countries eventually settle on will involve
bargaining between Belgium and Germany
over the gains from trade. The country that
gains more will be the one that is better at
bargaining, or the country that can more easily
do without the good produced by the other
country.
Edgeworth next went on to show that the
degree of indeterminacy in the final outcome
was a function of the number of traders on each
side. If many countries produced pretzels for
export and only a few produced beer, Germany
would not be able to extract such a good
bargain against Belgium. All the pretzel-
producing countries would compete against
each other by offering lots of pretzels for each
beer received from Belgium. Similarly, with
many beer producers and no other pretzel
producers, the trading advantage would favor
Germany. Everyone wants Germany’s pretzels,
but Germany can go to many different places
to get beer. Edgeworth showed that only under
conditions of perfect competition, where many
countries sell both pretzels and beer, would
there be only one possible outcome. All parties
would be price takers and each would lose any
bargaining power they had over the other party.
In addition to his work in economic theory,
Edgeworth (1996) made several contributions
to statistical analysis, including work on
drawing statistical inferences and developing
the correlation coefficient (see Stigler 1978).
This number, which can vary from zero to one,
shows the association between two economic
variables; in particular it shows how closely
two variables are related to one another. A
correlation coefficient of zero shows that the
two variables are not related at all and do not
move together. A value of one shows the two
variables move in unison, whenever one
variable changes we can predict with 100
percent certainty how the other variable will
change.
Rather uncharacteristically, his work in
mathematical statistics had a very practical side
to it, which Edgeworth drew out and explained.
In two papers Edgeworth (1886, 1888) showed
how the past history of demand for withdrawals
would let a bank estimate the probability that
a certain level of cash would be adequate to
meet future demand for withdrawals on a daily
basis. This computation allowed a bank to
determine how much money it could lend out
and how much money it had to keep on hand
as a contingency fund against depositors
coming to the bank to withdraw their money.
Notwithstanding this practical application
of his work, Edgeworth wanted above all to
establish theorems about economic principles.
This approach to the study of economics has
greatly influenced other economists.
Edgeworth also developed several important
tools of economic analysis. For these reasons,
Edgeworth was one of the five or six most
important economists of the early twentieth
century.
Works by Edgeworth
New and Old Methods of Ethics: Or ‘Physical
Ethics’ and ‘Methods of Ethics’, Oxford,
Parker, 1877
Mathematical Psychics: An Essay on the
Application of Mathematics to the Moral
Sciences, London, Kegan Paul, 1881
“Problems in Probabilities,” Philosophical
Magazine, 22 (1886), pp. 371–84
Metretike, or the Method of Measuring Probability
and Utility, London, Temple, 1887
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JOHN BATES CLARK
“The Mathematical Theory of Banking,” Journal
of the Royal Statistical Society, 51 (1888), pp.
113–27
Papers Relating to Political Economy, 3 vols.,
London, Macmillan, 1925
Writings in Probability, Statistics and Economics,
3 vols., ed. Charles R.McCann, Jr., Hants,
Edward Elgar, 1996
Works about Edgeworth
Creedy, John, Edgeworth and the Development
of Neoclassical Economics, Oxford,
Blackwell, 1986
Creedy, John, “F.Y.Edgeworth, 1845–1926,” in
Pioneers of Modern Economics in Britain, ed.
D. P.O’Brien and John R.Presley, Totowa, New
Jersey, Barnes & Noble, 1981, pp. 72–104
Hicks, John, “Francis Ysidro Edgeworth,” in
Economists and the Irish Economy from the
Eighteenth Century to the Present Day, ed.
Antoin E.Murphy, Dublin, Irish Academic
Press, 1984, pp. 157–74
Keynes, John Maynard, “Francis Ysidro
Edgeworth: 1845–1926,” in Essays in
Biography by John Maynard Keynes, New
York, Norton, 1951, pp. 218–38
Stephen M. Stigler, “Francis Ysidro Edgeworth,
Statistician,” Journal of the Royal Statistical
Society, 141, 3 (1978), pp. 287–322
JOHN BATES CLARK (1847–1938)
John Bates Clark was one of several people
who independently discovered the ideas of
marginal utility and marginal productivity in
the late nineteenth century. Clark also used the
notion of marginal productivity to develop a
theory of income distribution. He then used this
theory to justify the existing income
distribution as fair and equitable. In addition,
Clark studied the impact of large monopolistic
firms and powerful labor unions on the
American economy; and he argued that when
such economic power existed, it should be
restrained.
Clark was born in Providence, Rhode Island
in 1847. His father owned a dry-goods store
there; but poor health caused him to move to
Minnesota, where he started a small plow
business. Clark attended Brown University and
Amherst College, where he acquired interests
in both philosophy and ethics. After graduating,
he spent three years studying in Switzerland
and Germany at the Universities of Zurich and
Heidelberg respectively. At this time there were
few graduate programs in the United States,
and travel to Europe was necessary to pursue
advanced studies. When Clark returned to the
United States he accepted a teaching job at
Carleton College, where he taught Thorstein
Veblen. Other teaching positions followed at
Smith College, Amherst College and Johns
Hopkins. Clark finally settled down at
Columbia University, where he taught
economics from 1895 to 1923 (with the
exception of the 1898–9 academic year when
he replaced Irving Fisher at Yale who was
recovering from a case of tuberculosis). In 1880
Clark helped to found the American Economic
Association, now the largest and most
prestigious organization of economists in the
world. Three years later he became its
President.
While teaching at Columbia University,
Clark became active in the peace movement.
Convinced that the threat of war was a great
obstacle to improving the economic condition
of man, he joined the League to Enforce Peace,
actively supported the League of Nations, and
he became director of the Economic and
History Division of the Carnegie Endowment
for International Peace, which studied
international war and militarism.
Clark’s most important contribution to
economics was undoubtedly his development
of the marginal productivity theory of
distribution. The theory was designed to
explain the principles that determine how much
income different people receive, and thus the
principles affecting the distribution of income
in an economy.
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JOHN BATES CLARK
The precise inspiration for the marginal
productivity theory of distribution remains
somewhat obscure. Clark ([1899] 1965, pp.
viii, 84–5) himself stated that the theory was
developed in response to Henry George, and
was intended to prove George wrong about
income distribution. George ([1879] 1929, pp.
167–9) had held that rents stemmed from the
monopoly power of landowners, and that rents
existed only because there was a fixed stock
of land and someone was willing to pay to use
that land. Rents, therefore, were not morally
justified and were not the result of human
exertion. As a result, he proposed (like
Quesnay) abolishing all existing taxes and
instituting a single tax on land values.
Yet Clark’s son (J.M.Clark 1952) and John
Henry (1983) both contend that Clark
developed the marginal productivity theory as
a response to Marx, who claimed that workers
were exploited because employers kept some
of the value (the surplus value) that workers
created. Numerous passages in the writings
of Clark ([1899] 1965, p. 7; 1890a, p. 43;
1914, pp. 34–6) appear to support this
interpretation.
But more than likely, Clark had both
George and Marx in mind when working on
his marginal productivity theory of
distribution. Contra George, the theory
shows that rental income is earned income;
and contra Marx, it shows that workers are
not exploited because the income they
receive is equal to the income they earn. A
third motivation for the marginal
productivity theory may have been a more
pragmatic one. Late nineteenth-century
America was the age of the robber baron
(Josephson 1934). Labor organizations such
as the Knights of Labor and the American
Federation Labor arose in response to
growing business power and union attacks
on capitalism grew. Quite possibly, the
marginal productivity theory also stemmed
from a desire by Clark to justify business
profits and thus defend capitalism from
these attacks.
Whatever its inspiration, Clark used marginal
productivity theory to argue that the existing
distribution of income was fair— so long as the
incomes were received as part of a competitive
process. Clark ([1899] 1965, p. v) set forth the
essence of his theory in the introduction to his
book The Distribution of Wealth:
It is purpose of this work to show that the
distribution of the income of society is
controlled by a natural law, and this law, if
it worked without friction, would give to
every agent of production the amount of
wealth which that agent creates. However
wages may be adjusted by bargains freely
made between individual men, the rates of
pay that result from such transactions
tend…to equal that part of the product of
industry which is traceable to the labor
itself…. So far as it is not obstructed, [the
economic system] assigns to everyone what
he has specifically produced.
To understand marginal productivity
theory it helps to consider a particular firm,
say an educational institution. Whenever the
school hires an additional teacher it can offer
more classes and more courses of study, so it
should experience increased enrollments.
From each new student the school will receive
additional revenue. If the new faculty member
has a national or international reputation the
gain will be even greater; students from all
over the country or around the world will
come to the college in order to have the
opportunity to learn from the new faculty
member. The marginal productivity of the new
faculty member is the increased revenue
coming to the school hiring that person.
Clark took the position that if everyone
was paid the value of their marginal
productivity, no one could legitimately
complain about how much income they
received. Everyone would get exactly what
they contributed to the production of goods
and services. The resulting distribution would
be fair and everyone would be justly
compensated. On the other hand, if someone
received less than the value of their marginal
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JOHN BATES CLARK
product they were being robbed or exploited.
Such a condition, Clark felt, would lead to
potential social problems, as Marx
recognized.
Under the marginal productivity theory of
distribution, land is treated just like labor. It
contributes to the value of output because
things could not be produced without a place
to put buildings and factories. Similarly, the
land contains important raw materials that are
needed in producing goods and services. For
land’s contribution to the value of output
landowners must be paid some rent. Thus,
Henry George was wrong to claim that such
incomes were not earned. Land contributes
something to production, and the owners of
this land deserve some reward for this
contribution.
Similarly, according to the marginal
productivity theory, profits are justified by the
contribution that capital equipment or
machinery makes towards producing goods.
Thus profits are not robbery; they are a return
to capital. Moreover, as long as workers receive
their marginal product, they receive a fair return
even though they do not receive the surplus
value that they create when working.
One question immediately raised by this
theory has come to be called the product
exhaustion or adding up problem. There are
two ways to look at this problem. First, is
there enough money from the sale of a good
to pay all factors of production their marginal
product? Does my school, Monmouth
University, receive enough revenue to pay all
faculties their marginal product? If not,
someone will be exploited because they
receive less than their actual contribution to
the revenue of the school. Second, if everyone
gets paid their marginal product, and you add
up all such payments, is there anything left
over? This is a potential problem because if
anything is left over after Monmouth pays all
its faculty members and all other factors of
production, we need some way to determine
who gets this income and we need some way
of deciding whether this division of the extra
revenue will lead to a fair distribution of
income overall.
Clark (1890a, 1891) asserted that the sum
of all marginal productivities equals the total
value of goods and services produced by a
firm, and even developed a set of diagrams in
an attempt to show this result ([1899] 1965,
Ch. 13). He argued that any other result would
tend to be eliminated through competition.
Clark’s argument, however, was not
mathematically rigorous and he failed to
identify the restrictive circumstances under
which this result held. It was left to Knut
Wicksell (see below) to demonstrate the
correct solution to the adding up problem.
Wicksell showed that only in the case of
constant returns to scale would all factor
payments equal the value of the good
produced. Wicksell then argued that
competition would lead to constant returns.
Nonetheless, Clark got the gist of the solution
right; only when the forces of competition are
strong will product exhaustion or adding up
not be a real problem for the marginal
productivity theory of distribution.
Clark also made important contributions
to economics through his study of competition
and monopolies. Beginning with Adam Smith,
economists have worried about the
concentration of economic power in the hands
of a few firms. Monopolies, through their
market power, could restrict output and raise
prices, thus giving consumers fewer and more
expensive goods.
As we saw above, Clark held that
competition was a positive force in the
economy because it tended to make sure that
everyone got their fair share, or the value of
their marginal contribution to production.
With competition, if an employer tried to pay
a worker less than her marginal product, she
would offer her services to another employer.
And she should be able to find ready
employment because other firms would
benefit from hiring her. The firm would gain
additional profits plus the worker’s marginal
product. This would exceed the wage rate that
the employer would pay to the worker. But in
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JOHN BATES CLARK
the absence of competition among firms, this
worker has limited options and must accept
the wage offered by her employer.
This analysis had several important policy
implications. Anything disturbing
competition was anathema and to be opposed.
This included unions that threatened to strike
and used this threat to extract wages higher
than worker marginal products. Clark (1894,
p. 494) thus led the fight for right-to-work
(open shop) laws in the late nineteenth
century. Restraints on competition, however,
could also come from businesses; so Clark
began to study monopolies, other forms of
imperfect competition, and business practices
that restrained competition.
In a number of articles, Clark (1890b, 1901,
1904) defended large firms, holding that
monopolies and oligopolies were natural
phenomena. Large firms with monopoly power,
Clark held, were never really a problem
because of potential competition. If a firm
earned excessive or monopolistic profits, other
firms would soon enter the industry seeking a
share of these high profits. In addition, Clark
argued that if a large firm abused its monopoly
power, consumers and labor unions would
attempt to use the legislature and the courts to
reduce prices and break up the monopoly.
However, Clark (1900) did recognize that
in the competitive process some producers
might set their prices below their costs. Such
actions attempt to drive competitors out of
business and lead to monopoly power and
greater profits in the future. When done
domestically, this practice is called “predatory
pricing” and when done by a foreign firm it is
called “dumping.” To deal with this potential
problem Clark emphasized the need to prevent
any unfair methods of competition.
The Sherman Act of 1890 and the Standard
Oil case of 1911, made predatory pricing illegal
in the US. Unfortunately, it is always difficult
in practice to prove whether firms are engaging
in predatory pricing and Clark provided no
clear test to help us determine whether firms
are engaging in this practice. If a firm is pricing
below cost, this may be due to lack of demand
for their product or because competitors can
produce and sell goods at this low price. In the
latter case, to remain competitive, the firm will
have to cut its price to the same low level and
hope it can survive by cutting costs.
Arguments over this issue have recently
been raised by American businesses, which
have accused Japanese firms of dumping goods
in the US in order to develop a large market
share and drive US firms into bankruptcy. Like
predatory pricing, dumping is regarded as an
illegitimate form of business competition,
because its goal is to develop monopoly power.
The General Agreement on Tariffs and Trade
(GATT) has an antidumping code that all
nations are supposed to adhere to. But like
predatory pricing, dumping has been difficult
to prove in practice.
The one dominant theme running through the
economics of J.B.Clark is the importance of
competition among business firms. Competition
is necessary to make sure that everyone gets paid
what they contribute to the production process
and that we have a fair distribution of income;
and competition is also necessary to keep large
firms from abusing their economic power.
Although Clark’s achievements do not rank
him with the major British economists or the
continental marginalists, they do make Clark
the most distinguished American economist in
the late nineteenth and early twentieth century.
Europe was the center of economic thought
when Clark was alive and writing. But Clark
lead a parade of major American economists
that would soon grow very large.
Works by Clark
The Philosophy of Wealth (1886), New York,
Augustus M.Kelley, 1967
“The Law of Wages and Interest,” Annals of the
American Academy of Political and Social
Science, 1 (July 1890a), pp. 43–65
“The ‘Trust’: A New Agent for Doing an Old
Work: Or Freedom Doing the Work of
Monopoly,” The New Englander and Yale
Review, 16, 3 (March 1890b), pp. 223–30
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“Distribution as Determined by a Law of Rent,”
Quarterly Journal of Economics, 5 (1891), pp.
289–318
“The Modern Appeal to Legal Forces in Economic
Life,” Publications of the American Economic
Association, (December 1894), pp. 481–502,
(Presidential address)
The Distribution of Wealth (1899), New York,
Augustus M.Kelley, 1965
“Trusts,” Political Science Quarterly, 15, 2
(January 1900), pp. 181–95
The Control of Trusts, New York, Macmillan,
1901
The Problem of Monopoly, New York, Columbia
University Press, 1904
Works about Clark
Clark, J.M., “J.M.Clark on J.B.Clark,” in The
Development of Economic Thought, ed. H.W.
Spiegel, New York, Wiley, 1952, pp. 592–612
Henry, John, “John Bates Clark and the Marginal
Product: An Historical Inquiry into The
Origins of Value-Free Economic Theory,”
History of Political Economy, 15, 3 (1983), pp.
375–89
Henry, John, John Bates Clark: The Making of a
Neoclassical Economist, New York, St
Martin’s Press, 1995
Other references
George, Henry, Progress and Poverty (1879), New
York, Robert Schalkenback Foundation, 1929
Josephson, Matthew, The Robber Barons: The
Great American Capitalists, 1861–1901, New
York, Harcourt Brace, 1934
VILFREDO PARETO (1848–1923)
Vilfredo Pareto (pronounced pa-RAY-tow) is
remembered by economists primarily as one
of the fathers of mathematical economics. Yet,
late in life, Pareto rejected the trend to
formalize economics. He came to believe that
this approach was too narrow and could not
yield a comprehensive understanding of how
real economies worked. He then tried to
broaden economics by incorporating political
and sociological variables into his analysis of
the economic system.
Pareto was born in Paris in 1848 while his
father, a civil engineer, was in exile because of
his opposition to the policies of the Italian
government. His family was middle class and
provided Pareto with a good education. They
also imparted to him the values of hard work
and moderate living. In 1858 the family
returned to Italy, so Pareto was educated mainly
in Italian public schools. He then went on to
attend the Polytechnic Institute of Turin,
receiving an engineering degree in 1869 and
finishing first in his graduating class.
After receiving his degree, Pareto worked
as a civil engineer for a government-owned
railroad. Other engineering positions followed.
These jobs required that Pareto travel to
England and Scotland at times, and thus
enabled him to observe the British economy.
The success of the British government in
promoting a free market, and the beneficial
effects of this laissez-faire policy, were
especially striking. As a result, Pareto joined
the Adam Smith Society and became an active
member of the society in the 1870s and 1880s.
He contributed frequently to the society
newsletter, supporting democracy, free trade,
competition, and reduced government
regulation of business and individual activities.
In his spare time, and during evenings filled
with insomnia, Pareto read extensively in political
economy and sociology. In 1882 he retired from
his government job to become an engineering
consultant, and he began to write political and
economic commentaries that attracted a great deal
of attention. Pareto also put his training in
mathematics and engineering to good use by
translating economic theories from verbal,
declarative sentences into mathematical
equations. This work led to a faculty appointment
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VILFREDO PARETO
at the University of Lausanne in 1893 where he
succeeded Léon Walras.
At Lausanne, Pareto developed a worldwide
reputation as a pioneer in making economics
more mathematical. Despite his success, Pareto
became troubled by the increasing narrowness
of mathematical economics and did an about-
face. He argued that to understand real
economies one needed to understand the
cultural and political context in which
economic events took place. Pareto also
attempted to incorporate sociological, political,
and psychological factors into his analysis of
how economies change.
In 1898, when his uncle died, Pareto
inherited a substantial fortune. He used this
money to purchase a country villa on Lake
Geneva. There Pareto was able to work in peace
on his project to broaden economic analysis.
He also became an eccentric hermit, living in
a large house with more than a dozen cats.
In addition to making economics more
mathematical, Pareto made three substantive
contributions to economics—he developed a
law of income distribution that still bears his
name, he is responsible for switching the focus
of economists from cardinal to ordinal utility,
and he developed a test of whether economic
outcomes could be improved.
While teaching at Lausanne, Pareto became
interested in income distribution and he began to
study income inequality in various nations. These
studies led to the discovery of a simple pattern
governing income distribution. Pareto found that
if you were to rank order families in one country
by their income level, and then record family
income levels, you would find that income does
not increase proportionately or arithmetically.
Rather, Pareto found that income increases
geometrically as we move along our rank ordering
from the poorest to the wealthiest family. When
income increases proportionately, if a family at
the 30th percentile makes 20 percent more than
a family at the 20th percentile, a family at the
40th percentile would make 20 percent more than
a family at the 30th percentile and a family at the
100th percentile would make 20 percent more
than a family at the 90th percentile (see Figure
7). When income increases geometrically, income
disparities grow as one moves along the ordered
list of incomes. For example, if a family at the
30th percentile makes 10 percent more than a
family at the 20 percentile, a family at the 50th
percentile may make 40 percent more than a
family at the 50th percentile and a family at the
100th percentile may make twice as much as (100
percent more than) a family at the 90th percentile
(see Figure 8).
Figure 7 Arithmetic or proportional
increases in income
Figure 8 Geometric increases in income
Examining income statistics from the US
and numerous European countries, Pareto
found the pattern of income distribution to be
pretty much the same everywhere. As a result,
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VILFREDO PARETO
he called this pattern a “law” of income
distribution. Because he found income
distribution to be rigid and invariant, some
economists have criticized Pareto for justifying
existing patterns of income inequality. But
other explanations of the remarkably similar
income patterns found everywhere are possible.
For example, Pareto believed that the rich will
try to protect what they have and that they
usually have the power to do so. Programs to
redistribute income and reduce inequality will
thus fail due to the political clout of the
wealthy, a universal phenomenon.
Despite the great controversy it generated,
Pareto’s work on income distribution marked
a major advance in economics. Pareto was the
first economist to seriously study income
distribution data from around the world. He
was thus a pioneer in this area. Pareto also
made a major contribution by suggesting how
income inequality could be measured. In this
way, his work was path-breaking. Finally, the
suggestion that income distribution might
display some law-like order, raises intriguing
economic, social and political questions which
have been ignored by most subsequent
economists.
Pareto made another important contribution
to economics when he argued that ordinal
utility rather than cardinal utility should form
the basis of economic analysis. Measured in
ordinal terms, the individual consumer is
assumed to know that good A is preferred to
good B. Measured in cardinal terms, the
consumer is assumed to know not only that
good A is preferred to good B, but also by how
much good A is preferred to good B.
Shifting the focus from cardinal to ordinal
utility reduces the demands that economists
made of each consumer. Consumers need to
know only that they prefer peaches to plums.
This is something most consumers do actually
know. It is also something that most consumers
reveal through their everyday expenditures.
Consumers, however, are not likely to know
that they want peaches twice as much as plums
or three times as much as plums. The shift to
ordinal utility thus made economics more
realistic in the way it described human
behavior.
Also, by moving from cardinal to ordinal
utility it was no longer necessary to worry about
how utility could be measured or how it was
possible to compare the utility of different
people. Since the times of Bentham and Mill,
utilitarianism was plagued by these problems.
With ordinal utility a measuring rod was no
longer needed. The fact that two people traded
with each other demonstrated that they
preferred the goods they received to the goods
they traded away. Likewise, interpersonal
utility comparisons no longer had to be made.
Ordinal utility could guarantee that total utility
would rise as a result of any trade because
utility for each party to the exchange was
greater; if each person was not made better off,
they would not have traded.
A third contribution made by Pareto was
the introduction of the notion of an optimal
state of economic affairs, now called “Pareto
Optimality.” Pareto himself called such a
state “ophelimité,” from the Greek
“ophelimos.” His goal was to argue that
certain economic outcomes could not be
improved upon. Pareto Optimal outcomes are
situations where making one person better
off requires that someone else be made worse
off. Thus, no clear overall improvement is
possible; the Pareto Optimal condition is the
best that we can do.
Pareto began by noting that two
individuals in a market will trade only if each
of them gains something from the exchange.
If one party gains and the other loses there
will be no trading. If the two parties are
unwilling to trade on their own, any attempt
to redistribute goods between these people
will make one party better off but will make
the other party worse off. Therefore,
economies that allow free exchange in the
market will be Pareto Optimal.
The notion of Pareto Optimality can also
be used to evaluate proposed policy changes.
Tax cuts for the wealthy may increase
investment and spur economic growth. If those
with low incomes gain as a result of greater
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VILFREDO PARETO
growth, this tax policy would lead to a Pareto
Superior result. But if the tax cuts do not
generate sufficient income growth, those with
low incomes wind up worse off (because these
tax cuts will have to be paid for by someone).
In this case, the current tax system would be
Pareto Optimal.
In the 1930s, economists thought that the
notion of Pareto Optimality could help
evaluate economic performance without
resorting to value judgments. This, they
thought, would give economics a more
scientific grounding. As a result, economists
spent a great deal of effort trying to prove
theorems about the existence of Pareto
Optimality under certain conditions and to
determine whether Pareto Optimal situations
were stable or likely to change. The main
finding of this work is that competitive
capitalism leads to an outcome that is both
Pareto Optimal and stable.
However, this work has more recently
received a good deal of criticism. First,
situations are Pareto Optimal given an
initial distribution of income or resources.
If we were to begin with other initial
distributions of income we would reach
very different results. These outcomes
would be Pareto Optimal also, and there
is no way to decide among the various
possible Pareto Optimal outcomes.
Second, as Sen (1982) has pointed out,
Pareto Optimality does not really yield a
value-free or scientific welfare
economics. It assumes that if a change
makes every individual in society better
off, the society as a whole is better off.
While this may very well be true, Sen
points out it is still an individual opinion
rather than a scientific truth. Finally, Sen
(1987) has also argued that there is really
nothing desirable about Pareto Optimal
situations, since a famine could be Pareto
Optimal, while redistribution to prevent
mass starvation would not be Pareto
Optimal (see also SEN).
Despite his many important substantive
contributions, Pareto is best known for
introducing mathematical forms of reasoning
and analysis into economics. However, later
in his life, Pareto grew dissatisfied with
mathematical formalization and with abstract
economic theory. Important questions about
economic growth and overall economic
performance, he thought, could only be
understood within an historical and
sociopolitical context. Pareto then sought to
incorporate these factors into a theory of the
business cycle. He noted that social factors
influenced decisions to save, work and
consume, and thus the state of the economy.
Pareto then began to develop a sociological
theory of economic growth and stagnation.
Economic growth, according to Pareto,
required hard work and a willingness to delay
gratification. Social norms of hard work,
frugality, and professional commitment
contribute to these behaviors; economic
growth tends to soften and relax them. When
their incomes rise, people become more
hedonistic—they borrow and spend, and they
engage in speculative activities to make
money quickly. At some point, Pareto
thought, excessive consumer debt would
reduce consumer confidence and spending.
This would slow down economic growth; but
it would also lay the foundation for future
growth by reinvigorating social norms and
by providing more saving for future
investment.
It is somewhat ironic that Pareto is
remembered for contributing to the
mathematical economics that he came to
criticize and reject. But it is hardly
surprising that a discipline which has
become increasingly mathematical would
praise the mathematical Pareto and ignore
the sociological Pareto. Nonetheless, for his
many contributions to so many different
areas within economics, and for his
pioneering efforts to make economics more
mathematical and scientific, as well as more
historical and sociological, Pareto must be
regarded among the dozen or so most
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important figures in the history of
economics.
Works by Pareto
Manual of Political Economy (1906), New York,
A. M.Kelly, 1971
The Mind and Society, New York, Harcourt, Brace,
1935
Sociological Writings, ed. S.E.Finer, New York,
Praeger, 1966
Works about Pareto
Cirillo, Renato, The Economics of Vilfredo Pareto,
London, Frank Cass, 1979
Powers, Charles H., Vilfredo Pareto, Newbury
Park, Sage Publications, 1987
Schumpeter, Joseph, “Vilfredo Pareto: 1848–1923,”
Quarterly Journal of Economics, 63, 2 (May
1949), pp. 147–73. Reprinted in Ten Great
Economists: From Marx to Walras, New York,
Oxford University Press, 1965, pp. 110–42
Other references
Sen, Amartya, Social Choice and Welfare, Oxford,
Basil Blackwell, 1982
Sen, Amartya, On Ethics and Economics, Oxford,
Basil Blackwell, 1987
EUGEN VON BÖHM-BAWERK
(1851–1914)
Eugen von Böhm-Bawerk (pronounced
BAUM-BOW-work) made several related
contributions to economics. He helped to
develop the economic theories of capital and
interest, and he explained why real interest
rates had to be positive. Böhm-Bawerk was
also among the first economists to incorporate
time into economic analysis and to develop
an economic theory in which time plays a
crucial role.
Böhm-Bawerk was born in 1851 in the town
of Brünn (now Brno) in Moravia (then part of
the Austro-Hungarian Empire and now part of
the Czech Republic). His father was a high
government official. As a student, Böhm-
Bawerk studied law, administration, and
political science, and planned for a career in
the civil service. But because his family was
facing financial difficulties, he decided to study
law at the University of Vienna and follow a
more financially rewarding career path. The
law curriculum required students to take several
courses in economics. These courses likely
sparked Böhm-Bawerk’s interest in economics
and led to another change in career plans
(Hennings 1997, p. 9).
After obtaining a doctorate in law from the
University of Vienna in 1875, Böhm-Bawerk
received a government grant to study abroad
and prepare for a teaching career in economics.
Over the next five years, he studied in Germany
at Universities in Heidelberg, Leipzig, and
Jena; and he wrote a doctoral thesis. Being
certified to teach in 1880, he accepted a job in
Innsbruck, Austria.
Four years later he was promoted to full
professor. In 1889, Böhm-Bawerk left
academia to become a government economist
in the Ministry of Finance. There he studied
how to return Austria to the gold standard and
worked on reforming the Austrian income tax
so it would be a better source of revenue for
the government (at the time, Austria relied
heavily on sales taxes). In 1893 he became the
Austrian Finance Minister, and over the next
decade he held this position several times.
Böhm-Bawerk left the government in 1904
and returned to the University of Vienna, where
he was given a chair in political economy. For
the next ten years, until his death in 1914,
Böhm-Bawerk spent most of his time
defending himself from his many political and
economic critics.
Today Böhm-Bawerk is remembered
primarily for his theory of capital and interest.
He made three important and interrelated
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EUGEN VON BÖHM-BAWERK
contributions in this area—an analysis of
production as a roundabout process, an
explanation for why real interest rates had to
be positive, and an equilibrium theory of
interest rates that included time as an important
variable affecting interest rates.
Economists usually view economies as
moving towards equilibrium and ignore the fact
that this process takes place over time. Since it
may take considerable time before an economy
can reach a state of rest or equilibrium, many
other changes can occur which upset the initial
equilibrium, and move the economy down
another path. Böhm-Bawerk refused to ignore
time, and he stressed that time was an important
factor in understanding how economies
actually behaved.
Of greatest importance, time was a key
factor in the decisions made by business firms
to produce goods and services. Business firms
could use production techniques that yield
goods relatively quickly; unfortunately, these
methods give us relatively few goods.
Alternatively, the firm could use more
roundabout techniques of production, wait
longer for the goods to be produced, and in
the end get more goods. To take one of Böhm-
Bawerk’s (1889, Vol. 2, Ch. 2) favorite
examples, we can produce drinking water from
a spring either by hand, by bucket or by pipes.
Each successive method of production is more
roundabout; and each method is also more
efficient and yields more water.
Roundabout production means using more
tools or capital to produce final goods for the
consumer, producing more intermediate goods,
and having production take place in many
different stages. Large assembly plants were
just beginning to appear when Böhm-Bawerk
was writing. With larger and more
technologically advanced plants it was
necessary to wait longer for the final output
(for example, automobiles), since a plant must
be built before any goods can be made and sold.
Using robots will get us even more goods than
an automated assembly line; but in this case
we first have to build the robots and the
automated plant and then stock the plant with
robots. This is an even more roundabout
production process. It requires more time and
a longer waiting period for the final output than
the assembly line. But this more roundabout
production method also yields more goods over
a long time period.
One problem with this theory was the
difficulty of measuring roundaboutness in
production, or determining which of two
production processes was more roundabout.
While this task is easy when comparing an
automated assembly line with someone
building a car in his garage, it is more
complicated when two different assembly line
techniques have to be compared or when two
different systems of piping water into homes
must be compared. And it is these latter
decisions that most firms must make. Böhm-
Bawerk did attempt to deal with the problem
of measuring roundaboutness, but his efforts
met with little success.
However, the notion of roundabout
production contains a key insight—production
involves a trade-off between having things
soon, but having few things, and having more
things, but having them in the distant future.
One could have more goods in the future by
giving up consumption for a long period of
time; or one could consume goods now, but
have fewer goods over the long haul.
Böhm-Bawerk analyzed this choice in terms
of the subjective time preferences of economic
agents. People decided whether they wanted
goods now or whether they prefer to give up
something now in order to get more in the
future; and business owners determined
whether more or less roundabout techniques
get employed in producing goods based on
whether they wanted to make some money now
or more money in the future.
This idea of subjective time preference also
forms the basis for Böhm-Bawerk’s theory of
interest. Böhm-Bawerk first laid the
groundwork for his theory of interest by
presenting and critiquing all previous theories.
This was done in Volume 1 of his (1884)
Capital and Interest, which showed that prior
attempts to explain interest based on the
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EUGEN VON BÖHM-BAWERK
productivity of capital, the abstinence from
consumption, or the exploitation of workers,
lacked any merit and made little sense. Volume
2 (1889) then went on to present a theory of
interest based on time. It also tried to show that
a positive rate of interest was inevitable and
therefore justified.
For centuries economists had been trying,
without success, to explain why real interest
rates had to be positive. One can think of the
nominal interest rate as the rate of interest
two parties agree upon. In simple terms, if I
borrow money from a bank for one year at a
rate of 10 percent, I am paying back a stack
of dollar bills that is 10 percent taller than
the stack of bills that I borrowed. The real
interest rate measures how much more the
bank can buy with the stack of bills I repay
it compared to the purchasing power of the
stack of bills I borrowed. If over the past year
the price of goods rises by 10 percent, the
money I repay is worth less because it can
buy less. In this case, a 10 percent bigger
stack of bills and 10 percent inflation means
the money I repay can buy no more (real)
things than the money I borrowed, and the
real interest rate is zero. By definition, the
real rate of interest equals the nominal rate
minus the rate of inflation. Alternatively, one
can think of the real rate of interest as Böhm-
Bawerk did—the real rate of interest paid by
a consumer represents how many future
goods he has to give up in order to consume
goods now.
Böhm-Bawerk provided three explanations
for positive real interest rates. First, there was
an argument based on economic growth.
Incomes usually grow over time. If people are
going be richer in the future, they should be
willing to give up more than one dollar in the
future in order to get one dollar now.
Second, Böhm-Bawerk argued that people
had a positive time preference; that is, they
preferred consuming goods now because the
future was uncertain. In the future one might
not have the desire to consume goods, or the
ability to do so (because no one knows how
long they are going to live). Since we want
things now, we have to be bribed to give up
goods now in exchange for goods in the
future. This bribe can only be more future
goods.
Finally, Böhm-Bawerk argued that since
roundabout production processes were also
more productive processes, borrowers could
easily afford to pay positive real interest rates
and should be willing to pay positive real
interest rates.
After explaining why real interest rates had
to be positive, Böhm-Bawerk went on to
explain how interest rates actually get set. His
analysis rested on standard supply and demand
analysis—the supply and demand for borrowed
money determined its price, or the rate of
interest.
Böhm-Bawerk’s contribution here was to
explain how roundabout production and
consumer time preferences influenced the
demand for money and the supply of money,
respectively. As we have seen, for Böhm-
Bawerk production was a process for
transforming goods. It was a roundabout
process that required other goods produced
in the past. These goods must be paid for
somehow. Also, to produce intermediate
goods will require labor and raw materials;
but workers must be paid and material must
be purchased before final goods are sold to
consumers. Roundabout production thus leads
to a demand for money on the part of business
firms. How many intermediate goods had to
be stockpiled and how long the production
process takes determines the demand for
money.
Also, the supply of money for Böhm-
Bawerk was determined by preferences on the
part of lenders for more goods in the future
relative to having goods now. If people take a
long-term perspective, and are willing to
sacrifice now in order to have more later, they
will be more willing to supply money. On the
other hand, if people desire immediate
gratification, a high real rate of interest (or
many future goods) will be needed to obtain
the money necessary for more roundabout
production to take place.
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After setting forth this theory, Böhm-
Bawerk (1896) used the theory to explain
why, contra Marx, workers were not
exploited. He assumed that all workers were
paid the going wage rate. The difference
between the output they produced and their
wages was the profit of the entrepreneur.
Workers could not receive the full future
value of what they produced because
employers had to pay interest during the
time production was taking place. Profits
were thus justified as a reward to capitalists
for employing more roundabout production
methods and therefore for producing more
goods. Profits also covered the interest cost
that firms had to pay to borrow money and
use more roundabout production
techniques.
Schumpeter (1965, p. 147) hailed Böhm-
Bawerk as one of the five or six greatest
economists of all time. But since
Schumpeter was a student of Böhm-Bawerk,
this assessment must be regarded as a rather
biased assessment. For most economists,
Böhm-Bawerk lacks the stature of the very
best and most important figures in the
history of the discipline. However, he did
make several key contributions to economic
theory. He recognized that time was
important in understanding the economic
role of capital and interest. And he also
recognized that time played an important
role in the production process.
Works by Böhm-Bawerk
Capital and Interest, 3 vols. (1884 and 1889),
trans. G.D.Huncke and H.F.Sennhole,
South Holland, Illinois, Libertarian Press,
1959
Karl Marx and the Close of His System (1896),
New York, A.M.Kelley, 1949
Further Essays on Capital and Interest, South
Holland, Illinois, Libertarian Press, 1959
Shorter Classics of Böhm-Bawerk, South
Holland, Illinois, Libertarian Press, 1962
Works about Böhm-Bawerk
Buechner, M.Northrup, “Roundaboutness and
Productivity in Böhm-Bawerk,” Southern
Economic Journal, 62, 2 (October 1989), pp.
499–510
Hennings, Klaus H., The Austrian Theory of Value
and Capital: Studies in the Life and Works of
Eugen von Böhm-Bawerk, Cheltenham, UK,
Edward Elgar, 1997
Hirshleifer, Jack, “A Note on the Böhm-Bawerk/
Wicksell Theory of Interest,” Review of
Economic Studies, 34 (1967), pp. 191–9
Kuenne, Robert E., Eugen von Böhm-Bawerk,
New York, Columbia University Press, 1971
Schumpeter, Joseph, “Eugen von Böhm-Bawerk,
1851–1914,” in Ten Great Economists: From
Marx to Walras by Joseph Schumpeter, New
York, Oxford University Press, 1965, pp.
143–90
KNUT WICKSELL (1851–1926)
Throughout his life Knut Wicksell was a highly
controversial figure. On principle he refused to
marry the woman with whom he chose to live
and raise a family. In 1909 he served two months
in jail for a speech that mocked the story of the
Immaculate Conception. And he championed
the rights of women, birth control and universal
voting long before these ideas gained acceptance
in Sweden.
The economics of Wicksell was likewise
controversial. An early advocate of the
marginal productivity theory of distribution,
Wicksell, in contradistinction to other
proponents of this theory, drew policy
conclusions from the theory that required
greater government intervention in economic
life. And in contrast to virtually all his
contemporaries, Wicksell held that inflation or
unemployment would continue indefinitely
unless appropriate economic policies were
employed.
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Wicksell was born in Stockholm, Sweden
in 1851 to middle-class parents. Because his
mother died when he was very young Wicksell
was raised by an uncle and aunt. He received a
good high school education, showing talent in
mathematics and natural sciences. In 1869,
Wicksell enrolled at Uppsala University with
the goal of soon becoming a Doctor of
Philosophy and Professor of Mathematics. But
his academic career turned out to be long and
varied. He developed interests in poetry,
feminism, and politics, and he published a
collection of twenty-five poems in 1878. Then
in the 1880s he became an ardent neo-
Malthusian, and traveled throughout Sweden
lecturing about the dangers of overpopulation
and the need to control population growth
through celibacy and birth control. As a result
of these diversions, it was not until 1885 (15
years after he first enrolled at Uppsala) that
Wicksell received a graduate degree in
mathematics.
However, his interests continued their
metamorphosis, moving from mathematics to
economics and social reform. With an
inheritance he received after the death of his
father, Wicksell went to London in order to read
the classics of economics at the British
Museum. He returned to Sweden with a desire
to teach and write about economics. But, at the
time, economics was taught by the law faculty
in Swedish universities. So Wicksell had to
study law and obtain a law degree before he
could receive an appointment teaching
economics. In 1899, at the age of 48, Wicksell
passed his law examinations and became a
lecturer in political economy and law at
Uppsala University. His academic career,
understandably, was very short; Wicksell
retired in 1916.
Wicksell made substantive contributions in
three distinct areas of economics— marginal
productivity theory, monetary theory, and
public finance.
Wicksell and British economist Philip
Wicksteed each (independently) solved the
adding up or product exhaustion problem (see
also CLARK). This involved describing when
the marginal productivity theory could explain
the distribution of all the output produced by
one firm. Wicksell was an early proponent of
the marginal productivity theory of distribution,
which held that an individual’s income depends
upon their (marginal) contribution to firm
revenues. One question left unanswered about
this theory was whether the sum of all marginal
productivities, and hence all incomes, was
equal to the value of the output produced by
the firm.
Wicksell demonstrated that whether this
was true or not depended upon returns to scale.
This notion concerns how output increases
given a certain increase in inputs. To take a very
simple example, consider a farm devoted
exclusively to growing corn. If we double the
number of acres used for growing corn and get
exactly twice as much corn we have constant
returns to scale. If we double the number of
acres used, but output increases by less than
100 percent we have decreasing returns to
scale. Finally, if we double our acreage and our
output of corn more than doubles we have
increasing returns to scale.
Wicksell showed that if and only if there
are constant returns to scale would the sum of
all marginal products equal the value of output
produced. In contrast, with increasing returns
to scale the sum of marginal payments would
exceed the value of the product produced;
while with decreasing returns to scale the sum
of marginal payments would be less than the
total value of output. In the latter case, some
value created in the production process could
not be explained by marginal productivity. In
the former case, the theory explained too much.
Wicksell next explained how competition
forced firms to operate at an optimal size, and
argued that this optimal size would require
constant returns to scale. He began by noting
that firms face U-shaped cost curves. For the
typical firm, costs fall as output rises, then
remain constant for a while, and finally they
begin to rise. It is not hard to understand why
this should be so. As the size of a farm starts to
grow the farmer can take advantage of
economies of scale. A second tractor will not
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have to be purchased to grow more corn; one
tractor can till more land. Likewise, a second
barn will not be required. The output of corn
can be doubled without doubling the inputs
needed to grow that corn. At some point,
though, economies of scale will be exhausted
and the firm will reach its optimal or most
efficient size. The firm now faces constant
returns to scale and constant costs for
producing additional corn. Beyond this level,
additional capital equipment will be required,
worse quality land will have to be employed
to grow corn, and the farm will become too
large to run efficiently. Decreasing returns to
scale thus set in.
Due to competition, firms are forced to
operate at the most efficient level of production.
This will be the point of minimum average
costs, or the level of production where constant
returns hold. Firms that do not produce at this
level will be forced out of business by its
competitors, which do produce at minimum
cost. Thus, competition forces firms to produce
at minimum average cost and with constant
returns to scale. As a result, Wicksell argued,
the marginal products paid to all factors of
production will tend to equal the value of the
products they produce, and the marginal
productivity theory will be able to explain how
all income gets distributed.
A second major contribution made by
Wicksell concerned monetary theory. During
the time of Wicksell, monetary theory primarily
studied the impact of money on prices. Ignored
were any effects that money or interest rates
had on the real economy— either on
production or on employment. Wicksell
changed monetary theory by arguing that
changes in the rate of interest could affect the
real economy.
Wicksell assumed that there was a natural
rate of interest, or natural rate of return, on
capital. He took this natural rate to be the rate
of return (or the yield) on newly created plants
and equipment. Innovations, or improvements
in production technology, would increase the
natural rate of interest, making investment yield
a bigger return. In contrast, the market rate of
interest is the rate charged by banks to those
who want to borrow money. This rate was
determined by the banking system.
Whenever the natural rate of interest
exceeds the market rate of interest,
businesses will want to invest and produce
since their gains from investment (the
natural rate) will exceed their cost of
borrowed funds (the market rate).
Investment is able to exceed savings,
Wicksell argued, because investment is
financed not with savings, but with credit,
or through the creation of new bank deposits
when banks make new loans.
The economic expansion that begins under
these circumstances will be cumulative and
self-perpetuating. Rising investment demand
will shift workers out of industries producing
goods for consumption, and into industries that
produce investment goods. With fewer
consumption goods, the prices of consumption
goods rise. As such, producers of consumer
goods make greater profits and will want to
expand production, or invest more. This
process of greater investment and rising prices
for consumer goods will continue unabated.
Nothing will cause a slowdown in the process
of growth and investment according to
Wicksell.
In contrast, if the natural rate falls below
the market rate, the demand for investment
falls. Businesses will not want to borrow
money for expansion since the cost of borrowed
funds (the market rate of interest) exceeds the
gains from investment (the natural rate of
interest). As a result, business production falls
and employment drops. Deficient demand will
lower prices and spending. But with sales down
and prices low, business profits will suffer.
Moreover, firms with excess capacity will not
want to invest. The economic contraction will
continue until investment rises. But this will
not happen unless either the natural rate of
interest rises or the market rate of interest falls.
The policy implication that follows this
analysis is both simple and straightforward—
monetary authorities must prevent any
divergence between the market and natural
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rates. Only by setting the market rate of interest
equal to the natural rate of interest can
monetary authorities prevent either continued
growth and rising inflation or continued
stagnation and rising unemployment. Another
implication of this analysis concerns the casual
relationship between money and interest rates.
For Wicksell, in contrast to much twentieth-
century monetary theory (see also FISHER),
it is the rate of interest that determines bank
lending and the supply of money (rather than
it being the money supply that determines the
rate of interest).
The third main contribution of Wicksell
concerns public finance. Wicksell supported
a mixed economy containing a large role for
government. Using cost-benefit analysis as
his justification, he advocated a substantial
increase in public ownership of firms.
Wicksell pressed for public ownership of
natural monopolies, such as utilities, as well
as any other enterprises that showed a
tendency towards monopoly or that began
forming cartels for the purpose of restricting
output and raising prices. It was better,
Wicksell believed, that these firms be owned
and operated by the government.
Government ownership would give
consumers more goods and services plus the
benefits of lower prices.
Since price would most likely fall below
the average cost of production, government-
owned firms would be incurring losses on a
continual basis. Wicksell suggested that
these losses be financed from revenues raised
through general taxation. He therefore did
not think it was necessary for state-owned
firms to make profits. Rather, the state was
to assume ownership of firms in order to
improve the allocation of national economic
resources relative to a situation of monopoly.
A second aspect of Wicksell’s theory of
public finance involved reducing the heavy
reliance on regressive taxation in Sweden
during the 1890s. Towards this end he
advocated lowering excise taxes and tariffs,
which fell heavily on low-income groups,
and developing progressive taxes on
individual and corporate incomes as well as
on estates or inheritances. Wicksell also
advocated modifying the Swedish property
tax system so that it better taxed the rising
share of “unearned” increases in land values.
He stressed that earned income should be
taxed at lower rates than unearned income.
As to the other side of the fiscal equation,
Wicksell advocated more government
spending for social services, especially
education, in order to compensate for income
inequalities that arise when income gets
distributed based on marginal productivities.
However, Wicksell also stressed the
importance of broadly distributing
government expenditures so that every
member of society felt that they benefited
from their tax payments.
These many proposals concerning public
expenditure and taxation make Wicksell the
founder of the Swedish mixed economy—
with high taxes, progressive tax rates, large
government benefits to workers, and
substantial government ownership of
production facilities.
Of our fifty major economists,
Wicksell is one of the most underrated.
One likely reason for this is that Wicksell
made contributions in so many different
and diverse areas. Another reason is that
Wicksell did not develop any key
economic notions, nor did he contribute
to the mathematization of economic
analysis. Finally, Wicksell himself must
share some of the blame. He was too
controversial, and too readily expressed
great contempt for other economists and
their theories. This was true of those with
whom Wicksell agreed and those with
whom he disagreed.
Works by Wicksell
Value, Capital and Rent (1893), London, Allen
& Unwin, 1954
Interest and Prices (1898), London, Macmillan,
1936
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Lectures on Political Economy (1901, 1906), 2
vols., London, Routledge & Kegan Paul,
1934–5
Selected Papers on Economic Theory, Cambridge,
Harvard University Press, 1958
Works about Wicksell
Firsch, Ragnar, “Frisch on Wicksell,” in The
Development of Economic Thought: Great
Economists in Perspective, ed. H.W.Spiegel,
New York, Wiley, 1952, pp. 652–99
Garlund, Torsten, The Life of Knut Wicksell,
Stockholm, Almqvist & Wicksell, 1958
“Symposium on the Theoretical Contributions of
Knut Wicksell,” Scandinavian Journal of
Economics, 80, 2 (1978), pp. 127–249
Uhr, Carl G., “Knut Wicksell—A Centennial
Evaluation,” American Economic Review, 41,
5 (1951), pp. 829–60
Uhr, Carl G., The Economic Doctrines of Knut
Wicksell, Berkeley, University of California
Press, 1960
Uhr, Carl G., “Knut Wicksell, Neoclassicist and
Iconoclast,” in The History of Swedish
Economic Thought, ed. Bo Sandelin, London
and New York, Routledge, 1991, pp. 76–120
THORSTEIN VEBLEN (1857–1929)
Thorstein Veblen (pronounced VEB-LIN, the
first syllable rhyming with WEB) is one of the
sharpest and wittiest critics of orthodox
economic theory. His criticism of traditional
theory, and his own positive contribution to
economics, stressed the impact that societal
institutions have on individual behavior. In
addition, Veblen saw behavior as motivated by
habit, by envy, and by other psychological
dispositions, rather than seeing individuals as
driven by rationality and self-interest. Veblen
then used these behavioral dispositions to
explain the changes economies regularly
undergo.
Veblen was born to Norwegian immigrants
in 1857 on a small farm in Wisconsin. He was
raised in rural Wisconsin and rural Minnesota.
His parents stressed the importance of
education, and pushed their children to excel
and to pursue higher education. Veblen studied
economics at Carleton College under John
Bates Clark, who first formulated the marginal
productivity theory of income distribution (see
also CLARK). He then studied philosophy at
Johns Hopkins University under Charles
Peirce, a world-famous philosopher and
founder of American pragmatism. At Johns
Hopkins he also studied political economy
under Richard Ely, an eminent economist who
founded the American Economic Association.
Despite having such distinguished teachers,
Veblen was rather dissatisfied with Johns
Hopkins and so he transferred to Yale. There
he studied philosophy under Social Darwinist
William Graham Sumner, earning a Ph.D. in
philosophy in 1884.
Because of the bad job market for
philosophers, Veblen was unable to find a
position teaching philosophy. He spent the next
seven years reading on his own, and then finally
decided it was time to switch fields; so he
entered Cornell to study economics. One year
later, Veblen moved to the University of
Chicago with his Cornell mentor J.Laurence
Laughlin. He taught at Chicago for fourteen
years but never rose beyond the rank of
Assistant Professor, even though he wrote two
highly successful and critically acclaimed
books (Veblen 1899, 1904), published
numerous essays, and edited the prestigious
Journal of Political Economy.
After leaving Chicago, Veblen moved
constantly from school to school, usually
encouraged by college administrators to seek
employment elsewhere. Part of the problem
was the affairs he had with young co-eds and
faculty wives. Another problem was that his
caustic criticism—especially of academia
(Veblen 1918) and other economists—did not
endear him to his colleagues. A further
difficulty was that Veblen had no regard for
academic rituals like department meetings,
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THORSTEIN VEBLEN
taking attendance in class, holding office hours,
and grading. He usually gave all his students a
“C” regardless of the quality of their work.
Finally, there was the problem with Veblen the
teacher. According to Dorfman (1934, p. 248f.),
Veblen “mumbled, he rambled, he digressed.
His classes dwindled; one ended up with but
one student….”
Veblen was also renowned for his quirky
lifestyle. Dorfman (1934, p. 239) reports that
Veblen furnished his living quarters with boxes
that served as tables and chairs. Mundane
household chores such as making up a bed,
were deplored as a waste of time. Dirty dishes
were stacked in a tub until no clean dishes
remained; then Veblen hosed them down.
According to Diggins (1978, p. 33–8), while
teaching at the University of Missouri in the
1910s, Veblen lived in the basement of a
friend’s house, entering and leaving through
the basement window.
Veblen’s economics was nearly as quirky
as his lifestyle. While other economists studied
human behavior from their ivory towers, Veblen
studied human behavior within the context of
anthropology and other social sciences. For
Veblen many forces influenced human
behavior, and he brought these other forces into
his economic analysis. As such, he sought to
broaden and enrich economics with the insights
from other disciplines.
Using the insights from other social
sciences, Veblen rejected the economic
assumption that much behavior was rational
and that people sought only their own
pleasures. Instead, he saw people as behaving
irrationally and following customs and habits
rather than maximizing utility. In fact, Veblen
turned traditional economic analysis upside
down, arguing that human institutions and
experience help determine what people believe
to be pleasurable and painful.
Veblen is best known for his first book, a
work that instantly made him famous. The
Theory of the Leisure Class (Veblen 1899)
rejects the traditional view of consumption as
a means to human happiness, and rejects the
view that individuals look inside themselves
to determine the happiness that they would
receive from consuming different goods. In its
place Veblen develops a cultural theory of
consumption. Habit, convention, and
superstitious irrationality all determine human
consumption.
Another important purpose of consumption,
according to Veblen, is to impress others.
Veblen called this “conspicuous
consumption.” He then went on to provide an
historical account of this phenomenon. He
demonstrated that in early, predatory cultures
unproductive consumption was a mark of
human prowess and dignity. In more modern
cultures, conspicuous consumption involves
various sorts of ostentation—giving valuable
gifts to others, driving expensive sports cars,
and arranging expensive and extravagant feasts.
These acts provide evidence of one’s wealth
and importance. Even in lower economic
classes, conspicuous consumption can be
demonstrated through a spouse who stays at
home and does no work in the marketplace for
remuneration.
The doctrine of conspicuous consumption
undermines the traditional view of economic
man. Money is not spent because it yields
utility to the individual consumer. Rather, the
doctrine of conspicuous consumption holds
that consumers spend money in order to make
their friends and neighbors jealous, and to keep
up with the spending of their friends and
neighbors.
This analysis has several important
consequences. If I buy an expensive car
because it makes my neighbor envious, and if
my neighbor buys a similar car to keep up with
me, neither one of us is better off. We both have
more expensive cars, but we have both failed
to show up each other.
Things can be even worse than this.
Suppose my neighbor buys a more expensive
car than I bought in order to make me
jealous. Not to be undone, I trade up to an
even more expensive model. This process can
continue indefinitely, with me and my
neighbor continually buying more and more
expensive cars. As a result of this process
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THORSTEIN VEBLEN
both of us seem to be far worse off—we have
incurred a great deal of debt buying things
we do not really want, and we have engaged
in a competition that neither one of us can
win and that is destructive to both of us.
Because of human desires to emulate and
“one up” others, human decisions may
actually reduce individual well-being.
Conspicuous consumption also undermines
the doctrines of consumer rationality and
consumer sovereignty. Once it is recognized
that consumption patterns stem from habits and
customs, then consumption is no longer the
outcome of rational calculation. And once it is
recognized that consumption patterns depend
upon the consumption of others and that culture
can affect consumption decisions, then
consumers are no longer autonomous beings
who know what they want and then buy these
things. Rather, people are human beings with
human flaws, who usually do not know what
they really want. Thus they look to advertising,
to culture, and to what others are doing in an
attempt to make consumption decisions. They
are not, according to Veblen, passive agents
who merely add up the pleasure they might
receive from doing different things or
consuming different goods.
Besides studying consumer spending habits,
Veblen (1904) also studied the dominant
characteristics of American capitalism at the
beginning of the twentieth century. These
included the rise of an industrial economy
dominated by machines and robber barons, the
inability of moral systems to control the power
of modern business, severe business cycles, and
the rise of near monopolies like US Steel and
Standard Oil. Unlike most of his
contemporaries, who focused on how the
economy would move towards a stable
equilibrium, Veblen attempted to understand
and explain the changes he saw taking place
in the world.
Towards this end, Veblen distinguished
business activities from the machine process,
and analogously the capitalist from the
engineer. The business enterprise for Veblen
was run by capitalists who were only interested
in making profits. The capitalist was a predator,
interested in making money rather than goods.
Goods could be useless and of poor quality,
but as long as they made money nothing else
was important.
In contrast, machine processes were the
technical procedures used in producing goods.
These processes were designed and run by
engineers. Unlike the capitalist-businessman,
engineers were concerned with productivity,
serviceability, and efficiency. And unlike
business activities, the machine process valued
workmanship. Its output was functional or
useful goods that satisfied man’s needs to eat,
to work constructively, and to satisfy his
curiosity.
Business activities were the root causes of
the business cycle (Veblen 1904, p. 237).
Businessmen borrowed money based on their
expectations of future profits. This borrowing
increased economic activity and prices,
leading to higher profits. With their
expectations confirmed, businessmen would
form even more optimistic views of future
profits. And with things going so well,
businesses were able to borrow more and
make even more money. At some point,
however, unease about continued profits
would arise and some businessmen would see
the possibility of making money in a
contraction. Loans would get called in, small
businesses would start to go under, and a
recession would follow. Stagnation would
then continue until businessmen saw enough
opportunities for greater profit and were
willing to borrow and expand their operations.
In sharp contrast to other economists writing
on business cycles in the early twentieth
century, Veblen saw no tendencies for the
economic system to equilibrate. Rather, he saw
unending instability and oscillation. Any
analysis of how economies reached an
equilibrium was therefore unscientific
according to Veblen. For economic analysis to
be scientific, it had to focus on the evolutionary
changes of institutions over time rather than
on the way an economy moves to a static
equilibrium point.
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Where did Veblen think this process was
heading? Somewhat naively, Veblen thought
the machine process and the engineer would
help solve the many economic problems
facing America. The machine process would
allow greater planning of production and
distribution. It would allow us to do away with
the price system. It would also end the waste
of unemployment on the one hand and the
waste of conspicuous consumption on the
other hand.
Veblen was one of two or three bestknown
American economists in the early twentieth
century. He attempted to give economics
greater breadth by bringing to it the insights
from other social sciences. More specifically,
he showed how habits, culture, and institutions
mold human behavior, and how changing
human behavior affects the economy. As a
result of this work, Veblen has become the
intellectual father of the institutionalist school
of economics.
Works about Veblen
Diggins, Jack, The Bard of Savagery, New York,
Seaburg Press, 1978
Dorfman, Joseph, Thorstein Veblen and His
America (1934), New York, Augustus
M.Kelley, 1972
Mitchell, Wesley C., “Thorstein Veblen” in The
Backward Art of Spending Money and Other
Essays, New York, Augustus Kelley, 1950, pp.
279–312
Riesman, David, Thorstein Veblen: A Critical
Interpretation, New York, Charles Scribner’s
Sons, 1953
Rosenberg, Bernard, The Values of Veblen,
Washington, D.C., Public Affairs Press, 1956
Tilman, Rick, Thorstein Veblen and His Critics,
1891–1963: Conservative, Liberal and
Radical Critics, Princeton, New Jersey,
Princeton University Press, 1992
Works by Veblen
IRVING FISHER (1867–1947)
The Theory of the Leisure Class (1899), New York,
Macmillan, 1908
The Theory of Business Enterprise (1904), New
Brunswick, Transaction Publishers, 1978
The Instinct of Workmanship and the State of the
Industrial Arts, New York, Macmillan, 1914
The Higher Learning in America: A Memorandum
on the Conduct of Universities by Business
Men, New York, B.W.Huebsch, 1918
The Place of Science in Modern Civilization
(1919), New Brunswick, Transaction
Publishers, 1990
The Vested Interests and the State of the Industrial
Arts, New York, B.W.Huebsch, 1919
The Engineers and the Price System (1921), New
Brunswick, Transaction Publishers, 1983
Absentee Ownership and Business Enterprise in
Recent Times, New York, B.W.Huebsch, 1923
A Veblen Treasury: From Leisure Class to War,
Peace and Capitalism, ed. Rick Tilman,
Armonk, New York, M.E.Sharpe, 1993
Irving Fisher spent his career studying
questions about money and the economy—
how money affects interest rates, how money
affects inflation, and the impact of money on
overall economic activity. For this work, he
is regarded as the father of monetary
economics.
Fisher was born in 1867 in Saugerties, New
York. His father was a clergyman, and so Fisher
grew up in a highly religious environment.
More than likely, this contributed to the sense
of mission that characterized his personal life
as well as his professional life.
Fisher received a good public school
education and excelled in mathematics. When
he decided to attend college at Yale, his family
moved with him to New Haven. Graduating
first in his class, Fisher remained at Yale to do
graduate work in both mathematics and
economics. He began studying economics with
William Graham Sumner, an advocate of Social
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IRVING FISHER
Darwinism, the philosophy holding that in
social life the best competitors would always
win out and that human improvement requires
a competitive struggle (see Hofstadter 1944).
Under the influence of Sumner, Fisher took
every economics and social science course
offered at Yale (Allen 1993). However, it
appears that the philosophy of Sumner had little
influence on Fisher. Most of his work in
economics at Yale, as well as his doctoral
dissertation, involved making economics more
quantative rather than bringing philosophy or
social issues into the realm of economics.
When Fisher graduated from Yale in 1892
he was already regarded as one of the leading
mathematical economists of his day, and Yale
immediately hired him as an economics
professor. Many accolades and awards soon
followed. In 1918 Fisher was elected President
of the American Economic Association. In
1930 he helped to found the Econometrics
Society and became its first President.
During the 1920s Fisher applied his
knowledge of economics and financial markets
to Wall Street. Speculating heavily in stocks,
he soon became a multimillionaire. But Fisher
lost half his net worth in the crash of 1929.
Believing that stocks were a good bargain
following the crash, Fisher borrowed heavily
to buy more stock. When the market continued
to fall, Fisher lost his entire fortune and then
some. He remained heavily in debt for the rest
of his life and lived the simple lifestyle that
comes with such indebtedness.
Fisher devoted his life to many causes and
wrote many popular books advocating those
causes. He was a crusader for healthy living
and a wholesome lifestyle. He advocated eating
well and getting sufficient exercise, and he
started the Life Extension Institute in 1913. He
opposed smoking, eating meat, and drinking
alcohol. And he devoted much time and effort
to causes such as Prohibition and US entry into
the League of Nations.
Fisher was also an economic policy
crusader. His success in this arena, however,
was no better than his success on Wall Street
or his success in getting the US to join the
League of Nations. Neither his (Fisher 1935)
proposal to require that banks keep all their
deposits on hand instead of lending out these
funds, nor his (Fisher 1942) plan for taxing
individual expenditures rather than income (see
also KALDOR), nor his (Fisher 1920) plan to
control inflation by backing the dollar with a
diverse set of goods (see Patinkin 1993) was
ever taken seriously.
In contrast to his policy proposals, Fisher’s
theoretical work earned him the reputation of
being a first-rate economist. His main interests
were monetary theory—money, interest rates,
prices, and how they were all related. His main
contributions were to explain monetary
concepts and how money affected the
economy.
It is Fisher who first defined precisely the
notions of income, capital, and wealth. To
understand these terms requires knowledge of
the differences between stocks and flows.
Fisher claimed this distinction clicked into his
mind during a mountain climbing trip to the
Swiss Alps when he saw water cascading down
a mountain into pools of water (Allen 1993, p.
66f.). The pools of water at the bottom of the
mountain constituted a stock; the water flowing
down the mountain was an addition to the stock
and increased the size of the stock.
Fisher (1906) used this distinction to clarify
several economic notions. He defined capital
as a stock of wealth at one point in time,
analogous to a stock of water in a pool at the
bottom of a mountain. Out of current income
would come a flow of savings which, like the
water cascading down the Swiss mountain,
adds to our stock of wealth. Too much spending
(or spending more than your income) would
cause a flow out of current wealth, thus
reducing the stock of wealth.
Fisher (1896, Chs 1–3; 1907, Ch. 5) also
distinguished real interest rates from nominal
interest rates (see also BÖHM-BAWERK), and
he (Fisher 1920, pp. 35–9; 1928) coined the
term “money illusion” to refer to an inability
to distinguish a dollar from the purchasing
power of the dollar (or what the dollar could
buy after inflation). Interest rates on bank
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deposits provide one good example of money
illusion. When the rates on certificates of
deposit fall, people generally complain about
the low returns they are getting. Yet, these
people may have been doing worse with higher
nominal interest rates and higher inflation.
Money illusion also frequently occurs when
workers get pay increases. Since wages are a
major component of business costs, higher
wages usually lead to higher prices. Workers
suffering from money illusion will be happy
with a bigger pay check even though the bigger
check can buy fewer things.
For Fisher (1923, 1925), money illusion was
a prevalent phenomenon. He also thought it
was responsible for the business cycle.
Business firms, believing that real interest rates
are high during times of inflation and high
nominal interest rates, stop borrowing and
investing. This slows down economic activity.
Then, when a slowing economy reduces
nominal rates, businesses mistake this for a cut
in real rates and increase their borrowing and
investment. As the economy expands, money
illusion eventually brings the expansion to a
halt. As the expanding economy generates
inflationary pressures, banks must raise
nominal rates to maintain the real rate of
interest they make on their loans. Again,
businesses mistake this for higher real rates and
investment falls. According to Fisher, economic
expansion and contraction follow one another
continually as a result of this process.
Fisher also tackled the difficult problem of
how to measure inflation for the entire
economy. Inflation is simply the change in
prices faced by a typical family. Since each
family purchases a diverse set of goods, and
since the goods it buys changes regularly,
developing a single number to represent the
average change in prices becomes a complex
problem.
The simple solution to this problem of
measuring inflation is to measure the price
change for a set of goods that the typical family
buys at one point in time. One problem with
this method is that when prices change for
some good, people buy less of that good. This
problem became particularly acute in the
1970s, when oil prices rose dramatically and
energy consumption fell. Do we use the
original quantities here or do we use the
quantities bought after the price change? In the
late twentieth century, all nations used the set
of goods bought by people before prices
change when calculating inflation. Nations
have adopted this method for practical reasons
more than anything else. It is both expensive
and time consuming to take surveys of
consumer purchases. Surveys therefore are only
taken every few years. But this decision has
important consequences for our measurement
of inflation; it implicitly assumes that
consumers will not change their spending
patterns when prices change.
Fisher (1922) recognized that using original
purchases would overstate the actual inflation
rate because it assumes that people are buying
large quantities of the good (gasoline, in our
example) that increases most in price. He also
recognized that taking the opposite approach,
and using quantities bought by families after
the price change, would underestimate the loss
in purchasing power to the family when some
good rises in price by a large amount. Fisher
suggested that an ideal index number, or
inflation measure, should employ the average
of quantities bought before the price change
and quantities bought after the price change.
While Fisher devoted a great deal of effort
and energy to clarifying economic notions, he
did more than just help define concepts. His
main contributions to economics involved
analyzing what factors determined interest rates
and what factors caused inflation.
Fisher’s theory of the rate of interest is still
taught to most economics students today, and
is regarded by most economists as a correct
analysis of what determines interest rates for a
particular economy. Fisher (1930) proposed
that interest should be viewed as an income
flow that comes from using anything in
production. In particular, interest is the income
flowing to someone who allows their stock of
wealth to be used in producing goods. When
wealth gets used in the production process,
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someone lends money to a business firm and
does not spend it. Interest was thus a reward
for not consuming things today, and Fisher’s
theory is usually referred to as a time-
preference theory of interest. Because most
people desire to consume things now, they have
to be paid to wait until next year or the year
after to consume goods.
Two forces determined interest rates
according to Fisher. On the supply side, the
preferences of individuals for present and
future income is important. The rate of interest
gives the additional amount of goods that
people will be able to consume in the future
by not consuming today and lending the money
they save to someone else. Interest thus
becomes a payment to lenders who forgo
consumption now and consume (more) goods
at some later time.
On the demand side, interest rates depend
upon available investment opportunities and
the productivity of capital (including human
capital). Greater productivity will lead to
greater demand for borrowed money. With
greater productivity, profits increase and
business owners will want to expand more. To
do this they will need to borrow or will demand
more money.
The equilibrium rate of interest is the rate
of interest at which the quantity of funds
that borrowers want to lend equals the
quantity of funds that lenders are willing
to give up. Fisher made it clear that the
forces affecting both supply and demand
were unstable. Moreover, in addition to
economic factors, supply and demand were
also affected by social and psychological
factors such as the habits, intelligence, self-
control, and foresight of both borrowers and
lenders.
Finally, Fisher (1911) set forth the now-
famous equation of exchange, and he used
it to identify the causes of price inflation.
The equation, MV=PQ, says that the money
supply (M) times its velocity (V, the number
of times a unit of money is used during a
year to purchase goods and services) must
equal the output of goods and services (P
times Q). This equality must be true as a
result of the definitions of the various terms.
If an economy has a money supply of 1
trillion francs, and if each franc is used 7
times during the year to purchase things,
then 7 trillion francs worth of goods and
services will be purchased during the year.
This is the national output or gross domestic
product of the French economy. This output,
in turn, can be further divided into price (P)
and quantity (Q) components. The quantity
represents real things that are produced,
while the price component measures how
much each thing costs on average (Fisher’s
price index).
Using this equation Fisher was able to
explain the three potential causes of
inflation. First, if V and Q are both constant,
prices will vary with changes in the money
supply; that is, inflation will be due to too
much money in the economy. Second, if M
and Q are constant, prices will vary with
changes in velocity. In this case, inflation
stems from people trying to spend their
money too quickly, or trying to buy more
goods than the economic system can
produce. Finally, if M and V are constant,
prices go up if quantities go down. Here, a
shortage of goods leads to inflation.
Taking his analysis one step further,
Fisher (1910) analyzed the factors that
affect M, V, and Q. Most important was his
explanation of how the spending habits of
individuals, and the means by which people
get paid, affect the velocity of money. To
keep things simple, suppose all workers get
paid at the beginning of every month.
During the month they will normally use
just about all their pay to buy goods and
services. By the end of the month, then, all
money is again held by employers and can
be used to pay next month’s wages. In this
case, each 1franc will be used 12 times
during the year to purchase goods (once
each month), and the velocity of money will
be 12. On the other hand, if French workers
were paid two times a month, the same
process of wage payments followed by
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ARTHUR CECIL PIGOU
spending would occur 24 times a year, and
the velocity of money would be 24 instead
of 12. Because the frequency with which
people are paid is relatively constant, the
velocity of money should also be relatively
constant. This leaves changes in the money
supply (M) as the main cause of economic
fluctuations. For Fisher, changes in M could
affect either prices or real output.
Contemporary monetary economists follow
Friedman and contend that changes in the
money supply affect only prices in the long
run.
Although probably not as well-known by
the general public as Thorstein Veblen, Fisher
ranks as the most important American
economist in the first half of the twentieth
century. Lacking Veblen’s breadth and vision,
Fisher made up for this with the large number
of contributions he made to monetary theory—
both defining important notions, showing how
money affects the economy, and explaining
what determines interest rates.
100% Money: Designed to Keep Checking Banks
100% Liquid; to Prevent Inflation and
Deflation; Largely to Cure or Prevent
Depressions; and to Wipe Out Much of the
National Debt, New York, Adelphi, 1935
Constructive Income Taxation, New York, Harper,
1942
Works about Fisher
Allen, Robert Loring, Irving Fisher: A Biography,
Cambridge, Blackwell, 1993
Fisher, Irving Norton, My Father, Irving Fisher,
New York, Comet Press, 1956
Patinkin, Don, “Irving Fisher and His
Compensated Dollar Plan,” Economic
Quarterly (Federal Reserve Bank of
Richmond), 79, 3 (Summer 1993), pp. 1–33
Schumpter, Joseph, “Irving Fisher’s
Econometrics,” Econometrica, Vol. 16, 3 (July
1948). Reprinted in Ten Great Economists,
New York, Oxford University Press, 1965, pp.
222–38
Works by Fisher
Appreciation of Interest, New York, Macmillan,
1892
The Nature of Capital and Income, New York,
Macmillan, 1906
The Rate of Interest, New York, Macmillan, 1907
The Purchasing Power of Money, New York,
Macmillan, 1910. Revised edn . 1922
Stabilizing the Dollar, New York, Macmillan,
1920
The Making of Index Numbers, New York,
Houghton Mifflin, 1922
“The Business Cycle Largely a ‘Dance of the
Dollar’,” Journal of the American Statistical
Association, 18 (December 1923), pp. 1,024–
8
“Our Unstable Dollar and the So-Called Business
Cycle,” Journal of the American Statistical
Association, 20 (June 1925), pp. 179–202
The Money Illusion, New York, Adelphi, 1928
The Theory of Interest, New York, Macmillan,
1930
Other references
Hofstadter, Richard, Social Darwinism in
American Thought, Philadelphia, University of
Pennsylvania Press, 1944
ARTHUR CECIL PIGOU (1877–1959)
A.C.Pigou (pronounced PIG-GOO) is
known as the father of modern welfare
economics, which studies how to make
economies operate more efficiently as well
as the trade-offs between efficiency and
equity. Pigou is also one of the founders of
modern public finance. This work
developed the means to analyze how taxes
impact the economy and the justification for
government intervention in economic
affairs.
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ARTHUR CECIL PIGOU
Pigou was born in 1877 at Ryde, on the Isle
of Wright. His father was an officer in the
British army; his mother came from a long line
of Irish government officials. Pigou studied first
at Harrow, an elite English private school, and
then at King’s College, Cambridge. He began
studying history at Cambridge; but in his third
year he came under the influence of Alfred
Marshall and Henry Sidgwick, who convinced
him to study political economy. Like Marshall,
Pigou was attracted to economics for its
practical value. He sought to teach his students
that “the main purpose of learning economics
was to be able to see through the bogus
economic arguments of the politicians”
(Champernowne 1959, p. 264).
When Marshall retired from Cambridge in
1908 Pigou succeeded him in the Chair of
Political Economy. From then until his
retirement in 1943, Pigou was the main
expositor of Marshallian economics at
Cambridge.
World War I became a life-altering
experience for Pigou. He continued teaching
at Cambridge, but also served in the ambulance
corps close to the front line during vacations.
Johnson (1960, p. 153) reports that “this
experience was responsible for transforming
the gay, joke-loving, sociable, hospitable
young bachelor of the Edwardian period into
[an] eccentric recluse.” Besides being a recluse,
Pigou was also known as an extremely frugal
human being, especially when it came to
clothing. He frequently wore ratty and stained
clothing, and showed up “at the Marshall
Library one day in the fifties proudly wearing
a suit bought before the First World War”
(Johnson 1960, p. 150).
The main economic contributions of Pigou
fall into two broad categories. First, his analysis
of externalities provides the foundation for
modern public finance, environmental
economics and welfare economics. Second,
Pigou was the first major opponent of the
macroeconomic revolution started by Keynes.
Pigou’s (1906, 1912) first works in
economics were on industrial relations and
import duties. These studies led to an interest
in how government policy could increase
national well-being. Pigou (1912) raised this
general question, and then spent most of his
life trying to answer it. In so doing, he invented
a good deal of modern public finance,
especially the arguments and rationale for
government intervention in the economy.
For some goods, all production costs are
borne by the firm and passed on to the
consumer via the price of the good. Pigou
(1920) showed that the (private) production
costs to a firm may not reflect all the social
costs of production. When producers
manufacture a good they take into account
only their private costs—the labor, the raw
materials, and the capital that they have to
purchase. But production inevitably pollutes
the environment and these costs are paid for
by third parties who neither produce nor
consume the good. Here the social costs of
production exceed the private costs; the firm
and the consumer get others to pay part of
the cost of producing that good. Market
outcomes are not the best possible outcomes
in this situation. We get too many goods that
pollute the environment; and firms tend to use
technology that creates excessive pollution
since the costs of pollution are imposed on
third parties but free to the firm. As a result,
the market system produces too much polluted
air and water, as well as excessive noise and
congestion in urban areas.
On the other hand, production can yield
benefits to society that exceed the benefits
received by the consumers who buy that
good. The lighthouse, an example developed
by British economist and philosopher Henry
Sidgwick in 1883, is typically used by
economists to illustrate this case. Other
examples of this sort include police and fire
protection, national defense, and spending on
health care and education. The individual
who purchases a cold remedy benefits
because they feel better as a result of taking
this medication. But if this medication also
makes it less likely that others will be
infected, there are greater social benefits than
private benefits.
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ARTHUR CECIL PIGOU
Such divergences between private costs and
social costs have been called “externalities”
“spillover effects,” and “third-party effects.”
Pigou stressed that when marginal private costs
and marginal social costs diverge, the market
system was inefficient. These divergences
between private and social costs might justify
government intervention into the market place.
Whenever there are large positive
externalities, people gain whether or not they
pay anything. This ability to obtain the benefits
of some good or service without having to pay
for it gives rise to what is now called “the free
rider problem.” Each person, looking at things
from their own individual point of view, will
recognize that if they do not contribute money
towards the national defense, a defense system
will get built anyway; and they will still reap
the benefits of greater defense spending. If the
US gets attacked from abroad, my house will
be protected whether or not I helped to pay for
the national defense. Moreover, if I do not
contribute to the national defense, a defense
system will still be constructed. And my failure
to contribute anything will make little
difference to the type of defense system that
gets built or the quality of that defense system.
By not contributing to the national defense I
save my hard-earned money, but I lose nothing.
The problem here is that when everyone
reasons in this manner no money gets spent
for defense and everyone is worse off. The
solution to this problem is for the government
to improve upon market-based outcomes. The
government must develop a defense system and
must tax all beneficiaries (its citizens) for the
cost of its construction.
In many cases the government can remedy
problems that stem from externalities through
taxes and subsidies. But sometimes legal
remedies are sufficient to solve the problem.
For example, in the Economics of Welfare,
Pigou (1920, pp. 129–30) argued that railroads
should compensate farmers and other property
owners who suffered losses from the damage
of sparks and smoke emitted from trains. In
this case, the main policy change needed was
in British liability laws. If the railroads had to
compensate others for the damages done by
their trains, Pigou thought they would be more
careful and would run fewer trains. Private and
social benefits would thus no longer diverge,
and externalities would be internalized, or
become part of the cost of transporting goods
via railroads.
Finally, in some cases no government
intervention is justified to remedy the problems
stemming from externalities. When the costs
imposed on third parties are small and the costs
of any remedy are large, cost-benefit analysis
leads to the conclusion that externalities should
be allowed to persist. Consider the noise
coming from trains. If this imposes only minor
inconveniences on local residents, then the cost
of forcing the railroads to move their lines or
develop quieter trains may far exceed the cost
to people of hearing trains go by their home
every few hours.
Pigou (1920, Ch. 1) asserted that one job
of the economist was to identify externalities
and to help eliminate them by showing how
and when government action would improve
upon market outcomes. He even thought that
economists had a moral responsibility to
identify externalities. But Pigou was not only
interested in eliminating externalities. His main
concern was how to increase the economic
well-being of a nation. This, he noted,
depended on both the size of the economic pie
and its distribution.
More output would increase general
welfare, since people desire to have things, and
the more things they have (in general) the better
off they are. Redistributive economic policies
would likewise increase general welfare. This
conclusion followed from Pigou’s belief that
the satisfaction derived from money declines
as one has more and more money. Another few
hundred dollars means little to Bill Gates, who
is fabulously wealthy, but to someone who is
unemployed this extra money may make the
difference between life and death.
Consequently, the loss of welfare from taxing
the rich must be less than the gain in economic
welfare from giving that money to the poor.
Progressive taxation and transfer programs to
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ARTHUR CECIL PIGOU
aid the poor could thus be justified as
improving the overall well-being of the nation.
Pigou did recognize that progressive taxes
and transfers might reduce the size of the
economic pie, and that there could be a trade-
off between growth and equity. When there was
no trade-off the implications were clear.
Anything that increased national output, but did
not make the poor worse off, increased national
welfare. And anything that increased the share
of national output going to the poor, but did
not reduce the total size of the output, also
increased well-being.
However, when these two criteria clashed
(when transfers to the poor reduced output)
the situation was quite different. Judgments
would be required about how much output to
give up in order to improve the position of
the poor. Arthur Okun (1975, Ch. 4) has
vividly described this trade-off in terms of a
leaky bucket. Transfers from the rich to the
poor are always made with a leaky bucket,
which will lose some income as it redistributes
income. The leaking water represents the
inefficiencies or the reduced national output
due to these transfers. Okun (1975, p. 94), a
strong supporter of equality, thought transfers
should be stopped when the leakage hit 60
percent. Pigou (1920), was not quite as precise
but he did state that sacrificing a little output
was worth the gains that come from greater
equity.
Despite his many contributions to welfare
economics and to public finance, Pigou has
probably attained greatest notoriety as an
opponent of the Keynesian Revolution that
began in Cambridge, England during the
1930s. Keynes (1936) made Pigou his
whipping boy in the General Theory. For
many reasons, Pigou was an easy target. He
was a recluse with few followers who would
come to his defense; he dressed badly and was
a comic figure at Cambridge; and he was part
of the older establishment against whom
Keynes was rebelling.
Keynes lumped Pigou with the classical
school of economics and attributed to this
school the belief that supply would always
create its own demand. According to Keynes,
the classical economists held that this was true
for both goods and labor; they believed that
unemployment was impossible because when
people offered their services to some employer
there would have to be some demand for their
labor services. If not, wages would fall until
someone was willing to hire these workers.
There is a certain degree of validity to this
picture of Pigou. Pigou (1914) published a
popular work entitled Unemployment, which
argued that in the long run unemployment
was due to inflexible and high wages. Many
years later, Pigou (1927) argued that reduced
demand by businesses for workers would
lead to higher unemployment, but that this
problem could be remedied if workers let
their real wages fall. And The Theory of
Unemployment (Pigou 1933) argued that if
wage levels were greater than the marginal
productivity of workers, businesses would
not hire anyone since the cost of doing so
would exceed the benefits of hiring that
worker. Although Pigou never advocated
wage cuts (see Aslanbeigui forthcoming), in
all these cases the solution to the
unemployment problem seemed to be a
reduction in wages. And it was for this reason
that Keynes criticized Pigou.
Pigou was deeply offended by the
General Theory, both for its attacks on
himself and its attacks on the Marshallian
tradition at Cambridge. Reviewing the
General Theory, Pigou (1936) accused
Keynes of misrepresenting his views, and
claimed there was nothing at all of merit in
the book. He argued that in his previous work
he recognized that expansionary policies
could increase prices, thereby reducing real
wages and increasing employment in the
short run.
Pigou (1943, pp. 349f.) later developed
his own criticisms of Keynesian economics.
He formulated the real balance or Pigou
effect, which described one way that the
problem of high unemployment would tend
to be self-correcting and not require
Keynesian economic policies. Pigou pointed
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out that prices generally fall during periods
of high unemployment because firms cannot
sell goods otherwise. As a result, real wealth,
or the purchasing power of prior savings,
increases during a recession. Being
wealthier, people tend to spend more. This
additional spending will then spur
production, and businesses will hire more
workers. Unemployment would thus end
automatically and macroeconomic policy
was unnecessary.
Pigou spent most of his career within the
shadows of two giant Cambridge economists
—Marshall and Keynes. For this reason, his
contributions have seemed small by
comparison. While not achieving the stature
of either Keynes or Marshall, the influence
of Pigou remains large. The way that
economists analyze and justify government
intervention in economic affairs stems from
Pigou. It is for this reason that Pigou became
the father of modern public finance and
modern welfare theory. It is also for this
reason that the relatively new field of
environmental economics rests squarely
upon his shoulders.
Works by Pigou
Works about Pigou
Aslanbeigui, Nahid, A.C.Pigou, London,
Macmillan, forthcoming
Champernowne, D.G., “Arthur Cecil Pigou 1877–
1959,” Journal of the Royal Statistical Society,
122, pt II (1959), pp. 263–5
Collard, David, “A.C.Pigou, 1877–1959,” in
Pioneers of Modern Economics in Britain, ed.
D.P.O’Brien and John R.Presley, London,
Macmillan, 1981, pp. 105–39
Johnson, Harry, “Arthur Cecil Pigou, 1877–
1959,” Canadian Journal of Economics and
Political Science, 26, 1 (February 1960), pp.
150–5
Saltmarsh, John and Wilkinson, Patrick, Arthur
Cecil Pigou, 1877–1959, Cambridge,
Cambridge University Press, 1960
Other references
Keynes, John Maynard, The General Theory of
Employment, Interest and Money (1936), New
York, Harcourt, Brace & World 1964
Okun, Arthur M., Equality and Efficiency: The
Big Tradeoff, Washington, D.C., Brookings
Institution, 1975
Protective and Preferential Import Duties,
London, Frank Cass, 1906
Wealth and Welfare, London, Macmillan, 1912
Unemployment, New York, Holt, 1914
The Economics of Welfare (1920), 4th edn.,
London, Macmillan, 1932
Industrial Fluctuations, London, Macmillan, 1927
A Study in Public Finance (1928), 3rd edn.,
London, Macmillan, 1951
The Theory of Unemployment, London,
Macmillan, 1933
The Economics of Stationary States, London,
Macmillan, 1935
“Mr. J.M.Keynes’ General Theory of
Employment, Interest and Money,”
Economica, 3, 10 (May 1936), pp. 115–32
“The Classical Stationary State,” Economic
Journal, 53 (1943), pp. 343–51
JOHN MAYNARD KEYNES
(1883–1946)1
With Adam Smith and Karl Marx, John
Maynard Keynes (pronounced CANES) stands
as one of three giant figures in the history of
economics. As Smith can be viewed as the
optimist of this trio, seeing economic
improvement as the main consequence of
capitalism; and as Marx can be viewed as the
pessimist, believing that its many serious
problems would cause capitalism to self-
destruct; Keynes can be viewed as the
pragmatic savior of capitalism. Recognizing
both the benefits and flaws of capitalism,
Keynes looked to economic policy as a means
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of mitigating the problems with capitalism.
Intelligent government policy, he thought,
could save capitalism, allowing us to reap its
benefits without experiencing its dark side.
Keynes was born in Cambridge, England
in 1883 with the proverbial silver spoon in his
mouth. His father, John Neville Keynes, was
the registrar at Cambridge University and a
distinguished economist and philosopher at the
University. His mother, for a time, was the
mayor of Cambridge.
Keynes was educated at the best schools in
England—Eton and King’s College,
Cambridge. At Cambridge, he studied the
classics, philosophy with G.E.Moore,
mathematics with Alfred North Whitehead, and
economics with Alfred Marshall. Keynes also
became part of an exclusive club of intellectuals
at Cambridge, which later became the
Bloomsbury group. The group included major
literary and artistic figures such as Virginia
Woolf, E.M.Forster, and Lytton Strachey.
After graduation, Keynes sat for the British
Civil Service exam and received the second
highest score of all those taking the test. This
gave Keynes the second choice among all
open civil service positions. Although he
craved a job at the Treasury, this position was
taken by Otto Niemeyer, who had first choice
by virtue of scoring highest on the exam.
Ironically, Keynes received the highest scores
in Logic, Psychology, Political Science, and
Essays; but he scored second overall because
of a relatively low score in Economics. Later
in life, Keynes would quip that he “knew more
about Economics than my examiners” (Harrod
1951, p. 121).
Settling for a post in the India Office,
Keynes helped to organize and co-ordinate
British interests involving India. “His first
major job, lasting for several months, was
ordering and arranging for the shipment to
Bombay of ten young Ayrshire bulls”
(Moggridge 1992, p. 168). Things did not
get any more interesting after this and
Keynes, understandably, became bored with
his job. Two years later, in 1908, he returned
to Cambridge to teach economics. Three
years after that he assumed editorship of the
Economic Journal, which at the time was
the most prestigious economics journal in
the world.
Public acclaim first came to Keynes
following publication of The Economic
Consequences of the Peace, a book about the
Versailles Peace Treaty ending World War I.
During World War I Keynes served in the
British Treasury and was primarily responsible
for obtaining external finance to support the
British war effort. As the end of the war drew
near, Keynes was made a member of the British
delegation at Versailles that was negotiating
German war reparations. Besides containing
biting portraits of the major participants at the
peace conference (US President Wilson, French
Chancellor Clemenceau, and British Prime
Minister Lloyd George), Keynes (1971–89,
Vol. 2) also provided an angry critique of the
peace treaty itself. According to his
calculations, Germany could not possibly make
good on the British and French demands for
reparations. The economic consequence would
be the impoverishment of Germany, and rising
German hostility towards France and England.
The political consequence, which Keynes
equally feared, would be the rise of an angry
and militant Germany in the future.
Now a figure of national prominence,
Keynes turned his attention to questions of
economic theory and policy. His Tract on
Monetary Reform (Keynes 1971–89, Vol. 4)
warned of the dangers from inflation. It looked
to central bank control of the money supply as
a means of stabilizing the price level and
keeping inflation under control. This work also
contained Keynes’ famous and misunderstood
dictum “in the long run we are all dead.” Many
have taken this phrase to mean that Keynes was
willing to sacrifice long-term economic
performance for short-term economic benefits.
Yet this is not at all what Keynes was driving
at. Keynes meant to criticize others who
believed that the problem of inflation would
eventually remedy itself, without any active
government involvement. To the contrary,
Keynes felt that rather than waiting for
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inflationary problems to correct themselves in
the distant future, it would be better to employ
economic policy and improve things now. His
point was that there was no reason to wait for
elusive future gains, when more rapid progress
could be made solving economic problems by
intelligently employing economic policies.
In the 1920s, inflation receded and Britain
found itself increasingly subject to economic
fluctuations and prolonged periods of high
unemployment. Keynes thus turned his
attention to these new problems. A Treatise on
Money (Keynes 1971–89, Vols. 5 and 6)
examined in detail the relationships between
money, prices, and unemployment. Keynes
singled out the saving-investment relationship
as the main cause of economic fluctuations.
According to Keynes, when people attempted
to save more than businesses wanted to invest,
businesses would soon find themselves with
excess capacity to produce goods and too few
buyers for the goods it could produce. On the
other hand, when investment exceeded savings,
there would be too much spending taking place
in the economy. Consumers would be spending
rather than saving, and businesses would
demand more workers to produce goods and
more workers to build plants and equipment.
All this spending would bid up wages as well
as other costs of production, and also increase
the price of all consumer goods. Inflation
would be the outcome.
The problem, Keynes stressed, was that
savings decisions and investment decisions
were made by different groups of individuals.
As a result, there was no guarantee that the two
would be equal. Keynes then argued that it was
the responsibility of the central bank to keep
these two variables equal to one another, and
thus the responsibility of the central bank to
prevent inflation and recessions. If savings
exceeded investment, the central bank would
need to lower interest rates, thus both reducing
savings and stimulating borrowing. On the
other hand, if investment exceeded savings, the
central bank would need to raise interest rates,
thus increasing savings and reducing
borrowing for investment purposes.
Keynes, though, is best known for his 1936
classic, The General Theory and Employment,
Interest and Money (Keynes 1971–89, Vol. 7).
This work has been responsible for the
development of a whole branch of economics
(macroeconomics), and has been the most
referenced and debated work in twentieth-
century economics. The work itself is both an
attack on the predecessors of Keynes, and a
theory of what determines the amount of
production and employment in a country.
Although the book says very little about
economic policy, it provided the theoretical
foundation for government policy action to end
the Depression that was plaguing virtually
every country in the 1930s.
Keynes begins The General Theory by
attacking Say’s Law, the view that “supply
creates its own demand.” According to this
dictum, unemployment was not possible
because whatever the existing supply of
workers (or whatever the existing supply of
goods in the economy), there will be a demand
for these workers (or a demand for these
goods). Keynes then proceeded to turn Say’s
Law on its head, arguing that aggregate or total
demand determined the supply of output and
level of employment. Whenever demand was
high, economies would prosper, businesses
would expand and hire more workers, and
unemployment would cease to be a problem.
But when demand was low, firms would be
unable to sell their goods and they would be
forced to cut back on production and hiring. If
things got very bad, there would be massive
lay-offs, high unemployment, and a depression.
For obvious reasons, Keynes turned next to
study aggregate demand and the causes of
changes in aggregate demand. Analyzing the
two most important components of demand,
Keynes developed the modern theories of
consumer spending and business investment.
Keynes identified two broad determinants
of consumer spending—subjective factors and
objective factors. Among the subjective or
psychological factors affecting consumption
were uncertainty regarding the future, the desire
to bequeath a fortune, and a desire to enjoy
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independence and power. Greater fears about
one’s economic future, a greater desire to leave
money to one’s children, or a greater desire for
independence, would lead to more saving and
less spending. Conversely, a secure economic
future, no heirs and indifference to one’s
economic independence would reduce savings
and increase spending.
The objective factors affecting consumption
were economic influences like interest rates,
taxes, the distribution of income and wealth,
expected future income and most important of
all, current income. When interest rates rose,
consumers would become reluctant to borrow
money in order to buy homes, new cars, and
other goods on credit. Conversely, with low
interest rates, consumers would freely incur
debt and spend money. Likewise, when wealth,
current income, or expected future income
went up, people would spend more and save
less; and with less wealth, less current income
and lower expected income in the future,
people would spend less and save more.
In contrast to the many factors affecting
consumption, business investment depends on
just two factors according to Keynes—
expected return on investment and the rate of
interest. The former constitutes the benefits
from investing in new plants and equipment;
the latter constitutes the cost of obtaining funds
to purchase the plants and equipment. If the
expected rate of return on investment exceeded
the interest rate, business firms will expand and
build new plants of equipment. However, if
interest rates exceeded the expected rate of
return on investment, that investment will not
take place.
Changes in expectations and changes in
interest rates lead to changes in business
investment. When business owners are
optimistic about the economy (believing that
they will be able to sell many goods in the
future and get a good price from consumers
for these goods), they will expect high rates of
return on money used to build new plants and
equipment. However, when pessimism sets in,
business decision makers expect fewer sales to
consumers and think that only if they offer
goods at low prices will consumers purchase
these goods. In this case, expectations are for
meager rates of return on new investment, and
few new plants get built.
Keynes next had to explain what
determined interest rates. The interest rate was
determined, according to Keynes, in money
markets where people and businesses demand
money and where central banks control the
money supply. The demand for money came
from portfolio decisions made by people and
businesses—they could hold money or they
could hold their wealth in the form of stocks,
bonds and other assets.
By necessity, the supply of money
existing in the economy must by held by
someone. When central banks increase the
money supply they buy government bonds.
A bond is merely a promise to pay the
person who owns the bond a fixed sum of
money at some point in the future. To keep
things simple, consider a bond that promises
to pay its owner $1,000 one year from today.
If I were to purchase this bond for $800,
my interest rate, or the rate of return on the
money I lent to whoever printed the bond,
will be 25 percent (a $200 gain on the $800
I paid for the bond). If the price for the bond
were $909 rather than $800, I would be
getting back around 10 percent on my
money (a $91 gain on the $909 I paid for
the bond). And had I bought the bond for
$990, I would be making only 1 percent on
my money ($10 additional on the $990 I lay
out now). Consequently, bond prices and
interest rates are inversely related—as one
goes up, the other goes down, and vice
versa.
When central banks buy bonds this
drives up the price of bonds and lowers the
rate of return on these assets. On the other
hand, when central banks want to reduce the
money supply they must sell bonds. To get
people to hold these bonds the central bank
must offer them at a low price. Those buying
the bonds will thus be receiving a good rate
of return on their money, or interest rates
will rise.
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After his critique of classical economic
theory, and his presentation of the
determinants of total demand for goods and
services, Keynes, surprisingly, had little to
say about how to reduce unemployment and
end Depressions. This is especially
surprising since Keynes was interested first
and foremost in economic policy.
He supported both money creation
(monetary policy) and government spending
and tax cuts (fiscal policy). In a much quoted
passage, Keynes writes about the need for more
houses, hospitals, schools and roads. But he
notes that many people are likely to object to
such “wasteful” government spending. Another
approach (money creation) was therefore
necessary.
If the Treasury were to fill old bottles with
banknotes, bury them at suitable depths in
disused coal mines which are then filled up to
the surface with town rubbish…private
enterprise [would] dig the notes up and there
need be no more unemployment.
(Keynes 1971–89, Vol. 7, p. 129)
And in a much maligned passage, Keynes
(1971–89, Vol. 7, p. 378) calls for “a somewhat
comprehensive socialization of investment.”
While many have taken Keynes to be
advocating government control of all business
investment decisions, what Keynes really
advanced was government spending policies
to stabilize the aggregate level of investment
in the national economy (Pressman 1987).
Keynes believed that consumer spending was
relatively stable, and changed little from year
to year. Business investment, however, was
driven by fickle “animal spirits.” Changes in
business confidence or expectations about the
future of the economy would change the level
of investment and would have a major impact
on the economy. Moreover, self-fulfilling
prophesies were likely to be at work. When
businesses were confident about the economy,
they would invest more and the economy
would expand. This boom would reinforce
expectations about profits, and lead to even
greater optimism and investment. On the other
hand, expectations about a poorly performing
economy will lower investment, slow economic
activity, and reinforce and strengthen business
pessimism about future profits. As a result of
all this, when optimism took hold the economy
would boom, but when pessimism set in there
would be dramatic declines in investment and
massive unemployment.
Keynes’ solution was to have government
stabilize the level of investment. When private
investment was low, the government should
borrow money (i.e., run a budget deficit) and
engage in public investments such as building
new roads and bridges and spending more
money on schools and better education. This
would expand the economy as well as improve
expectations. In contrast, when business
investment was high due to great optimism,
government should stop borrowing and cut
back on its public investment.
The 1940s found Keynes again working
for the British government. He also returned
to policy issues surrounding the war effort.
He helped negotiate British loans from the
US to help fight World War II; and he
developed a proposal to help Britain finance
its war effort. Rather than raising taxes
(which would reduce British incomes), and
rather than doing nothing to finance war
spending (which would generate inflation
due to shortages of goods and high demand),
Keynes proposed a plan of compulsory
savings or deferred pay. His idea was that
all British citizens with incomes greater than
some minimal level would have money taken
out of their regular paychecks and put into
special bank accounts to help finance the war.
These accounts would earn interest during
the war, but the money in them could not be
withdrawn except under emergency
circumstances. These savings could then be
lent to the government and used to finance
the war effort. After the war, the money in
these accounts could be freely withdrawn and
used for consumption needs. As an added
benefit, this additional spending would help
prevent another Depression.
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JOHN MAYNARD KEYNES
When World War II ended, Keynes worked
on the new international monetary
arrangements being developed by the
victorious governments. He believed that one
major cause of the world Depression in the
1930s was that every country tried to export
unemployment to its trading partners. By
running a trade surplus, each country could
produce more and create more domestic
employment; its trading partners would import
goods instead of producing them within their
borders. As a result, fewer workers would be
needed abroad and unemployment would rise
abroad.
Most countries attempted to generate
trade surpluses through devaluating their
currencies. By making foreign monies and
foreign goods more expensive, national
governments knew that their citizens
would buy fewer foreign goods and buy
more goods made by domestic firms.
Similarly, by making domestic money and
domestic goods cheaper for people in other
countries, devaluation would increase
exports. The problem was that whenever
one country devalued its currency in an
attempt to create exports and employment
for its citizens, other countries would
follow suit. The result was a series of
currency devaluations that did not benefit
any country.
In order to prevent competitive currency
devaluations, Keynes proposed a system of
relatively fixed exchange rates. This
system was agreed to by the Allied victors
at Bretton Woods, New Hampshire in 1944,
and came to be known as the Bretton
Woods system. Bretton Woods required
that each country peg its currency to an
ounce of gold and keep it there. Because
every currency was tied to gold, the value
of every currency was tied to every other
currency. If the US government said each
dollar was worth 0.1 ounces of gold, and
if the British government decreed that each
pound would be worth 0.2 ounces of gold,
then $2 had to equal £1, since both were
equal to 0.2 of an ounce of gold.
Bretton Woods operated for around
twenty-five years. During this time the world
economy grew at unprecedented rates and
unemployment rates in developed countries
reached their lowest levels in the twentieth
century.
But difficult problems simmered below
the surface. At the agreed upon fixed
exchange rates gold was rapidly leaving the
US and the US feared it would soon run out
of gold. Something had to be done to stop
this. Bretton Woods died in August 1971,
when President Nixon ended the
convertibility of dollars into gold, and then
announced that he would let the dollar float
relative to an ounce of gold. The current
system of flexible and variable exchange
rates was born.
A second way to stem the deflationary
impact of each country attempting to run
trade surpluses was to set up an
international mechanism to help clear trade
imbalances. Keynes wanted to establish a
system that would lend money to countries
running trade deficits, and to penalize
countries that persistently ran trade
surpluses. Like the fiscal and money
policies contained in The General Theory,
this would encourage countries to spend
money on foreign goods and thereby would
counter any tendencies towards another
depression. The clearing mechanism and the
lending facility Keynes wanted were also
established at Bretton Woods; these are the
International Monetary Fund and the World
Bank. But the US expected it would be
running trade surpluses because its
manufacturing capacity was not destroyed
in the war; so it refused to support any
system that would penalize countries with
persistent surpluses. Keynes pushed hard for
this policy proposal; but the US had all the
bargaining chips because of all the money
it had lent to Britain and would not budge
(see Block 1977). While negotiating the
details of the final compromise, Keynes
suffered a series of fatal heart attacks. He
died at his home in Cambridge.
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JOSEPH SCHUMPETER
Without doubt, no twentieth-century
economist has had a greater impact than
Keynes. At the theoretical level Keynes
developed macroeconomic analysis, and
macroeconomics as it is taught in colleges
and universities today still relies on the
concepts and modes of analysis developed
by Keynes. Even contemporary
macroeconomists opposed to the ideas of
Keynes (see also FRIEDMAN and LUCAS)
find it necessary to start with Keynes and
then explain the limitations and problems
with his theory. At the policy level, the many
tools employed by central banks and central
governments to help control the business
cycle, and the international mechanisms that
exist to deal with trade imbalances, are
primarily due to Keynes.
Lekachman, Robert, The Age of Keynes, New
York, Random House, 1966
Moggeridge, Donald, Maynard Keynes: An
Economist’s Biography, London and New
York, Routledge, 1992
Pressman, Steven, “The Policy Relevance of The
General Theory,” Journal of Economic
Studies, 14 (1987), pp. 13–23
Skidelsky, Robert, John Maynard Keynes, 2 vols.,
New York, Viking, 1983 and 1992
Other references
Block, Fred L., Origins of the International
Economic Order, Berkeley, California,
University of California Press, 1977
Note
JOSEPH SCHUMPETER (1883–1950)
1 An earlier version of this piece appeared in the
Encyclopedia of Political Economy, ed. Phil
O’Hara et al., New York and London,
Routledge, 1998
Works by Keynes
The Collected Writings of John Maynard Keynes,
ed. D.Moggridge, 30 vols., London,
Macmillan, 1971–89. Paperback editions of
Essays in Biography and Essays in Persuasion
are published by Norton. Harcourt, Brace &
World publishes a paperback edition of The
General Theory of Employment, Interest and
Money.
Works about Keynes
Dillard, Dudley, The Economics of J.M.Keynes,
New York, Prentice Hall, 1948
Hansen, Alvin, A Guide to Keynes, New York,
McGraw Hill, 1953
Harrod, Roy, The Life of John Maynard Keynes,
New York, Norton, 1951
For Joseph Schumpeter (pronounced
SHUM-PAY-ter) economics was all about
change. He studied both short-run economic
fluctuations as well as the long-run
tendencies of capitalism. In these studies he
identified the phases and causes of business
cycles. He also examined the factors
contributing to the rise and decline of
capitalism.
Schumpeter was born to middle-class
parents in Triesch, Moravia (then part of the
Austro-Hungarian Empire and now part of
the Czech Republic) in 1883. His father,
who owned a textile factory, died when he
was very young. His mother soon remarried
and moved to Vienna, where Schumpeter
attended high school with the aristocratic
elite. He received an excellent education in
the humanities, but inadequate grounding
in mathematics and science. As a law
student at the University of Vienna,
Schumpeter took several courses in
economics. A seminar taught by Böhm-
Bawerk sparked his interest in the long-term
future of capitalism.
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JOSEPH SCHUMPETER
After receiving a doctorate of law in 1906,
Schumpeter went to Cairo to practice law and
to manage the finances of an Egyptian princess.
In 1909 he accepted a teaching job at the
University of Czernowitz, and two years later
was appointed to a chair in political economy
at the University of Graz.
Schumpeter then became interested in
politics. In 1918 he became a member of
the German Socialization Commission,
which argued for socializing German
industry in order to make it more efficient.
In 1919, he became Finance Minister of
Austria. His political career, however, was
both short and unsuccessful. He proposed
an unpopular tax on capital to control
inflation. A flippant remark about the
Austrian dollar (“a crown remains a crown”)
in the face of rampant inflation was viewed
as insensitive to the plight of most
Austrians. And there was much criticism of
his plans to nationalize Austrian firms.
Unable to handle the pressures of political
life, Schumpeter resigned after just seven
months in office (Shionoya 1955, p. 18). He
then became President of a small private bank.
At the same time he invested in highly
speculative activities and lost his shirt while
incurring massive debts, which it took him
many years to repay.
In 1925, Schumpeter accepted an
appointment as Professor of Economics at the
University of Bonn. Seven years later he
accepted a position at Harvard, where he
remained until his death in 1950. In 1949,
Schumpeter served as President of the
American Economic Association, thus
becoming the first non-American to be so
honored.
For Schumpeter, all capitalist economies
had two prominent characteristics—they were
unstable and they experienced rapid growth.
Schumpeter sought to analyze and understand
these features of capitalism.
Schumpeter (1939) was one of the first
economists to study business cycles, the regular
fluctuations that economies experience. He
identified three different cycles occurring
simultaneously. First, there were short-run
fluctuations of three to four years, which
Schumpeter called “Kitchin Cycles,” after
economist Joseph Kitchin who first discovered
them. These cycles were due to changes in
business inventories. For one to two years,
businesses would expand their inventories in
order to keep ahead of rising sales. But when
the growth of sales slowed, inventories would
begin to pile up in warehouses. As a result,
businesses would cut back production for a
year or so in order to reduce their inventory
backlog. When inventories finally returned to
more desirable levels, and sales picked up,
businesses would again seek to expand their
inventories.
A second cycle was associated with changes
in business investment in new plants and
equipment. These cycles lasted eight to eleven
years, and Schumpeter called them “Juglar
Cycles,” after Clement Juglar who first
discovered them. Usually when people speak
of “the business cycle,” they refer to these
economic fluctuations. Expansions lasting four
to five years, Schumpeter thought, were due
to the desire of businesses to expand and
modernize their capital equipment. But after
most businesses have expanded and
modernized, they have little need for new
investment. Consequently, spending on plants
and equipment gets cut back during the next
four or five years. Over this period, capital
equipment gets worn out and outdated, thus
setting the stage for another investment boom
of four to five years.
Finally, there are long-run cycles, or
Kondratieff waves, lasting 45 to 60 years.
Schumpeter named these cycles after
Russian economist Nikolai Kondratieff,
who first noticed them but could not explain
what caused them (see also KUZNETS).
Schumpeter saw invention and innovation
as the driving force behind long-run cycles.
In times of slow growth businesses would
not be likely to introduce new innovations.
As a result, new discoveries and innovations
would pile up for several decades. When
rapid economic growth finally begins, the
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JOSEPH SCHUMPETER
stockpile of innovations gets employed in
the production process and economies grow
rapidly. Schumpeter regarded the Industrial
Revolution, which introduced the steam
engine, the spinning jenny, and other
discoveries, as the beginning of one long-
term economic expansion. Railroad
construction in the mid-nineteenth century
began a second Kondratieff wave. In the
early twentieth century, electricity,
automobiles, and chemicals sparked a third
Kondratieff wave.
In his early work, Schumpeter (1911) held
that invention was determined by
noneconomic forces and could not be
understood through studying economics. In
later work, Schumpeter (1942) held that
innovation was shaped by economic forces
inside the large firm. But throughout his life,
Schumpeter refused to believe that
innovation was a rational activity; instead he
thought it was a creative activity that could
neither be explained nor understood as the
result of rational thinking processes. The
agent of innovation and invention was the
entrepreneur.
Unlike many of his contemporaries,
Schumpeter did not believe that
entrepreneurs merely hired resources in order
to produce goods and meet consumer
demand at minimum cost. Rather, like
Cantillon, he thought that entrepreneurs were
individuals willing to take risks. As such,
they were the key force causing capitalist
economies to grow. When there were many
entrepreneurs, capitalism would thrive; on
the other hand, if the entrepreneurial spirit
was destroyed or severely hindered,
capitalism would quietly transform itself into
socialism.
For entrepreneurs to succeed, Schumpeter
held that they had to mold and shape
consumer tastes. In contrast to other
economists, who saw firms responding to
consumer tastes, Schumpeter held that “the
great majority of changes in commodities
consumed has been forced by producers on
consumers who, more often than not, have
resisted the change and have had to be
educated up by elaborate psychotechnics of
advertising” (Schumpeter 1939, Vol. 1, p.
73). Consumer preferences do not lead to
production and innovation; rather innovation
leads to new goods and services that
consumers either reject or develop tastes for.
Invention and innovation by the
entrepreneur was the driving force behind
long-run economic cycles according to
Schumpeter (1911). Invention, backed by
bank credit, leads to innovation and growing
prosperity. This soon attracts imitators, and
the original innovation leads to economic
prosperity. But imitators are always less
effective than innovators, and many arrive
too late in the expansion cycle.
Miscalculation and tighter credit will push
some firms into bankruptcy, and lead to
recession or depression. But these
bankruptcies also weed out inefficient firms,
thus correcting the errors of the past
expansion. Inventions accumulate during the
contraction, when entrepreneurs cannot find
the funds to convert them into innovations
that spark growth, and thus remain poised
to start a new cycle of growth.
In Capitalism, Socialism and Democracy,
Schumpeter (1942) adopted an even broader
perspective on economic change. Rather than
examining the cyclical changes that a
capitalist economy goes through, he
examined the very future of capitalism. The
big question he asked was “Can capitalism
survive?” The answer he gave was “No. I do
not think it can” (Schumpeter 1942, p. 61).
In essence, he thought that Marx was right
in believing that socialism would replace
capitalism. However, rather than being
destroyed by its failures, as Marx predicted,
Schumpeter believed that capitalism would
be destroyed by its many successes.
Schumpeter (1942, p. 83) thought that
creative destruction was one main reason for
the success of capitalism. Capitalism is not
only about successful innovation; it is also
about destroying old and inefficient
processes and products. This replacement
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JOSEPH SCHUMPETER
process makes capitalism dynamic and
causes incomes to grow rapidly. Problems
arise, however, because smaller firms are
constantly being replaced by larger firms.
Through this process, managerial
bureaucrats, rather than innovative
entrepreneurs, come to run the firm. These
managers are employees rather than owners.
They prefer a steady income and job security
to innovation and risk-taking. As a result,
capitalism loses its dynamic tendency
towards innovation and its spirit of continual
improvement and change.
Schumpeter (1942, pp. 121–5) also saw
potential problems stemming from the fact that
capitalism requires rational calculation and
logical choice from all participants. This leads
people to develop a skeptical and critical frame
of mind. In addition, because capitalism is so
successful at increasing incomes, it can support
a large number of middle-class intellectuals.
With much free time on their hands, these
individuals will criticize the capitalist system
and push for measures that enhance the
economic role of government bureaucrats.
Resentment against the income inequalities that
make capitalism possible will also be strong
among intellectuals, and they will push for
measures that try to keep incomes equal. These
actions will reduce the incentive to take risks
and innovate.
Finally, Schumpeter (1942, pp. 160–1)
thought that capitalism undermines the family.
Capitalism is all about satisfying individual
wants, while the family requires sublimating
one’s desires and compromising. The family,
however, is important for capitalism because
it is a main reason for saving. Families save so
that if anything happens to the main
breadwinner, other family members will be
provided for. By undermining the motivation
to save, capitalism destroys its own
foundation—the capital needed for future
growth.
Long-term economic growth has always
been a central economic concern. Adam Smith
and most classical economists saw capitalism
as the best way to achieve rapid growth. By
the late nineteenth century, however,
economists came to focus more on the question
of economic efficiency, and they lost interest
in the issue of growth. The main contribution
of Schumpeter has been to redirect the attention
of economists to the issue of long-term
economic growth. In so doing, he stressed the
importance of noneconomic factors like
innovation and the entrepreneur for a healthy,
thriving, and growing capitalism.
Works by Schumpeter
Theory of Economic Development (1911),
Cambridge, Massachusetts, Harvard
University Press, 1954
Economic Doctrine and Method: An Historical
Sketch (1914), London, George Allen &
Unwin, 1954
Business Cycles: A Theoretical, Historical and
Statistical Analysis of the Capitalist Process,
2 vols., New York, McGraw Hill, 1939
Capitalism, Socialism and Democracy, New York,
Harper, 1942
Ten Great Economists, New York, Oxford
University Press, 1951
History of Economic Analysis, New York, Oxford
University Press, 1954
Works about Schumpeter
Allen, Robert Loring, Opening Doors: The Life
and Work of Joseph Schumpeter, 2 vols., New
Brunswick, Transaction Publishers, 1994
Heertje, Arnold (ed.), Schumpeter’s Vision:
Capitalism, Socialism and Democracy After
40 Years, New York, Praeger, 1981
Heilbroner, Robert, “Was Schumpeter Right?,”
Social Research, 48, 3 (Autumn 1981), pp.
456–71
Oakley, Allen, Schumpeter’s Theory of Capitalist
Motion: A Critical Exposition and
Reassessment, Hants, Edward Elgar, 1990
Rosenberg, Nathan, “Joseph Schumpeter: Radical
Economist,” in Exploring the Black Box:
Technology, Economics, and History,
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Cambridge, Cambridge University Press,
1994, pp. 47–61
Shionoya, Yuichi, Schumpeter and the Idea of
Social Science, New York, Cambridge
University Press, 1995
Stolper, Wolfgang F., Joseph Alois Schumpeter
The Public Life of a Private Man, Princeton,
New Jersey, Princeton University Press, 1994
PIERO SRAFFA (1898–1983)
Piero Sraffa (pronounced SRAH-fah) made
two contributions to economics. First, he
pointed out that the marginalist theory of value
is logically inconsistent. Second, Sraffa
attempted to construct an adequate theory of
value based upon the work of Ricardo and the
classical notion of a surplus that gets generated
during the production process.
Sraffa was born in Turin, Italy in 1898
into a wealthy and distinguished Jewish
family. His father was a well-known lawyer,
who both practiced his profession and taught
law at various Italian universities. As his
father moved from one university to another,
Sraffa moved from city to city and from
school to school. After graduating from
secondary school, Sraffa enrolled in the law
faculty at the University of Turin. At Turin
he studied political economy under Luigi
Einaudi, a well-known specialist in public
finance and later President of the Italian
Republic. Following a brief stint in the
Italian army, Sraffa completed his degree in
1920, writing his doctoral thesis under
Einaudi on monetary inflation in Italy during
the 1914–20 period.
After graduation Sraffa worked at an Italian
bank, but he left this job in the Spring of 1921
in order to spend time in England studying
British monetary problems. Through a friend
of his father, Sraffa made the acquaintance of
John Maynard Keynes.
In 1922, at the invitation of Keynes, Sraffa
wrote two articles on Italian banking. One was
published in the Economic Journal, a scholarly
journal edited by Keynes (Sraffa 1922a), and
concerned the bankruptcy of an Italian bank.
The second article appeared in the Manchester
Guardian (Sraffa 1922b), and criticized the
reporting procedures of Italian banks and
government supervision of bank reporting
procedures. This article was soon translated
into four languages, including Italian. As a
result, it came to the attention of Mussolini,
who became enraged and called it “an act of
true and real sabotage of Italian finance”
(Kaldor 1985, p. 618). Mussolini contacted
Sraffa’s father, insisting on a full and complete
retraction. Sraffa refused; but he had to flee
Italy until Mussolini calmed down.
Despite his precarious relationship with
Mussolini, Sraffa held numerous jobs in Italy
during the 1920s. He set up a government
department in Milan to collect labor statistics,
but resigned as soon the fascist regime took
power. Then he lectured in Public Finance and
Political Economy at the University of Perugia,
and he held the position of Professor of
Economics at Cagliari University in Sardinia.
As the Fascist government became
increasingly repressive, Sraffa sought
employment outside Italy and Keynes helped
arrange a lectureship for Sraffa at Cambridge
University. Sraffa, however, found lecturing
difficult. He disliked delivering his ideas in
public and felt uncomfortable having to lecture
in English. Again Keynes came to the rescue,
getting Sraffa a job as head of the Marshall
Library of Economics. Keynes also arranged
for Sraffa to edit the works of David Ricardo
for the Royal Economic Society. This project
helped shift Sraffa’s interests from money and
economic policy to the abstract and theoretical
issues of value theory. Sraffa spent a good deal
of time in the 1930s, 1940s, and early 1950s
compiling the ten-volume edition of Ricardo’s
Works and Correspondence (Sraffa 1951–5).
While he received many awards for this
scholarly endeavor (including the Söderström
Gold Medal of the Swedish Royal Academy
of Sciences, a precursor to the Nobel Prize in
Economics), it is mainly for his theoretical
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PIERO SRAFFA
work on the theory of value that Sraffa made
his mark.
By the 1920s, supply and demand analysis
had come to dominate economic thinking in
Europe. Sraffa was dissatisfied with this mode
of thinking. His contributions to value theory
were twofold—one destructive and one
constructive. First, he pointed out the logical
flaws in the Marshallian analysis of supply.
Second, he developed a more adequate theory
of supply that relied on the classical notion of
a surplus.
In 1925 Sraffa published an article in the
Annali di Economia of Bocconi University
attacking the foundations of orthodox Marshallian
economics. Edgeworth read this paper in Italian
and told Keynes about it. He also asked Keynes
to have Sraffa write a shorter version of the paper
for the Economic Journal (Sraffa 1926). Both
articles pointed out logical problems with the
supply curve analysis of Marshall.
According to Marshall, the supply curve
of any firm was independent of the supply
curves for all other firms in the industry. An
industry supply curve was derived by simply
adding up the supply curves of every firm in
the industry. If there were 100 firms in the
industry, and 50 wanted to produce 1,000
coffee mugs if they could be sold for $1 while
the other 50 firms wanted to produce 2,000
coffee mugs if the price was $1, total output
in the industry would be 150,000 coffee mugs
if the price was set at $1 in the market. Similar
calculations could be made for different
prices. Adding up the quantities at each
different price, we get the industry supply of
coffee mugs.
Sraffa argued that the conditions of
production, and thus the supply curve, for any
one firm had to affect the conditions of
production for all its competitors. For
example, when one firm expands its
production of coffee mugs it will increase its
demand for the materials (e.g. clay) that are
needed to produce coffee mugs and so the
price of these materials will increase. But if
the cost of making coffee mugs rises because
of higher material costs, all firms make less
profit by producing coffee mugs. As a result,
other firms will want to produce fewer mugs
at each price. Because of such
interdependence, Sraffa contended, it was
illegitimate to draw Marshallian supply curves
for any industry.
Sraffa’s second criticism was an attack on
the assumption of diminishing returns in
production. He argued that most production,
especially manufactured consumer goods,
occurs under conditions of increasing returns.
He also showed that diminishing returns
cannot apply to a particular industry or good
in isolation, since changes in the cost of
production in a particular industry will affect
the cost of production in all other industries
that require this good in the production
process. For this reason, Sraffa held that the
economic model of perfect competition had
to be abandoned, and it had to replaced with
a model recognizing firm interdependence and
the existence of monopoly and oligopoly. This
critique led to the development of models of
monopolistic competition by Joan Robinson
and others (see Harcourt 1986).
Sraffa was responsible for other criticisms
of orthodox microeconomics. The Cambridge
Controversy (see also ROBINSON), suggested
by Sraffa to Robinson, involved the argument
(being made in Cambridge, England) that the
orthodox theory of value was circular. Another
approach to value theory was thus needed.
Sraffa went back to the economics of Ricardo
and the classical notion of a surplus to find this
approach.
According to Sraffa, a logically
consistent theory of value and distribution
had to return to the classical conception of
the circular nature of production—goods
getting used to produce goods, and a surplus
getting created if you wind up producing
more goods than you started off with. Sraffa
(1960) then went on to show the consistency
of this model. He showed how such a model
can be used to explain value or relative
prices, as well as the principles that
determined the distribution of income
between wages and profits.
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Beginning with a given technology that
details what is necessary to produce goods, and
given either a real wage (determined by
subsistence needs of workers) or profit rate (and
assuming that competition would result in a
uniform rate of profit throughout the economy),
Sraffa demonstrated that relative prices would
be determined. The distribution of income
between wages and profits would be
determined outside the model by some other
forces. The main point of this analysis is that
current technology, or the costs of production,
determines relative prices.
Let us take a simple case, one with no
surplus, to demonstrate the main point of
Sraffa. Suppose that the economy produces
only two types of goods—manufactured goods
(M) and agricultural goods (A). Technological
requirements for producing these goods are as
follows:
2A+2M=6A
4A+1M=3M
Two units of agricultural goods and two
units of manufactured goods are required to
produce six units of agricultural goods,
while four units of agricultural goods and
one unit of manufactured goods yield three
units of manufactured goods. Starting with
six units of agricultural goods and three
units of manufactured goods, and engaging
in the production of these goods, we wind
up with six units of agricultural goods and
three units of manufactured goods. Our
economy reproduces itself from year to
year, but creates no surplus or fails to grow
during the year.
If we think about prices in terms of this
model or set of equations, we should
recognize that the cost of inputs must equal
the value of the output produced in each
sector. Thus we can think of A as the price
of agricultural goods and M as the price of
manufactured goods. To find the prices of
these two commodities we need to solve the
above two equations for A and for M.
Unfortunately, there is no unique
mathematical solution here; but we do know
that the mathematics of production
technology will require A to equal 2M, or
the price of agricultural goods must be twice
the price of manufactured goods. The
technology of production thus determines
values or relative prices, although it does
not tell us what the price of each good will
be.
Sraffa was able to extend this model to
a world of many goods and again show that
the technology of production still
determines relative prices. He was also able
to extend the model to cases where a
surplus gets produced. Here things get even
more complicated, and Sraffa had to make
a few simplifying assumptions. First, he
assumed that capital mobility would lead
to a uniform rate of profit. This is a fairly
reasonable assumption, since capital
should flow to those industries or sectors
yielding greater returns and should leave
those industries or sectors with lower
returns. This should reduce profit rates in
the former set of industries and increase
profit rates in the latter set of industries.
Next, Sraffa assumed that the rate of profit
depended on the rate of interest (Roncaglia
1993). With these two assumptions, Sraffa
was able to again demonstrate that it was
technology or the cost of production that
determined relative prices. Values or
relative prices could thus be explained
without having to resort to the circularity
of marginalist analysis. Likewise, we do
not have a circular theory of income
distribution that depends on the notion
marginal productivity. Instead, the
distribution of income between wages and
profits gets determined by monetary
policy, by competition, and by other forces
that affect interest rates.
Sraffa’s place in the history of economics
is rather difficult to pinpoint. He made several
telling criticisms of standard economic theory,
and he began to develop a new and different
theory of value. Yet few economists, even the
majority of economists who are critical of
traditional economic theory, have followed the
path pioneered by Sraffa.
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Works by Sraffa
Other references
“The Bank Crisis in Italy,” Economic Journal, 32
(June 1922a), pp. 178–97
“The Current Situation of the Italian Banks”
Manchester Guardian Commercial: The
Reconstruction in Europe, Supplement No. XI,
(7 December 1922b), pp. 675–6
“The Laws of Return under Competitive
Conditions,” Economic Journal, 1 (December
1926), pp. 535–50
“General Preface” and “Introduction,” in On the
Principles of Political Economy and
Taxation, 1 of The Works and
Correspondence of David Ricardo, 10 vols.,
ed. Piero Sraffa, Cambridge University
Press, 1951–5
Production of Commodities by Means of
Commodities: Prelude to a Critique of
Economic Theory, Cambridge, Cambridge
University Press, 1960
Works about Sraffa
Kaldor, Nicholas, “Piero Sraffa 1898–1983,”
Proceedings of the British Academy, 71 (1985),
pp. 615–40
Mongiovi, Gary, “Piero Sraffa,” in A
Biographical Dictionary of Dissenting
Economists, ed. Philip Arestis and Malcolm
Sawyer, Hants, Edward Elgar, 1992, pp.
536–45
Potier, Jean-Pierre, Piero Sraffa: Unorthodox
Economist (1898–1983), London and New
York, Routledge, 1991
Roncaglia, Alessandro, Sraffa and the Theory of
Prices, Wiley, 1978
Roncaglia, Alessandro, “Piero Sraffa’s
Contribution to Political Economy,” in
Twelve Contemporary Economists, ed.
J.R.Shakleton and G. Locksley, New York,
Wiley, 1981, pp. 240–56
Rocaglia, Alessandro, “Towards a Post-Sraffian
Theory of Income Distribution,” Journal of
Income Distribution, 3, 1 (Summer 1993),
pp. 3–27
Harcourt, G.C., “On the Influence of Piero Sraffa
on the Contributions of Joan Robinson to
Economic Theory,” Economic Journal, 95
(1986), pp. 96–108
GUNNAR MYRDAL (1898–1987)
The economics of Gunnar Myrdal
(pronounced mirr-DALL) has two
distinguishing characteristics—a focus on real
world economic issues and an effort to bring
the insights from other disciplines into
economic analysis. Myrdal spent much of his
life studying the problems of race relations,
unemployment and poverty. He also sought to
understand how economies change over time,
and he looked towards psychological,
historical, sociological, and cultural factors as
the cause of these changes.
Myrdal was born in 1898 in the village of
Solvarbo, a rural, farming area in central
Sweden. His father was a wealthy landowner,
who was able to provide Myrdal with an
excellent education. Myrdal studied
mathematics at the Royal Gymnasium and then
enrolled at Stockholm University to study law.
He chose this course of study because he wanted
to understand how society worked. Although
Myrdal received a law degree in 1923, the
grueling course of study killed his interest in
the law. His wife Alva then convinced him to
study economics, a discipline that combined
science and mathematics with an attempt to
understand the workings of society (Angresano
1997, pp. 146f.). After studying under Knut
Wicksell, Myrdal received a Ph.D. in Economics
from Stockholm University in 1927 and then
began teaching there.
In 1932 Myrdal was appointed by the Social
Democratic government to a new housing and
population commission, and was thus able to
influence Swedish housing policy. From 1934
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GUNNAR MYRDAL
to 1936, and again from 1942 to 1946, he
served in the Swedish Parliament, and in the
late 1930s he served on the Board of the
National Bank of Sweden. In the mid-1940s,
Myrdal became chairman of the Swedish Post-
War Planning Commission and Minister for
Trade and Commerce.
Because of his economic ideas and his many
positions of political influence Myrdal became
one of the main architects of the Swedish
welfare state. Furthermore, Myrdal was a
strong advocate of using Keynesian fiscal
policy in Sweden. Kindleberger (1987, pp.
394f.) credits Myrdal with convincing Finance
Minister Ernst Wigters to spend money for
public works and run budget deficits in order
to reduce unemployment. In 1974, Myrdal
shared the Nobel Prize in Economics with
Friedrich Hayek.
Myrdal had wide and diverse interests,
and he made important contributions to both
economic theory and policy analysis. At the
theoretical level, he introduced the ex ante-
ex post distinction to help clarify
macroeconomic analysis, and he developed
the notion of cumulative causation as an
alternative to equilibrium analysis. At the
policy level, Myrdal explained the
persistence of poverty throughout the
developing world and among blacks in the
US, and he suggested numerous policies to
deal with the problem of poverty.
The lack of a distinction between
expectations and actual outcomes created
much confusion in economics during the
1920s. Businesses, for example, invest to
make a profit; yet they sometimes lose
money. Businesses even invest at times when
there is no additional savings; but all
economists know that savings must equal
investment. Myrdal (1939) helped clarify
these matters with his distinction between
expected outcomes and final outcomes, or
between ex ante and ex post economic
variables. Expected or ex ante economic
variables are measured at the beginning of
some process; final or ex post variables are
measured at the end of the process.
With this distinction Myrdal was able to
explain how an increase in investment over ex
ante saving would lead to additional savings
(through increases in profits and other
incomes), so that ex post, savings will equal
investment. By the same token, greater savings,
ex ante, would cause a recession and lead to
lay-offs and lower profits for businesses.
Unable to sell what they already produce,
businesses would scale back investment. Again,
when measured ex post, saving will equal
investment.
Although the ex ante-ex post distinction
helps to explain how economies will move
towards an equilibrium where savings equals
investment, for the most part Myrdal was
opposed to equilibrium analysis and proposed
an alternative means of understanding the way
economies work. Cumulative causation
involves a positive or negative feedback
mechanism involving two or more variables.
Since changes in any one variable lead to
similar changes in other variables, the entire
system moves along in one direction. The
principle of cumulative causation was first
applied in economic analysis by Wicksell,
when he examined what happens when real and
natural interest rates diverge. It was Myrdal,
however, who first described this principle and
recognized its importance.
A cumulative economic process can be
contrasted with a unidirectional causal
schema, where A causes changes in B, but
B has no further effects on A. With
unidirectional causation, changes in A lead
to changes in B and things end there; the
system reaches a new stable equilibrium
with higher (or lower) values for the
variables A and B.
With cumulative causation, the variables A
and B impact each other. Changes in A will
affect B, which will further affect A, again
impact B, etc. There is no equilibrium or point
of rest for the system. When A and B both
increase, we have a virtuous cycle or positive
feedback loop; and when A and B both decline,
we have a vicious cycle or negative feedback
loop. Myrdal used the idea of cumulative
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causation to explain economic problems like
poverty and race relations.
In 1938 while lecturing at Harvard, Myrdal
was approached by the Carnegie Corporation
to study racial problems in the US. He accepted
the invitation and spent the next five years
working on the pathbreaking An American
Dilemma (Myrdal 1944). This book argued that
there was a moral conflict in America. On the
one hand, Americans believed in the ideals of
justice and equal opportunity, and did not think
blacks were less able than whites. On the other
hand, in practice blacks and whites were not
treated equally and America did not live up to
its high ideals. Much of An American Dilemma
attempted to trace the discrimination existing
in America against blacks. It documented the
political and socioeconomic condition of
blacks and whites, and marshaled considerable
evidence to show that blacks were treated
differently from whites.
In his typical fashion, Myrdal employed
sociological, historical, psychological, and
political insights into his analysis. He also
showed the damage that stemmed from racial
segregation and discrimination. He argued that
the entire American society suffered by denying
blacks a decent education, by not providing
them with job training, and by discriminating
against them in employment and housing.
Myrdal also made the case that America’s
treatment of blacks was inconsistent with the
needs of a technologically advanced society.
Thus, as a result of discrimination, the US
economy performed poorly.
Myrdal also used the notion of cumulative
causation to help explain the socioeconomic
condition of black Americans. Prejudice
against blacks led to lower living standards for
blacks. Seeing that blacks do indeed have lower
living standards, white prejudices were
reinforced. This led to further declines in black
living standards relative to whites. As Myrdal
(1944, p. 381) succinctly put it,
“Discrimination breeds discrimination.”
Myrdal went on to document the many ways
black Americans were kept down due to a
cumulative process of discrimination.
Discrimination in education, for example,
meant that blacks were less likely than whites
to become doctors. Discrimination in education
also meant that blacks would be less
knowledgeable about health and sanitation. In
addition, blacks had less money than whites
for medical care. For all these reasons, blacks
receive less adequate medical treatment and are
in poorer health than whites. Consequently,
blacks find it harder than whites to obtain and
keep a job; and with lower incomes, black
education will suffer (Myrdal 1944, p. 172).
Myrdal (1944, p. 956) also noted that
segregation leads to white stereotypes of blacks
and causes whites to focus on the differences
between blacks and themselves. This, in turn,
affects how whites regard blacks. When whites
have less regard for blacks, they are less likely
to associate or interact with blacks, and blacks
will be less likely to work or live with whites
who have little regard for them. Segregation
and racial stereotypes are thus further
reinforced.
The view that the condition of black America
results from a negative feedback process has one
important policy implication —this situation can
be remedied in any one of a number of ways.
Improvement in any one area will lead to gains
in other areas through a cumulative process of
improvement. But where to start?
Myrdal looked to American institutions to
break into the vicious cycle of discrimination
against black Americans. Organizations such as
churches, schools, trade unions, and the
government were repositories of the American
creed of justice and equality. Moreover, many
of these institutions could immediately improve
the socioeconomic condition of blacks, thus
reducing prejudice against blacks and beginning
a positive or virtuous cycle. Myrdal thus
proposed expanding the role of the federal
government in the areas of education, housing,
and income security. Laws making it easier for
blacks to vote was another easy way to break
the cycle of discrimination and prejudice.
Myrdal (1944, pp. 198ff.) also advocated
migration from the rural South to the industrial
North and West, where discrimination was not
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GUNNAR MYRDAL
so prevalent and high-paying jobs were more
plentiful. Incorporating blacks into the labor
movement would help both American labor and
black Americans. Finally, Myrdal advocated
using fiscal policy to achieve full-employment,
so that blacks migrating to Northern and Western
cities could get jobs and become integrated into
the post-war industrial economy.
Myrdal (1957) later applied the principle of
cumulative causation to the study of economic
development, and used it to explain persistent
poverty in South Asia (Myrdal 1968). He
contrasted “spread effects,” which create a
positive cumulative cycle with “backwash
effects,” which create a negative cumulative
cycle. Once a region begins to develop
economically it will attract capital and labor
from other regions. These new resources will
assist in the development process. On the other
hand, persistent poverty normally leads to high
fertility rates, poor nutrition, and low labor
productivity, all of which contribute to even
greater poverty.
Following along the lines of his policy
recommendations for reducing black poverty in
the US, Myrdal (1970) stressed the need to end
the vicious cycle of poverty and begin a virtuous
cycle of growth and development. First and
foremost, developing nations must spend more
money on education. Second, efforts had to be
concentrated on improving sanitation, providing
clean water and developing other public
amenities. Third, income support programs had
to address the problem of income inequality and
the lack of adequate income received by most
citizens in these countries.
While most economists have claimed that
a trade-off exists between equality and growth
(see also KUZNETS and PIGOU), Myrdal held
that there is no such trade-off, and that greater
equality would lead to more rapid growth.
Myrdal (1970, p. 51) argued that inequality
leads to slower growth because of the physical
and psychological consequences of poverty,
and because the poor are unable to utilize their
talents. Because it raises productivity growth,
greater consumption is really greater
investment in developing countries. Also, a
welfare state that redistributes income will lead
to higher levels of demand and more rapid
growth.
Throughout his entire life Myrdal was
highly critical of the methods employed in
orthodox economic analysis. We have seen how
he rejected equilibrium analysis in favor of
cumulative causation. Myrdal (1969) also
criticized social scientists in general, and
economists in specific, because they could not
write and speak so that ordinary people could
understand them. Instead, professionals write
and speak to each another. This reduces the
importance of social science scholarship.
Myrdal (1929) also criticized the attempt by
economists to hide their normative or value
assumptions behind the façade of scientific
objectivity. He was not against economists
making value judgments; he was only opposed
to their refusal to acknowledge them. Even after
winning the Nobel Prize, Myrdal claimed that
the prize was inappropriate for an unscientific
field like economics. He often quipped that the
only reason he accepted the prize was that the
award committee called him very early in the
morning, before he was fully awake.
Myrdal is the rare economist who has made
significant contributions to both economic
theory and economic policy. His theory of
cumulative causation provides a theoretic
alternative to traditional equilibrium analysis.
And the proposals to help reduce poverty and
unemployment that follow from this theory
provide an alternative to traditional laissez-faire
policy prescriptions.
Works by Myrdal
The Political Element in the Development of
Economic Theory (1929), Cambridge, Harvard
University Press, 1965
Monetary Equilibrium, London, Hodge, 1939
An American Dilemma, New York, Harper &
Brothers, 1944
Rich Lands and Poor The Road to World
Prosperity, New York, Harper & Brothers,
1957
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Asian Drama: An Inquiry into the Poverty of
Nations, New York, Pantheon Books, 1968
Objectivity in Social Research, New York,
Random House, 1969
The Challenge of World Poverty: A World
AntiPoverty Program in Outline, New York,
Pantheon Books, 1970
Against the Stream: Critical Essays on
Economics, New York, Pantheon Books, 1972
Works about Myrdal
Angresano, James, The Political Economy of
Gunnar Myrdal, Cheltenham, UK, Edward
Elgar, 1997
Dostaler, Gilles, Ethier, Diane and Lepage,
Laurent, (eds.) Gunnar Myrdal and his Work,
Montreal, Harvest House, 1992
Jackson, Walter A., Gunnar Myrdal and
America’s Conscience: Social Engineering
and Radical Liberalism, Chapel Hill, North
Carolina, University of North Carolina Press,
1990
Kindleberger, C.F., “Gunnar Myrdal 1898–1987,”
Scandinavian Journal of Economics, 89
(1987), pp. 393–403
Lundberg, E., “Gunnar Myrdal’s Contributions to
Economic Theory,” Swedish Journal of
Economics, 76 (1974), pp. 472–8
Pressman, Steven, “An American Dilemma: Fifty
Years Later,” Journal of Economic Issues, 28,
2 (June 1994), pp. 577–85
Reynolds, Lloyd G., “Gunnar Myrdal’s
Contributions to Economic Theory, 1940–
1970,” Swedish Journal of Economics, 76
(1974), pp. 479–97
Streeten, Paul, “Gunnar Myrdal,” World
Development, 18, 7 (1990), pp. 1,031–7
FRIEDRICH HAYEK (1899–1992)
Friedrich Hayek (pronounced HI-YACK)
achieved worldwide recognition as a champion
of the free market and an opponent of
government interference with the right of
individuals to engage in free exchange through
the market. His work makes a strong case that
individual choice, rather than government
decision-making, yields both economic
benefits (greater efficiency) and non-economic
benefits (greater liberty and freedom).
Hayek was born in Vienna in 1899. His
grandfather was a friend of Austrian economist
Böhm-Bawerk; his father was trained as a
physician and then became a Professor of
Botany at the University of Vienna. During
World War I, Hayek served in the Austrian
Army on the Italian front. Returning from the
war he enrolled at the University of Vienna and
earned two doctorates—one in law (1921) and
one in political science (1923).
Ludwig von Mises, head of the Austrian
Institute of Economic Research, then hired
Hayek. In 1927, he appointed Hayek to be
Director of the Institute. Four years later Lionel
Robbins hired Hayek as Tooke Professor of
Economic Science and Statistics at the London
School of Economics in order to bring the
economic ideas from continental Europe to
England.
Following publication of the Road to
Serfdom in 1944 Hayek became a world-
renowned social theorist. Receiving many
teaching offers, Hayek accepted an appointment
at the University of Chicago in 1950. He retired
in 1962 and returned to Europe, accepting a
position at the University of Freiburg. In 1974
Hayek shared the Nobel Prize in Economics
with Gunnar Myrdal. The committee singled out
Hayek’s original way of advocating political
ideas in announcing the award.
Early in his career (in the 1930s) Hayek
made contributions to monetary theory and the
theory of business cycles. Then he began to
focus on the problems of inflation and
unemployment. By the 1940s Hayek became
a strong critic of socialism, of government
planning, and of all government intervention
in the economy. He blamed governments for
creating economic problems and for making
economic problems worse by meddling with
the market economy.
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FRIEDRICH HAYEK
In his first major book, Hayek (1933)
examined the role that money played in
economic expansions and contractions. This
work attempted to develop and explain the
dynamics of Wicksell’s (1898) Interest and
Prices. Hayek argued that monetary factors
were a necessary condition for the business
cycle, but that changing the money supply was
not enough to cause fluctuations in output.
Changes in relative prices were also necessary
to explain the business cycle.
Following Böhm-Bawerk, Hayek believed
that capitalist economies produce goods in ever
more roundabout ways. The length of time it
takes to bring goods to market constantly
increases because machinery and tools had to
be developed before they could be employed
in the production of goods and services.
When money is created by banks, but no
additional savings takes place, there is
immediately a greater demand for consumer
goods. This pushes up the prices of consumer
goods relative to other goods. Businesses, in
an attempt to meet this demand, adopt less
roundabout means of production. But soon
after prices begin to rise, interest rates must
rise so that banks do not incur great losses
when the loans they made in the past get paid
back with money that can buy much less than
the money they lent. Higher interest rates,
in turn, will slow down consumer spending.
Industries that produce consumer goods will
go idle and lay off workers. Now past
excesses begin to take their toll. The failure
to produce more investment goods means
that firms producing investment goods
cannot absorb the labor no longer needed to
produce consumer goods.
This analysis of the causes of
unemployment was quite different from that
of Keynes. For Hayek it is not a lack of demand
that creates unemployment; rather,
unemployment stems from the composition of
demand, or demand for the wrong types of
goods (consumer goods rather than investment
goods). It can only be remedied by reducing
consumer demand so that extra savings
becomes available for businesses to use for
additional investment, enabling them to adopt
longer production processes.
For this reason, Hayek opposed attempts to
employ Keynesian expansionary policies to
deal with unemployment during the Great
Depression. He was against stimulating
consumer demand, expanding public works
projects, or propping up prices. And he argued
that these Keynesian policies helped convert
what might have been a mild recession into a
prolonged depression. In addition, by creating
inflation, Keynesian policies ultimately hurt the
economy.
Hayek pointed out several harmful
consequences of inflation. First, for Hayek
(1945) one of the most important
characteristics of the market system is that it
provides information. Prices tell consumers
which goods require less effort and fewer
resources to produce; prices also tell businesses
which inputs and means of production are least
costly. Inflation distorts this signaling function
of prices. When all prices are continually rising,
it is hard to know which goods are less costly
to produce and what is the cheapest way to
produce those goods. As a result, inflation
distorts the economy by moving resources to
where they should not be employed (inefficient
and unwanted activities). This reduces
economic efficiency and thus the standard of
living for the nation. Second, by causing greater
spending in order to beat the price increase,
more consumer goods get produced and less
roundabout means of production get employed
by businesses. This too reduces future
economic growth.
While opposed to inflation, Hayek was even
more opposed to using incomes policies as a
tool to combat inflation. He saw this as a step
down the road to a totalitarian state. In addition,
incomes policies, like inflation, destroy the
informational function of prices. Finally,
Hayek saw incomes policies as ignoring the
real cause of inflation—too much money. Since
inflation stemmed from too much money,
money creation had to be slowed down to
eradicate inflation. And excessive money
creation, Hayek (1976a) argued, was the result
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FRIEDRICH HAYEK
of government monopolization over the
printing and circulation of money. Monopoly
control over money creation by the government
leads to inflation for two reasons, according to
Hayek. First, the government is always tempted
to print more money in order to pay its bills.
Second, governments are tempted to print
money and create inflation in order to repay
borrowed money with money that is worth
much less because it can purchase fewer goods.
To keep governments from deliberately
creating inflation, Hayek (1976a) proposed
allowing private businesses to issue their own
currency. Thus large firms, or more likely large
banks, would each print up their own money.
People and firms would choose to hold those
currencies they expect to be most accepted by
others and least likely to decline in value.
Privately issued money, Hayek felt, would keep
inflation in check because it would keep the
inflationary tendencies of government in check.
Also, private money issuers would have to be
concerned about their reputation and the value
of the money they created. As a result, Hayek
thought that they would not tend to issue too
much money.
The argument that economic problems that
arise due to government intervention became
a dominate theme in the economics of Hayek
starting in the 1940s. He increasingly relied on
philosophical and psychological insights when
making his case against government
involvement in economic affairs. He stressed
that there were finite limits to the amount of
knowledge that any one individual or
institution can acquire, as well as limits to
human reason. Men and women could
understand general economic relations, but
could never understand the exact relationships
operating at any time. Hayek (1955, pp. 53–
63) also stressed that the social sciences were
fundamentally different from the natural
sciences. People do not obey psychological or
economic laws the way that matter obeys the
laws of physics, and so all attempts to control
society in the way that science controls the
environment are misplaced. Both of these
beliefs have implications for economics, and
each supports Hayek’s case against
government involvement in economic affairs.
One argument for economic planning in the
1930s and 1940s was that central planners
could figure out the supply and demand for all
goods in the economy and manipulate prices
accordingly. Going even further (see also
LANGE), some economists argued that
because the economy was so complex, planners
with a good mathematical model could do
better than the market in setting prices. Others
(see also GALBRAITH) argued that as firms
became larger and more monopolistic,
government planning was needed to
countervail this power.
Hayek turned these arguments on their head.
For Hayek, the complexity of the economy
means that any one person could not
understand the workings of the whole
economy. As a result, supply and demand
equations could not be known by planners, and
planning would only lead to inefficiencies.
Similarly, Keynesian macroeconomic
management (fine-tuning) was flawed since
policy makers cannot understand all the
intricacies and subtleties of the market system.
Instead of improving economic performance,
government policy would only stifle the
economic system that is responsible for
improving our living standards.
Hayek also turned on its head the case that
government power had to be used to counter
monopoly power. He held that monopoly
power is usually the result of government
actions. For example, domestic producers
lobby the government to keep out imports and
restrict entry into an industry or profession
through licensing requirements. Hayek also
thought that even if large firms become
powerful, potential competition (or the threat
of new rivals starting up) would force firms to
operate efficiently and produce the goods
demanded by their customers at the lowest
possible cost.
But Hayek went even further than this. He
argued that government policy has limited
individual liberties and taken us down The
Road to Serfdom. This applies to socialist
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FRIEDRICH HAYEK
economies as well as capitalist economies that
undertake planning for the future or attempt to
reduce unemployment. Similarly, it is true of
government policies that attempt to redistribute
income in the name of economic justice. Hayek
(1976b) contends that it is illegitimate to
describe the outcome of the market process as
either just or unjust. Income distribution is a
fact about the world, the result of impersonal
market forces. The notion of justice does not
apply to such situations. In addition, attempts
on the part of government to redistribute
income will do more harm than good. The poor
are hurt because redistribution reduces
economic incentives and therefore decreases
the economic pie. This leaves less for everyone,
wealthy and poor alike. The poor are also hurt
because the wealthy perform important
economic functions like taking risks,
supporting arts and education, and testing new
and expensive products that, if successful, get
mass produced at lower prices.
Going even further, Hayek (1944; also see
Butler 1983, Ch. 4) argued against government
attempts to provide equal economic
opportunity to all individuals in order to obtain
equality of results. He contends that the notion
of equal opportunity is illusory. If the
government attempted to give all children an
equal starting point, this would mean
redistributing the wealth of their parents so that
no child starts out ahead of others. It would
also mean keeping the income of all parents
equal so that some children do not gain any
advantages. Again, in seeking to provide equal
opportunity, governments by necessity must
become more totalitarian.
Hayek did support equity in another sense,
however. He thought that all men and all
women should be treated as equals before the
law. Equality of the law, or equal rules that
apply to all citizens, would preserve liberty
against the coercive power of government
(Hayek 1976b).
Hayek’s main contribution as an economist
has been his arguments about the benefits of
free markets and the information provided by
prices. These arguments lead to the conclusion
that attempts to alter or control markets should
be opposed because they inevitably limit
individual freedom, reduce economic
efficiency and lower living standards. Markets,
for Hayek, were self-regulating devices that
promote prosperity. Government policy and
other attempts to hinder the workings of
markets make us worse off economically and
reduce individual liberty.
Works by Hayek
Prices and Production (1931) 2nd edn., London,
Macmillan, 1934
Monetary Theory and the Trade Cycle (1933),
Fairfield, New Jersey, Augustus M.Kelly, 1975
The Pure Theory of Capital, London, Routledge
& Kegan Paul, 1941
The Road to Serfdom (1944), Chicago, University
of Chicago Press, 1956
“The Use of Knowledge in Society,” American
Economic Review, 35, 4 (September, 1945),
pp. 519–30
Individualism and Economic Order, Chicago,
University of Chicago Press, 1948
The Counter-Revolution of Science: Studies on the
Abuse of Reason (1955), Chicago, Liberty
Press, 1979
The Constitution of Liberty, Chicago, University
of Chicago Press, 1960
The Denationalization of Money, London, Institute
of Economic Affairs, 1976a
Law, Legislation and Liberty,Vol. 2, Chicago,
University of Chicago Press, 1976b
New Studies in Philosophy, Politics, Economics
and the History of Ideas, London, Routledge
& Kegan Paul, 1978
The Fatal Conceit: The Errors of Socialism,
Chicago, University of Chicago Press, 1988
The Collected Works of F.A.Hayek, 10 vols., Chicago,
University of Chicago Press, 1989–94
Works about Hayek
Barry, Norman P., Hayek’s Social and Economic
Philosophy, London, Macmillan, 1979
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Barry, Norman P., “Restating the Liberal Order:
Hayek’s Philosophical Economics,” in Twelve
Contemporary Economists, ed. J.R.Shakleton
and G.Locksley, New York, Wiley, 1981, pp.
87–107
Butler, Eamon, Hayek: His Contribution to the
Political and Economic Thought of Our Time,
New York, Universe Books, 1983
Machlup, Fritz, “Hayek’s Contribution to
Economics” in Essays on Hayek, ed. Fritz
Machlup, Hillsdale, Michigan, Hillsdale
College Press, 1976, pp. 13–59
Nishiyama, Chiaki, and Leybe, Kurt R., The
Essence of Hayek, Stanford, Hoover Institution
Press, 1984
Other references
Wicksell, Knut, Interest and Prices (1898),
London, Macmillan, 1936
SIMON KUZNETS (1901–85)
Simon Kuznets is best known for developing
the system of national income accounts that
all countries employ to measure economic
activity. He also measured income distribution,
and examined how the distribution of income
in the US changed during the twentieth century.
But the work of Kuznets went beyond
measuring economic phenomena. He also
sought to determine the causes of economic
growth and changing income inequality,
studied the cycles of growth that economies
go through, and attempted to understand the
consequences of economic growth on income
distribution.
Kuznets was born in Pinsk (then part of the
Soviet Union, now part of Belarus) in 1901.
His father was a skilled furrier, who moved the
family to Kharkov, a city noted for its
intellectual life, at the beginning of World War
I. After graduating from the local public school,
Kuznets enrolled at the University of Kharkov.
There he began to study economics and became
exposed to Joseph Schumpeter’s theory of
innovation and the business cycle. When the
Russian Revolution closed the university and
led to civil war in Russia, the Kuznets family
fled Russia, going first to Turkey and eventually
to the United States (Kapuria-Forman and
Perlman 1995).
Kuznets taught himself English over one
summer and then enrolled at Columbia
University. At Columbia, Kuznets studied
under Wesley Clair Mitchell, who trained
Kuznets in empirical economic methods and
sparked his interest in business cycles. He
received a BA from Columbia in 1923 and a
Ph.D. in 1926. His dissertation (on fluctuations
in wholesale and retail trade) involved
questions of both economic measurement and
cyclical variations in economic activity
(Kuznets 1926).
After receiving his doctorate, Kuznets
worked at the National Bureau of Economic
Research (NBER) for around three years.
Then in 1931 he accepted a position at the
University of Pennsylvania. Kuznets left
Pennsylvania for Johns Hopkins in 1960,
where he remained until his retirement in
1971. All the while, Kuznets maintained his
connections with the NBER.
Over the course of his academic career
Kuznets received many professional accolades.
In 1949 he was made President of the American
Statistical Association; in 1953 he became
President of the American Economic
Association; and in 1971 he was awarded the
Nobel Prize in Economic Science.
While the Nobel Prize committee singled
out his work in the area of economic growth
and changing social structure, the most
important contribution of Kuznets was
probably his work developing a system of
national income accounting.
Macroeconomics studies the overall
performance of national economies. To test
hypotheses about macroeconomic
relationships, or to find the causes of good
macroeconomic performance, it is necessary
to have some measure of overall economic
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SIMON KUZNETS
activity. In the seventeenth-century William
Petty made some rudimentary attempts at
calculating economic activity in England, and
national income estimates for the UK were
made several times subsequent to the
pioneering work of Petty. However, no one
attempted to make such measurements on an
annual basis, and few estimates were done
carefully or systematically. Still, in the 1920s,
England was far ahead of the US in compiling
national income data. Kuznets was primarily
responsible for changing this. He moved the
US from the position of laggard to being a
leader in national income statistics.
At the NBER Kuznets was responsible for
developing the first estimates of US national
income for the years from 1929 to 1932. He
then went on to develop estimates of national
income for all the years between 1919 and
1938, and to provide estimates of US economic
activity going back as far as 1869 (Kuznets
1941, 1946a, 1946b, 1952a).
Kuznets (1933) carefully described both the
methodology that he used in compiling
measures of economic activity as well as some
of the problems he encountered in making such
estimates. As such, he set the standards for
measuring economic activity and developed the
procedures that are still employed today.
For example, Kuznets was aware that
estimates of national income excluded goods
and services that were not marketed and sold.
When households cook their own meals, mow
their own lawns, and clean their houses, they
are producing goods and services; but these
goods and services do not get counted in
government figures of economic activity.
Likewise, illegal activities like prostitution and
drug trade are difficult, if not impossible, to
measure and so cannot be included in estimates
of overall economic activity.
Kuznets was also careful to distinguish final
goods from intermediate goods, and was able
to use this distinction to avoid the problem of
double counting. An automobile, a final good
sold to consumers, gets assembled from
intermediate goods such as tires, glass, engines,
and brakes. To count the value of tires sold to
the automobile manufacturer and also the value
of the whole car would be to count twice the
tires that are produced. In order to get a more
accurate measure of economic activity it is
necessary to subtract the value of all parts from
the final price of the car sold to the consumer.
Taking this difference, or computing the value
added by the car manufacturer, provides the
foundation for measuring national income.
National income is simply the sum of the value
added by every firm in the economy over a
specific time period. It can be derived from the
periodic reports made by business firms about
their revenues from sales, their expenditures
on parts, and their quarterly profits.
Kuznets understood that national income
measures had severe limitations as indicators
of national well-being or national welfare.
Just because national income increased it did
not mean that some country was necessarily
better off. Income could have become
distributed more unequally; so despite higher
incomes overall, a large majority of
households might be worse off. Kuznets also
noted that the growth process itself might
lead to undesirable outcomes like
urbanization, traffic congestion, and
pollution. Finally, national income accounts
do not take into account how much output
goes to the government, and gets paid for by
compulsory taxation.
Kuznets’ work on measuring national
income led naturally to a study of business
cycles, or the periodic expansion and
contraction of economic activity. Prior to the
work of Kuznets, Nikolai Kondratieff (1925),
a Russian economist, noted the existence of
long-run economic cycles lasting between 45
and 60 years. Examining several hundred years
of price data for the US, France, and Germany
(plus data on the production of iron, coal, and
other products, throughout the world),
Kondratieff noticed that there were regular 20–
30 year periods during which prices rose and
then 20–30 year periods during which prices
declined. These long-run economic changes
have since been called “Kondratieff waves.”
Shorter cycles, of around ten years, have been
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SIMON KUZNETS
associated with changes in business investment
(see also SCHUMPETER).
In his study of economic fluctuations,
Kuznets (1930) found intermediate cycles of
growth and decline lasting around 20 years.
These cycles have come to be called
“Kuznets cycles” (Abramovitz 1961) in
honor of their discoverer. Kuznets thought
that demographic changes could explain
these 20-year cycles. Increasing population
can stem from waves of immigration or from
growing birth rates due to favorable
economic circumstances. Whatever the
cause, population growth leads to a greater
demand for consumer goods, especially
larger and more housing. Additional demand
encourages additional business investment.
This, plus the ability to take advantage of
economies of scale, contribute to more rapid
productivity growth. As a result, living
standards rise as the population grows. But
soon the new citizens will become part of a
larger labor force, and this will lead to a
downward pressure on wages. As wages fall,
so too does spending and investment, and the
downward phase of the economic cycle
begins.
Kuznets (1965) expanded his work on
economic cycles to study the structural
economic changes that result from economic
growth and decline. Here he studied how the
business cycle affects savings and
consumption rates, productivity, income
distribution and other factors (like the
international flow of capital, goods, and
people).
Kuznets (1953, 1955) also examined the
impact of economic growth on income
distribution, and pioneered the measurement
of income distribution. Using both IRS
income tax data and US Census Bureau
survey data, he examined the fraction of total
income received by each of ten income
groups (the top 10 percent of income earners,
the next 10 percent, the third 10 percent, etc.)
for virtually every year between 1913 and
1948. Kuznets (1953) found that in the
interwar years the top 1 percent of the US
population received 15 percent of all national
income and the top 5 percent of the US
population received between 25 percent and
30 percent of all income. He also found a
decline in income inequality in the US during
and after World War II, with the top 1 percent
of the population getting only 8.5 percent of
all income and the top 5 percent receiving
18 percent of all income. The business cycle,
Kuznets argued, could explain these changes.
Low unemployment during and after World
War II increased the fraction of total income
going to lower income groups. At the same
time, lower interest rates and higher income
taxes reduced the fraction of income going
to the most affluent. Looking at data over
longer time horizons and for many different
nations, Kuznets (1955) found that income
equality followed a U-shaped pattern—it
declined during the early stages of economic
development making the poor relatively
worse off, but it rose at later stages of
development thus benefiting those with
lower incomes.
Another important empirical finding by
Kuznets involved savings rates in the US, or
its converse, the ratio of consumption to
national income. Kuznets (1946b, 1952b)
found that saving rates in the US were
remarkably constant, and did not change as the
US economy grew. This contradicted the
prediction of the simple Keynesian
consumption function, C=a+bY, where C is
consumption and Y is current income. If this
hypothesis were true, then spending rates
should fall as incomes increase. Falling
spending rates means rising savings rates.
Essentially, the simple Keynesian view was that
people would save more as their incomes
increased. The fact, discovered by Kuznets, that
savings rates were constant led Milton
Friedman to develop the permanent income
hypothesis and Franco Modigliani to develop
the life-cycle hypothesis as a means of
explaining constant savings rates.
Finally, Kuznets devoted substantial
attention during his lifetime to the factors
affecting productivity growth. This was a
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natural extension of his focus on economic
growth, since growth is due to the combined
effects of greater productivity and a larger
population. Of the two factors, productivity
growth is certainly the more important, for as
Adam Smith pointed out it is productivity
growth that will lead to improvements in living
standards. Studying productivity growth
allowed Kuznets to incorporate his diverse
interests in population changes, in making
precise empirical estimates, and in improving
living standards.
Kuznets placed heavy emphasis on
technological change and innovation as the
means to improve productivity growth. He
estimated (Kuznets 1946) that over a 50-year
period three-fifths of the gain in US productivity
was due to technological advances and two-fifths
was due to redistributing labor from less
productive sectors (i.e. agriculture) to more
productive sectors (i.e. manufacturing). Since
technology was the more important factor
historically, and since redistributing labor
becomes less important over time as fewer
Americans work in agriculture, he thought that
the effort to improve productivity must focus
on technological breakthroughs and advances.
At the end of the twentieth century, most
work in economics was highly abstract and
theoretical. Economists even looked down
upon empirical studies seeking to measure
economic variables and examine how these
variables change over time. Kuznets stands
firmly within the empirical tradition in
economics that began with Petty’s political
arithmetic. The work of Kuznets has
allowed a substantial body of knowledge to
be developed about economic growth and
development. It has also yielded an
enormous amount of data that lets economic
theories be tested. And it has allowed
governments to compile and report
macroeconomic data on a regular basis. If
economics is to be regarded as a study of
the behavior of real world economies,
Kuznets must be regarded as one of its half
dozen most important figures.
Works by Kuznets
Cyclical Fluctuations: Retail and Wholesale
Trade, United States, 1919–1925, New York,
Adelphi, 1926
Secular Movements in Production and Prices,
Boston, Massachusetts, Houghton Mifflin,
1930
“National Income,” Encyclopedia of the Social
Sciences, Vol. 11, New York, Macmillan, 1933,
pp. 205–24
National Income and Its Composition, 1919–
1938, 2 vols., New York, National Bureau of
Economic Research, 1941
National Income: A Summary of Findings, New
York, National Bureau of Economics
Research, 1946a
National Product Since 1869, New York, National
Bureau of Economic Research, 1946b
Income and Wealth of the U.S.: Trends and
Structure, Cambridge, Bowes & Bowes,
1952a, with Raymond Goldsmith
“Proportion of Capital Formation to National
Product,” American Economic Review, 42, 2
(1952b), pp. 507–26
Shares of Upper Income Groups in Income and
Savings, New York: National Bureau of
Economic Research, 1953
“Economic Growth and Income Inequality,”
American Economic Review, 45, 1 (March
1955), pp. 1–28
Economic Growth and Structure: Selected Essays,
New York, Norton, 1965
Economic Growth of Nations, Cambridge,
Massachusetts, Harvard University Press, 1971
Population, Capital, and Growth, New York:
Norton, 1973
Growth, Population, and Income Distribution:
Selected Essays, New York, Norton, 1979
Works about Kuznets
Abramovitz, Moses, “The Nature and
Significance of the Kuznets Cycle,” Economic
Development and Cultural Change, 9 (April
1961), pp. 349–67
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Hinck, Harriet, “Simon Kuznets 1971,” in Nobel
Laureates in Economic Sciences: A
Biographical Dictionary, ed. Bernard S.Katz,
New York, Garland, 1989, pp. 143–59
Kapuria-Foreman, Vibha and Perlman, Mark, “An
Economic Historian’s Economics:
Remembering Simon Kuznets,” Economic
Journal, 105 (November 1995), pp. 1524–47
Lundberg, Erik, “Simon Kuznets’ Contribution to
Economics,” Swedish Journal of Economics,
73 (December 1971), pp. 444–61
Ben-Porath, Yoram, “Simon Kuznets in Person and
Writing,” Economic Development and Cultural
Change, 36, 3 (April 1988), pp. 435–47
Other references
Kondratieff, Nikolai, The Long Wave Cycle (1925),
New York, Richardson and Synder, 1984
JOHN VON NEUMANN (1903–57)
John von Neumann (pronounced NOY-mon)
was trained as a mathematician, and is regarded
as one of the most brilliant mathematical
geniuses of the twentieth century. Nevertheless,
he made several contributions to economics.
As might be expected, these contributions
involved applying mathematics to economic
decision making. But unlike other major
figures who brought mathematical techniques
to economics, von Neumann did not employ
the calculus to explain economic relationships.
Rather, he brought to economics the insights
from games of strategy. By so doing, he shed
new light on the human interactions that form
the basis of economic life.
Von Neumann was born in Budapest,
Hungary in 1903. His father was a
successful and wealthy Jewish banker. Early
in life von Neumann’s mathematical talents
became obvious. By the age of six he could
divide two eight-digit numbers in his head;
by eight he mastered calculus (Halmos
1973, p. 383). At school he was excused
from regular math classes to receive private
tutoring from college mathematics
professors. By the end of his senior year of
high school he was regarded as a
professional mathematician and had
published his first mathematical paper.
Although registered as a student at the
University of Budapest, von Neumann did not
attend classes. Instead, he studied at the
University of Berlin and returned to Budapest
only to take exams. After two years he
transferred to the Swiss Federal Institute of
Technology, where he encountered the
outstanding mathematicians of his time. He
received a diploma in chemical engineering
from the Swiss Federal Institute in 1923 and a
doctorate in mathematics from the University
of Budapest in 1926.
From 1926 to 1930 von Neumann taught
mathematics at the University of Berlin and
then at the University of Hamburg, while also
publishing articles on set theory, algebra, and
quantum physics. Fearing the consequences of
remaining in Germany, he accepted a teaching
position at Princeton University in 1930. In
1933, he was hired by the Institute for
Advanced Studies at Princeton, a post that he
held for the rest of his life.
When World War II began, von
Neumann was called to serve on important
war committees and advisory groups. He
helped develop the world’s first computer
for the US military and, at the behest of
J.Robert Oppenheimer, he participated in
the Manhattan Project, which led to the
development of the first nuclear weapons.
After the war, von Neumann vigorously
defended US nuclear testing and supported
development of the hydrogen bomb. In
1954 he was appointed to the Atomic
Energy Commission (AEC) by President
Eisenhower. Soon after his arrival in
Washington, von Neumann was diagnosed
as having cancer and his health rapidly
deteriorated. Because he attended AEC
meetings in a wheelchair, and because of
his strong pro-nuclear position, many
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people (Poundstone 1992) believe that von
Neumann was the model for Dr
Strangelove in the 1963 Stanley Kubrick
film with that title.
Fellow Hungarian Nicholas Kaldor met von
Neumann while they were both on vacation in
Budapest in the late 1920s. Von Neumann
expressed interest in mathematical economies
and Kaldor suggested he read Walras (Macrae
1992, p. 250). According to Walras, general
equilibrium can be shown to exist if the set of
mathematical equations representing supply
and demand was equal to the number of
unknowns (the price of each good and the
quantities of each good bought and sold). In
this case, the system of equations could be
solved for the price and the quantity of each
good (see also WALRAS). Von Neumann
pointed out that this procedure of counting
equations and unknowns fails to rule out
negative prices, which makes no sense and can
never exist in the real economic world.
Consequently, counting equations and
unknowns fails to demonstrate that all markets
can achieve equilibrium at the same time.
Von Neumann also suggested that the
Walrasian supply and demand equations
ignored important interdependencies among
markets, such as when low car prices lead to
an energy crisis. He (von Neumann 1928)
developed game theory to account for just such
interdependencies. He also conceived of game
theory as a challenge to standard economic
analysis which adopted the metaphor of
classical mechanics and the maximization
assumption that followed from adopting the
differential calculus. Von Neumann thought
that social phenomena required different
models and methods of analysis. Game theory
provided this method.
Game theory is about conflict situations
where individuals are competing against one
another and are uncertain about what their
opponent or competitor will do; yet all
individuals know that the outcome of the
conflict depends upon what each party decides
to do. Essentially, then, game theory concerns
the interaction between two or more people.
Most economic analysis does not concern
itself with such interaction, and at one level
this approach is perfectly satisfactory. Many
economic decisions that get made are
independent of the behavior of others. For
example, when I go to the supermarket, the
price I pay for Grape Nuts cereal does not
depend upon the number of boxes of cereal that
I buy. However, in many instances the reaction
of others does play an important role in
economic decision making. This is most likely
to be the case where the number of economic
agents or decision makers is small, such as in
an oligopolistic industry. In these situations the
decision made by one firm will likely affect
the decisions made by other firms, and these
interactions will affect economic outcomes.
When Oskar Morgenstern arrived in
Princeton in 1939, he and von Neumann
quickly became close friends. Morgenstern
read von Neumann’s (1928) paper on strategy
for parlor games and recognized that the
framework von Neumann developed could be
applied to many economic situations. The two
then became collaborators on the theory of
games and the use of game theory for economic
analysis.
Von Neumann and Morgenstern (1944)
began by describing the characteristics of a
game. Each game could be described by three
features: (1) a number of players, (2) a set of
decisions that each player had to make, and
(3) a pay-off matrix, or a table showing the
outcome for every combination of decisions
made by the players.
Once a game is defined in these terms, each
player can calculate their gains or losses from
each move they might make or each strategy
they might employ in playing the game. Von
Neumann and Morgenstern assumed that each
player would try to achieve the best possible
result, meaning that each player would employ
a strategy that would likely lead to the largest
gain for them.
Figure 9 illustrates the pay-off matrix for a
game with two players, each of whom has two
possible moves. This gives us four possible
outcomes, each with a different pay-off for the
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JOHN VON NEUMANN
two players. For each outcome, the first pay-
off goes to Player 1 and the second pay-off goes
to Player 2. Thus, if Player 1 selects a and
Player 2 selects b, then Player 1 gains 1 and
Player 2 loses 1. It is possible to think of the
pay-offs as monetary gains and losses (say
$1000), but strictly speaking the numbers in
the boxes should represent the utility received
by each player.
Von Neumann (1928) demonstrated that
there is always a rational course of action for
two players in a game. The rational course of
action may be to use a pure strategy (always
making the same choice) or a mixed strategy,
which involves selecting each option or choice
with some probability. With a pure strategy, a
player would choose the same alternative all
the time because that decision is the very best
the player could do. With a mixed strategy, the
best a player could do would be to select each
alternative with some fixed probability.
Figure 9 A Game Theory Pay-off Matrix
Figure 9 is an example of a game where
mixed strategies are required. In its simplest
real world instantiation, it is the game of
matching pennies. Player 1 wins the game and
wins a penny, whenever both players show
heads or both players show tails; otherwise
Player 2 wins. If Player 1 tends to choose
strategy a, then Player 2 would soon recognize
this and could gain by choosing strategy b. On
the other hand, if Player 1 tends to choose
strategy b, Player 2 gains by employing
strategy a more frequently. The only way for
Player 1 to break even over the long run is to
select strategy a half the time and select strategy
b half the time.
Various extensions and applications of this
simple framework are possible. For games of
more than two people, von Neumann and
Morgenstern (1944) studied the conditions
under which players would form coalitions in
order to gain at the expense of other players
who are not in the coalition. In the real world,
this is analogous to studying the conditions
under which it would make sense for two firms
in an oligopolistic industry to merge, thus
forming a very large monopoly by reducing the
number of competitors in the industry. It is also
analogous to studying the conditions under
which it makes sense for business firms to
collude and raise prices, for workers to get
together and form a union, or for groups of
individuals to form a special interest group and
lobby the government for legislation that would
confer economic benefits on the members of
the group.
Perhaps the most famous extension of
game theory is the prisoner’s dilemma,
which shows how two individuals pursuing
their own best strategy can wind up in a less
than optimal situation. A typical prisoner’s
dilemma is shown overleaf in Figure 10. The
following story usually goes along with the
prisoner’s dilemma pay-off matrix. Two
criminals have been captured and put into
separate rooms. If neither confess to their
crime, (i.e., if both choose a) they both get
off scott free. If both criminals confess (i.e.,
if both choose b), they each get three years
in prison. But if one prisoner confesses and
the other prisoner does not, the confessor
gets rewarded (with a new identity and new
life) while the other prisoner serves five years
in jail.
From the point of view of Player 1, he is
better off confessing (choosing b) regardless
of what Player 2 does. If Player 2 refuses to
confess (choosing a), Player #1 does better
by confessing than by not confessing
(gaining 3 rather than gaining nothing).
Likewise, if Player #2 confesses (choosing
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JOHN VON NEUMANN
b), Player 1 does better by confessing,
because b gives him a loss of -3 rather than
a loss of -5. The same thing is true of Player
2. No matter what Player 1 does, Player 2 is
better off confessing. The paradox here is
that the outcome of the game (both players
confessing and spending three years in jail)
Figure 10 The Prisoner’s Dilemma
is worse than the outcome that results from
the “irrational strategy” of not confessing.
Prisoner’s dilemma situations are
common in every day life and in economic
life. They are the heart of the free rider
problem. Like the prisoner who confesses,
the free rider does not pay to support
community services that everyone takes to
be desirable. The outcome of free riding is a
lack of important community services. Free
riders will also bring down utopian
socialists’ schemes of the sort proposed by
Robert Owen.
The prisoner’s dilemma has been used to
study a wide range of topics, some of which
are only tangentially related to economics.
It has been used to explain the arms race
(Schelling 1966; Russell 1959). Under this
analysis both the US and the Soviet Union
had to build missiles (strategy b) because had
they not done this they would have been at
the mercy of their adversary. The prisoner’s
dilemma has also been used to explain the
advantages of oligopolists colluding to raise
prices rather than competing and earning
little or no profits. It has been employed in
international trade to explain how two
nations might come to adopt protectionist
policies (strategy b), even though both
countries would gain from free trade. Finally,
Schelling (1978) has used the prisoner’s
dilemma to explain why racial segregation
exists in neighborhoods and why hockey
players do not want to wear helmets even
though all players gain from the safety
provided by helmets.
One potential drawback of game theory
is that it does not always provide determinant
solutions. For example, the prisoner’s
dilemma does not let us predict exactly what
each prisoner will choose to do. It can only
help us analyze the decision facing each
prisoner. However, the real world itself may
not always have definite or determinate
results. Rather, actual results may depend on
a number of different factors. Game theory
is a useful tool in analyzing these situations,
capturing the different factors that go into
making decisions and helping people to see
their best strategy in a particular situation.
As Leonard (1995, p. 756) has observed,
game theory was “part of a general shift in
science which involved…the abandonment
of determinism, continuity, calculus, and the
metaphor of the ‘machine’, to allow for
indeterminism, probability, and
discontinuous changes of state.” In large part
von Neumann was responsible for this shift
of focus and orientation on the part of
economists.
Works by von Neumann
“Zur Theorie der Gesellschaftsspiele” (“Theory
of Parlor Games”), Mathematische Annalen,
100 (1928), pp. 295–320. Translated and
reprinted in Tucker and Luce (eds.)
Contribributions to the Theory of Games, Vol
4, Princeton, New Jersey, Princeton University
Press, 1950, pp. 1–27
Theory of Games and Economic Behavior,
Princeton, Princeton University Press, 1944
with Oskar Morgenstern
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JOAN ROBINSON
“A Model of General Equilibrium,” Review of
Economic Studies, 13 (1945–6), pp. 1–9
Works about von Neumann
Halmos, Paul, “The Legend of John von
Neumann,” American Mathematical Monthly,
80, 4 (April 1973), pp. 382–94
Leonard, Robert J, “From Parlor Games to Social
Science: von Neumann, Morgenstern, and the
Creation of Game Theory 1928–1944,”
Journal of Economic Literature, 33, 2(June
1995), pp. 130–61
Macrae, Norman, John von Neumann, New York,
Pantheon Books, 1992
Morgenstern, Oskar, “The Collaboration between
Oskar Morgenstern and John von Neumann on
the Theory of Games,” Journal of Economic
Literature, 14, 3 (September 1976), pp. 805–16
Poundstone, William, Prisoner’s Dilemma, New
York, Doubleday, 1992
Other references
Russell, Bertrand, Common Sense and Nuclear
Warfare, New York, Simon & Schuster, 1959
Schelling, Thomas, Arms and Influence, New
Haven, Connecticut, Yale University Press, 1966
Schelling, Thomas, Micromotives and
Macrobehavior, New York, Norton, 1978
JOAN ROBINSON (1903–83)
Joan Robinson made major contributions in
two areas of economics. Early in her career,
she focused the attention of economists on
market forms in between perfect competition
and monopoly. Later she was instrumental in
defending and expanding the theories of
Keynes, and became one of the founders of
post-Keynesian economics.
Robinson was born Joan Maurice in Surrey,
England in 1903. Her family was upper middle
class and put a high premium on education and
independent thinking. Her father was a military
general, an author and, later in life, head of one
of the colleges making up the University of
London. Her mother was the daughter of a
Cambridge University professor. Robinson
attended St Paul’s, a leading school in London
for girls, where she studied history; she then
went to Girton College, Cambridge, where she
studied economics. She became interested in
economics in order to learn why poverty and
unemployment existed in the world, and
because she thought economics could solve
these problems (Shaw 1989, p. 145).
With the exception of a few years spent in
India with her husband (economist Austin
Robinson), Robinson spent the half century
following her 1925 graduation teaching and
lecturing in Cambridge. However, because she
was a woman, she did not become a full-time
member of Cambridge University until 1948.
In the 1930s, Robinson was an active
participant in the “Cambridge Circus,” a small
group of economists helping Keynes to develop
his General Theory. She then helped defend
Keynes from his many critics and expanded his
ideas along several lines. In 1974 Robinson was
made President of the American Economic
Association, becoming its first female President
and one of its few non-American Presidents. She
is the first woman to have made the list of
finalists for the Nobel Prize in Economics.
As an undergraduate, Robinson studied
Marshall’s Principles of Economics, the
standard textbook at the time. What she found
especially unsatisfactory was the conclusion of
this work—that producers and consumers jointly
maximized their well-being. This conclusion
seemed incompatible with the actual British
economy of the 1920s, which was plagued with
high unemployment and industries operating at
low capacity. Robinson was also dissatisfied
with the fact that Marshall and other economists
focused on just two extreme types of
industries—perfect competition and monopoly.
The interesting real world, she thought, fits in
between these two extremes. The Economics of
Imperfect Competition (Robinson 1933)
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JOAN ROBINSON
analyzed these real world industries falling part
way between a highly competitive industry with
many small firms and an industry made up of
only one firm.
To explain firm decision-making Robinson
used the concept of marginal revenue (see also
COURNOT), the additional revenue a firm gets
when it produces and sells one more thing. For
competitive firms, marginal revenue would
always equal price, since firms can always sell
more goods without having to run a sale or lower
the price they charge. But under imperfect
competition firms faced downward sloping
marginal revenue curves. To sell more, goods
had to be put on sale. But when firms run sales,
some consumers pay less than they would have
otherwise paid. The firm loses this revenue.
Taking into account both the lower price and
the greater sales, firms might cut prices to sell
more but not receive any more revenue (i.e. their
marginal revenue from selling more would be
zero or negative). Conversely, firms might
receive more revenue if they increased their
prices, producing and selling less.
By showing how raising prices and
producing less output could yield more revenue
for the large firm, Robinson was able to explain
why imperfect competition was characterized by
insufficient production and underutilized
resources. Imperfect competition could thus
explain (while the theory of perfect competition
could not) the high rates of unemployment
prevailing in England during 1920s and during
the Great Depression of the 1930s.
The Economics of Imperfect Competition
(Robinson 1933, Ch. 25) also showed that under
imperfect competition, workers received wages
less than the value of what they produced.
Consequently, the marginal productivity fails to
hold when imperfect competition exists. With
imperfect competition labor gets exploited by
powerful businesses. To help drive home this
point, Robinson developed the notion of
monopsony, a case in which there is only a single
employer in a particular geographic region or
one employer for workers with certain skills.
With only one potential employer, and with
many individuals looking for work, people are
at a competitive disadvantage. They are forced
to accept the wage offered by the single
employer. Robinson recognized that the world
did not consist of monopsonistic labor markets
any more than it was comprised of monopolistic
product markets. However, the notion of
monopsony helped focus attention on wage
determination as a bargaining process and the
exploitation of workers due to their lack of
bargaining power against a few large firms.
Another important contribution in
Economics of Imperfect Competition was its
analysis of price discrimination. Economists
knew that large, monopolistic firms charged
different prices to different people, but Robinson
(1933, Ch. 15) was the first to explain its
operating principles and its consequences.
Robinson (1933, p. 179) pointed out that price
discrimination was possible only with monopoly
or imperfect competition. Through price
discrimination, monopolistic firms would be
able to increase their revenues and their profits.
To engage in price discrimination, firms
needed to segment the market for their product
into two parts—those consumers willing and
able to pay high prices and those consumers who
were price sensitive. Then the firm needed some
way to charge higher prices to the first group.
One way of doing this would be to charge
different prices at different times of the day.
Thus, telephone companies offer lower rates in
the evenings and on weekends. Business
customers, generally insensitive to price, pay the
higher day rates; and individuals pay the reduced
off-peak phone rates. Discount coupons also
help to segment the market and allow for price
discrimination. Those who are cost conscious
will clip coupons and buy goods at a lower price;
those who are not will pay full price. Likewise,
the practice of pricing through haggling, as done
at automobile dealerships, will lead to price
discrimination. Here the hagglers, unwilling to
pay higher prices, buy cars for less money than
those who do not want to negotiate over price
for hours and hours.
An economic world characterized by
imperfect competition also led to a new theory
of price determination, one hinted at by Robinson
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JOAN ROBINSON
and developed later by post-Keynesian
economists (see Eichner 1976). In competitive
markets, firms were all price takers; they had to
set their prices equal to what the market would
bear and what all the other firms in the industry
were doing. With imperfect competition,
however, prices were set by producers, who added
a mark-up to their prime costs (primarily wages).
The less competitive the industry, the greater the
mark-up. And the greater the need by the firm
for internal sources of funds for expansion, the
greater the mark-up.
Despite its many advances, Robinson grew
dissatisfied with The Economics of Imperfect
Competition almost as soon as she finished
writing it. Her dissatisfaction came from the
numerous problems she saw with
microeconomic analysis. On a theoretical level,
Robinson became aware of logical problems
with supply and demand analysis. On a
practical level, the Great Depression and work
of Keynes made her lose interest in the pricing
and output decisions of firms.
One problem with supply and demand
analysis according to Robinson (1980, Vol. 5,
pp. 48–58) was that it ignored time and
expectations; instead a timeless notion called
“equilibrium” took center stage. Robinson
thought that the notion of stability inherent in
equilibrium analysis was inappropriate for a
discipline like economics which deals with
growing and changing economies. Contrary to
standard economic theory, consumers and
businesses do not respond to current prices in
ways that move the economy towards an
equilibrium price. Rather, consumers and
businesses respond to prices today based upon
what they think prices will be in the future.
Moreover, changing prices can change
expectations. Lower prices can lead to
expectations of even lower future prices,
making consumers less willing to buy some
good despite a sharp drop in its price. Under
such conditions no equilibrium, or market
clearing, price is possible; and supply and
demand analysis cannot illuminate what is
going on in the real world. To understand real
economies requires a new theoretical
orientation, one focused on how prices change
over time rather than on how prices move
towards the present equilibrium price.
A second problem with supply and demand
analysis for Robinson concerned the nature of
capital. Robinson began the so-called
Cambridge Controversy with her critique of the
marginalist theory of distribution. According to
this theory (see also CLARK), the rate of profit
was determined by the marginal productivity of
capital. The question Robinson (1953–4) raised
was how to measure capital in order to find its
marginal product. This relatively simple and
innocuous question sparked a heated debate
between Cambridge, England and Cambridge,
Massachusetts over the possibility of measuring
capital when you don’t know the rate of profit
(see Harcourt 1972).
Robinson pointed out that the marginal
productivity theory of distribution requires that
we know the demand for capital in order to
measure marginal productivity. Constructing
such a demand curve requires relating the profit
rate and the quantity of capital. The problem is
that capital is not something homogeneous (like
workers) that can easily be counted and added
up. Capital consists of large plants and small
plants, automated assembly lines, hammers and
screwdrivers, computers and computer software.
These goods have nothing in common that we
can use to find “a quantity” of capital; so some
other approach must be used.
The traditional means of counting capital
is to measure its value, or future profitability.
This works fine as a practical or accounting
matter, but is unsatisfactory as part of a theory
that explains what determines the rate of profit.
As Robinson pointed out, if economic theory
is supposed to explain the profit rate, it cannot
assume it knows the profitability of capital in
order to measure the quantity of capital. This
procedure is circular; therefore, the marginal
productivity theory of distribution must be
abandoned.
Robinson’s critique of microeconomic
theory also supported the macroeconomic
approach of Keynes. If we reject marginal
productivity as a theory of distribution, labor
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JOAN ROBINSON
supply and labor demand do not determine
wages and employment. We no longer have a
good reason to believe that unemployment will
disappear by waiting for wages to fall.
Similarly, if the notion of equilibrium is useless
for studying real economies there is no reason
to assume that the labor market will clear at
full employment equilibrium.
Robinson was also instrumental in
extending the economics of Keynes into the
international realm. Traditionally, economists
held that changes in exchange rates or money
flows (see also HUME) would correct any trade
imbalances. Countries with trade surpluses
would experience either an influx of money or
an appreciating currency. This would make
their goods more expensive to citizens of other
countries and reduce their exports. Countries
running trade deficits would experience the
reverse set of changes —their goods would be
less expensive abroad and they would export
more goods. Price changes thus bring trade into
balance according to standard economic theory.
Contrary to this conventional view,
Robinson (1980, Vol. 1, pp. 182–205; Vol. 4,
pp. 212–40) argued that there is a Keynesian
adjustment mechanism. Trade problems get
resolved through income changes rather than
through relative price changes. Countries
running a trade deficit fail to sell enough goods
throughout the world. Consequently,
production declines and unemployment rises.
As a result, people in this country buy fewer
goods and services from abroad and their trade
deficit moves to a position of balance. But this
affects surplus countries, which now
experience reduced demand for the goods they
produce. Their trade surplus gets reduced, but
their unemployment rate also goes up.
Robinson next extended Keynes by
examining international trade in dynamic
terms, or how trade balances change over time.
Rather than perceiving international trade as
an issue of the best way for countries to divide
up the task of producing different goods (see
also RICARDO), Robinson (1980, Vol. 4, pp.
14–24; Vol. 5, pp. 130–45) saw foreign trade
as part of a national growth strategy. Trade
surpluses, especially when achieved by
specializing in manufacturing industries, would
raise the domestic rate of profit and lead to
greater investment and technological
improvements. This, in turn, would create more
domestic employment and greater income.
Trade surpluses could thus lead to long-term
improvements in productivity and living
standards. By attempting to generate trade
surpluses, trade policy became part of the
arsenal of tools that governments might use to
spark economic growth (see also KALDOR).
The economics of Joan Robinson was
always focused on the real world. But it was
also critical of accepted economic theories
that were not realistic or plausible. Her
analysis of imperfect competition looked at
how large firms actually make decisions
about price, production, and employment.
Her contributions to post-Keynesian
macroeconomics and the theory of
international trade were also important in
helping economists understand how real
economies worked.
Economics has always been a male-
dominated profession. Somewhat
surprisingly, it seems that the mathematical
nature of the discipline is not responsible for
this. Economics has smaller fractions of
female undergraduate majors and smaller
fractions of female Ph.D.s than in either
mathematics or the natural sciences (Kahn
1995). Within this male bastion, Joan
Robinson stands out as the most
distinguished female economist.
Works by Robinson
Economics of Imperfect Competition, London,
Macmillan, 1933
Introduction to the Theory of Employment,
London, Macmillan, 1937a
Essays in the Theory of Employment, London,
Macmillan, 1937b
An Essay on Marxian Economics, London,
Macmillan, 1942
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“The Production Function and the Theory of
Capital,” Review of Economic Studies, 21, 2
(1953–4). Reprinted in Robinson (1980), Vol.
2, pp. 114–31
The Accumulation of Capital, London,
Macmillan, 1956
Economic Heresies: Some Old-Fashioned
Questions in Economic Theory, New York,
Basic Books, 1971
An Introduction to Modern Economics, New
York, McGraw Hill, 1973, with John Eatwell
Collected Economic Papers, 5 vols., Cambridge,
Massachusetts, MIT Press, 1980
Works about Robinson
Gram, Harvey, and Walsh, Vivian, “Joan
Robinson’s Economics in Retrospect,” Journal
of Economic Literature, 21, 2 (June 1983), pp.
518–50
Rima, Ingrid (ed.) The Joan Robinson Legacy,
Armonk, New York, M.E.Sharpe, 1991
Shaw, G.K., “Joan Robinson 1903–83,” Pioneers
of Modern Economics in Britain,Vol. 2, ed.
David Greenaway and John R.Presley, New
York, St Martin’s Press, 1989, pp. 144–69
Skouras, Thanos, “The Economics of Joan
Robinson,” in Twelve Contemporary
Economists, ed. J.R.Shackleton and
G.Locksley, New York, Wiley, 1981, pp. 199–
218
Turner, Marjorie, Joan Robinson and the
Americans, Armonk, NY, M.E.Sharpe, 1989
Other references
Eichner, Alfred S., The Megacorp and Oligopoly:
Micro Foundations of Macro Dynamics, New
York, Cambridge University Press, 1976
Harcourt, Geoff, Some Cambridge Controversies
in the Theory of Capital, Cambridge,
Cambridge University Press, 1972
Kahn, Shulamit, “Women in the Economics
Profession,” Journal of Economic
Perspectives, 9, 4 (Fall 1995), pp. 193–205
JAN TINBERGEN (1903–94)
Jan Tinbergen was a pioneer in econometrics
and economic modeling. He constructed the
first statistical economic models, and then used
these models to study business cycles and the
effect of economic policy on national
economies. But Tinbergen was not just a
number-cruncher. Rather, as Baum (1989, p.
305) points out, all his statistical work was
driven by a “deep-seated concern for human
welfare and a conviction that scientific,
mathematical analysis can be combined with
a broader humanistic approach.”
Tinbergen was born in 1903 in The Hague,
which borders on the North Sea in the
Netherlands. His father was a language teacher
who stressed the need to express complicated
ideas in simple language. Despite the influence
of his father, Tinbergen gravitated towards
science and mathematics in high school rather
than to language courses.
After graduating from high school,
Tinbergen enrolled at the University of Leiden
to study physics. During this time (the mid-
1920s), Einstein gave annual lectures at Leiden
and stayed with Paul Ehrenfest, the professor
under whom Tinbergen was studying.
Tinbergen even got to meet Einstein on several
occasions. Nonetheless, Tinbergen lost interest
in physics and shifted his course of study—
first to mathematics and statistics, then to
economics. One reason for this change was that
the economic conditions in Leiden during the
1920s were among the worst in Holland.
Unemployment and poverty were high and
there was virtually no public assistance.
Tinbergen felt a responsibility to help improve
the lives of the Dutch people and economics
was the logical means towards this end.
Tinbergen also developed personal concerns for
peace, justice and the welfare of humanity. He
became an active member of the Dutch Social
Democrat Labor Party and a conscientious
objector. Rather than serve in the army, he
agreed to perform alternative service to his
country in the Rotterdam prison administration.
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After completing a dissertation on
minimization problems in economics and
physics in 1929, Tinbergen joined the Dutch
Central Bureau of Statistics. He spent most of
the next 16 years there studying business cycles,
except for a short stint working for the League
of Nations. From 1945 to 1955, Tinbergen
served as director of the Central Planning Bureau
of the Dutch government. During this time he
devoted his energies to economic planning. After
a one-year teaching position at Harvard, he
became a professor at the Netherlands School
of Economics (now Erasmus University). In
1969, Tinbergen shared the first Nobel Prize in
Economics with Ragnar Frisch. The prize was
awarded for their contributions to the
development of econometrics.
Tinbergen made several important
contributions to economics. Most of these
were statistical in nature. He is responsible
for developing the first economic model of
an entire economy, and he used this model
to study and explain the fluctuations of the
Dutch economy. He was also instrumental
in creating and developing econometrics.
Econometrics is a set of mathematical
techniques that economists use to estimate
the quantitative relationship between two or
more variables. For example, by studying
historical relationships between interest rates
and savings, economists can estimate how
much more people are likely to save when
interest rates rise. Putting interest rates on
Figure 11 Interest rates & savings
the x-axis and savings rates on the y-axis,
we can construct a two-dimensional graph
of the relationship between these variables
(see Figure 11).
Each point on the graph represents the
savings rate (the amount of savings relative to
household disposable income) and the interest
rate in one particular year. Regression analysis
is a statistical technique that enables
economists to find the best line depicting the
relationship between interest rates and savings
rates, where “best” means the line that
minimizes the difference between individual
data points and the line, so that the set of points
lie as close to the line as possible.
Mathematically, regression analysis enables
economists to find this line in the form of an
equation such as y=a+bx, where a is the y-
intercept and b is slope of the line, or the
regression coefficient. The regression
coefficient b measures how much y changes for
each unit change in x, or how much more
households save when interest rates rise by one
percentage point.
Macroeconomic models are just large sets
of regression equations. Each equation relates
one part of the economy to other parts of the
economy.
In 1936 Tinbergen developed a
macroeconometric model of the Dutch
economy containing twenty-four equations
(see Tinbergen 1959, pp. 37–84). These
equations described the key macroeconomic
relationships of the Dutch economy—what
determined consumer spending, business
investment, exports, and so on. In many
cases, lags were introduced so that
consumption (and other macroeconomic
variables) did not change immediately
whenever income rose; rather consumption
(and other variables) changed slowly as
income changed, and would adjust to higher
income levels only after several years.
Mathematically, this was shown by having
consumption depend on a weighted average
of present and past income (rather than on
just present income).
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Shortly after building his macroeconomic
model of the Dutch economy, Tinbergen (1939)
developed a model of the US economy for the
1919–32 period that contained forty-eight
equations. During World War II he built a similar
model for the UK economy (Tinbergen 1951).
This statistical work led to a heated debate
between Tinbergen and Keynes about the
nature and usefulness of econometrics.
Critically reviewing a book by Tinbergen
(1939), Keynes (1939) claimed that
econometrics merely gave quantitative
precision to what is already known to be true
qualitatively about economic relationships.
Tinbergen (1940) replied that regression
coefficients can help test theories and that they
might also suggest new economic theories. To
prove his point, Tinbergen began using his
macroeconomic models to study economic
fluctuations and develop theories about the
business cycle.
In the 1930s, macroeconomists studied the
different phases of the business cycle and
provided different explanations for each of the
different phases. Moreover, they mainly paid
attention to how economies moved towards
equilibrium (static analysis), but they gave little
attention to how economies grow and oscillate
over time. Tinbergen provided a single, unified
explanation of the business cycle. He also showed
how and why economies change over time. His
inspiration for this came from the cobweb
theorem, which Tinbergen discovered in 1930.
Traditional economic theory assumes that
prices and markets move in a straightforward
manner towards an equilibrium or point of
rest (see also MARSHALL). Thus if price is
too high, there will be excess goods in the
market. This will push down prices and
reduce the supply of goods brought to the
market. Conversely, if price is too low, a
shortage will lead to higher prices and a
greater supply of goods brought to the
market. The problem, however, was that in
many agricultural markets it was not
uncommon to see prices and quantities move
in opposite directions—prices would fall and
more goods would be produced for sale.
Tinbergen provided an explanation for this
phenomenon. His explanation was that output
in agricultural markets responded to prices with
a lag. Farmers needed time to react to changes
in the market and some types of production,
for example raising pigs, required considerable
time. If too many pigs were brought to market,
this would reduce the price of pigs. But because
of the lower price, farmers would raise fewer
pigs for sale in the following year. At the same
time, the low price would lead to a large
demand for pigs as consumers became used to
consuming pork, bacon, and other pig products.
This combination of low supply and high
demand would create a shortage of pigs and
push up prices. In response, farmers produce
too many pigs the following year, leading to
another surplus.
The cobweb theorem provided the
foundation for Tinbergen’s (1937) analysis of
the business cycle. He developed twenty-two
statistical equations, each of which showed
how supply and demand respond over time to
shortages and to excess supply. Each equation
also modeled the change taking place in
different economic sectors. From these
equations Tinbergen was able to show how
economies oscillated over time, just like the
production of pigs.
After developing his macroeconometric
model of the workings of an economy,
Tinbergen diverted his attention to policy
issues. He showed how policy makers could
use macroeconomic models to measure the
effects of any proposed policy. Then he showed
how his statistical model could help politicians
make policy decisions when facing
contradictory or conflicting economic goals.
Prior to the work of Tinbergen, different
economic policies were studied in isolation
from each other and no method existed for
dealing with multiple policy targets. Tinbergen
(1952, Chs 4, 5) saw that multiple targets
required multiple policies. Thus if one wanted
to lower unemployment and strengthen the
national currency, two different policies were
needed to achieve these two aims. In general,
if policy makers had a certain number of
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quantitative targets, they must have at their
disposal at least an equal number of policy
instruments.
Tinbergen also explained how economic
analysis could be used to help national
governments develop plans to improve
economic outcomes. First, policy makers
needed to determine the collective preferences
of its citizens regarding economic targets. Then
they needed to manipulate policy instruments
in order to best satisfy the collective
preferences of its citizens. The preferences led
to policy targets that could either be fixed or
flexible. The means to this end could be either
far reaching reforms in the way economies
operate (for example the introduction of social
security legislation, guaranteed employment,
or incomes policies), qualitative changes
affecting the structure of the economy (such
as changes in the laws governing monopoly and
competition and new forms of taxation) or
quantitative changes, which involve
manipulating policy instruments such as the
money supply, exchange rate or amount of
government spending (Tinbergen 1952; van der
Linden 1988).
In the 1970s, Tinbergen shifted his attention
from economic planning to income
distribution. Several factors are probably
responsible for this change. First, interest in
economic planning was waning throughout the
world (see also LEONTIEF). Second, income
disparities were large and growing in most
countries as well as between countries. This
conflicted with Tinbergen’s desire to increase
social justice and economic welfare.
Like his other work, Tinbergen approached
income distribution from a dynamic perspective.
Rather than seeking the causes of the present
distribution of income, Tinbergen (1975) sought
to find the root causes of changes in the
distribution of income over time. He located
these in the factors affecting both the supply of
labor and the demand for labor. The two most
important factors affecting labor supply and
labor demand, according to Tinbergen, were
education and technological development. His
analysis also relied upon the dual labor market
hypothesis (see Piore and Doeringer 1971),
which sees two different labor markets operating
in developed countries rather than one large
labor market. According to the dual labor market
theory, one labor market exists for highly-skilled
workers while a separate market exists for those
lacking skills and adequate education. Workers
cannot easily cross over from one market to the
other, and employers demand workers from
either labor pool.
From this perspective, expanded education
tends to reduce income inequality because it
tends to equalize the abilities of individuals
in a country. In addition, education will
equalize the wages received by these two
groups of workers. A greater supply of
educated workers will reduce their (higher)
wages. At the same time, more education
reduces the supply of less-educated workers.
This means that the remaining low-skill
workers receive higher wages.
On the other hand, technological advances
tend to increase income inequality. Technology
requires skilled and educated manpower, thus
increasing the demand for skilled workers and
hence their earnings. Technology also displaces
those who do not meet the higher
qualifications. This reduces the demand for
unskilled workers and their earnings.
Tinbergen (1975, p. 2) saw changing
income inequality as the outcome of a race
between education and technological
development. If education improves more
rapidly than technology, income inequality
declines; if technology has the upper hand,
income inequality becomes greater.
Three policy implications follow from this
analysis. First, government support for
education needs to be increased so that
education expands faster than technological
development. Second, policies should direct
technological innovation so that it requires
more low-skill labor. Increasing the demand
for low-skill labor would push up the wages
of those at the bottom of the distribution and
would mitigate the tendency for technology to
increase income inequality. Finally, Tinbergen
suggested using tax policy as a means of
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reducing inequality. He thus advocated higher
taxes on wealth, capital gains, and inheritances.
Today, virtually every developed country
in the world has constructed a large
macroeconometric model of nearly 1,000
equations. These models are used to study
economic activity and to predict the future
course of the economy. They are also used
by governments and by central banks to help
formulate economic policies. The existence
of these macroeconometric models is due to
the pioneering work of Tinbergen. This work
makes Tinbergen one of the half dozen most
important economists of the twentieth
century.
Works by Tinbergen
“Annual Survey of Significant Developments in
General Economic Theory,” Econometrica,
2, 1 (January 1934), pp. 26–8
An Econometric Approach to Business Cycle
Problems, Paris, Hermann, 1937
Statistical Testing of Business Cycle Theories,
2 vols., Geneva, League of Nations, 1939
“On a Method of Statistical Business Cycle
Research: A Reply,” Economic Journal, 50
(1940), pp. 141–54
Business Cycles in the United Kingdom, 1870–
1914, Amsterdam, North-Holland, 1951
On The Theory of Economic Policy,
Amsterdam, North-Holland, 1952
Centralization and Decentralization in
Economic Policy, Amsterdam, North-
Holland, 1954
Economic Policy: Principles and Design,
Amsterdam, North-Holland, 1956
Selected Papers, Amsterdam, North-Holland,
1959
Shaping the World Economy: Suggestions for
an International Economic Policy, New
York, Twentieth Century Fund, 1962
Lessons from the Past, Amsterdam, North-
Holland, 1963
Income Distribution: Analysis and Policies,
Amsterdam, North-Holland, 1975
Works about Tinbergen
Baum, Sandra R., “Jan Tinbergen 1969” in Nobel
Laureates in Economic Science, ed. Bernard
S. Katz, New York and London, Garland
Publishing, 1989, pp. 304–17
Bos, Henk C., “Jan Tinbergen: A Profile,” Journal
of Policy Modeling, 6, 2 (1984), pp. 151–8
Hansen, Bent, “Jan Tinbergen: An Appraisal of
His Contributions to Economics,” Swedish
Journal of Economics, 71, 4 (1969), pp. 25–
36
Keynes, John Maynard, “Professor Tinbergen’s
Method,” Economic Journal, 39 (September
1939). Reprinted in The Collected Writings of
John Maynard Keynes, XIV, London,
Macmillan, 1973, pp. 306–20
Kol, J. and Wolff, P. de, “Tinbergen’s Work:
Change and Continuity,” De Economist, 141,
1 (1993), pp. 1–28
Van Der Linden, J.T.J.M. “Economic Thought in
the Netherlands: The Contribution of Professor
Jan Tinbergen,” Review of Social Economy, 46,
3 (December 1988), pp. 270–82
Other references
Piore, Michael and Doeringer, Peter Internal
Labor Markets and Manpower Analysis,
Lexington, Massachusetts, D.C.Heath, 1971
JOHN HICKS (1904–89)
John Hicks is best known for developing
several pictorial diagrams used to demonstrate
economic principles and techniques of
analysis. These now form the basis of
contemporary economics, especially as it is
taught to undergraduate students.
Hicks was born in Warwick, England in
1904 into a middle-class family. His father was
a journalist and an editor. Hicks received a good
high school education at private British
schools, and then earned a scholarship to
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JOHN HICKS
Balliol College, Oxford. Hicks began studying
mathematics at Oxford, but soon changed fields
and concentrated on economics. He received
his degree in philosophy, politics, and
economics in 1926.
After graduating, Hicks taught at the London
School of Economics, at Cambridge University,
and briefly in South Africa. He was not
enamored with Cambridge, disliking both the
physical climate and the intellectual climate (a
great tendency to quarrel), but he found the
London School a congenial place to work. Hugh
Dalton of the London School got Hicks to read
Pareto’s Manual, an event of great importance
in his life. When he got to the mathematical
appendices, Hicks realized Pareto did not finish
what he set out to do—make economic analysis
clearer and more precise by translating it into
mathematics. At that moment Hicks decided to
devote his career to completing what Pareto
started (Klamer 1989, p. 169).
In 1938 Hicks was appointed to the Stanley
Jevons Professorship at Manchester University.
Eight years later he returned to Oxford, where
he taught until his retirement in 1965. Hicks
was knighted in 1964, thus becoming Sir John
Hicks. In 1972 he shared the Nobel Prize in
Economics with Kenneth Arrow.
Hicks has made important contributions to
both macroeconomics and microeconomics—
a rare feat in the twentieth century, when
macroeconomics and microeconomics have
Figure 12 IS-LM diagram
remained separate and distinct fields and when
specialization prevails in all academic
disciplines. As a macroeconomist, Hicks is best
known for formalizing the macroeconomic
theories of Keynes. In one of the most cited
economic papers of all time, Hicks (1937)
condensed Keynes’ General Theory into a set
of two curves (see Figure 12).
Standard Keynesian theory never made the
relationship between the goods market and the
money market clear. In the goods market,
businesses produce things and sell these things
to consumers, government, other businesses
and other countries. Equilibrium in the goods
markets requires that the supply of goods
brought to market equals the demand for these
goods. In the money market, people and
businesses demand a fixed stock of money that
is set by the nation’s central bank. Equilibrium
in the money market requires that the demand
for money equals the supply of money.
These two markets, however, are
interrelated rather than independent of each
other. If the supply of money were increased,
this would lower interest rates in the money
market. But with lower interest rates,
investment would rise and the total demand for
goods and services would increase in the goods
market. Of course, with more goods and
services being produced, people would need
more money so that they can buy more things.
But a greater demand for money would push
up interest rates, reduce investment and output,
and thereby lower the demand for money.
Interactions between the goods market and
the money market could conceivably go back
and forth forever, yielding no final and stable
outcome. The IS-LM model demonstrated that
the goods market and the money market would
achieve equilibrium simultaneously. This
diagram now serves as the basis for most
undergraduate education in macroeconomics,
and has made IS-LM and Keynesianism
synonymous in the minds of most economics
students.
The IS curve in Figure 12 represents
equilibrium positions in the goods market of
the economy. IS stands for the fact that in the
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JOHN HICKS
goods market investment (I) equals savings (S).
The downward sloping IS curve shows that as
interest rates fall, economic output must
expand to keep the goods market in
equilibrium. This is because lower interest rates
will increase business investment, but it will
also reduce savings. To get savings up, and
ensure that savings and investment are equal,
the economy must produce more goods, more
jobs, and greater incomes.
The LM curve shows possible
equilibrium positions in the money market.
LM stands for the fact that money demand
(L) must equal money supply (M) in the
money market. Figure 12 shows that as
interest rates rise it is necessary for the
economy to expand if the money market is
to remain in equilibrium. This is because
higher interest rates reduce the demand for
money, since by holding money people lose
the interest they could be earning by holding
some interest-bearing asset. However, if the
economy grows, people will want to hold
more money because they will be buying
more goods. With more goods produced,
money demand will increase and will come
to equal the money supply.
Simultaneous equilibrium is achieved at
the point of intersection between the IS and
LM curves. Since the goods market moves
towards points on the IS curve and the money
market moves to points on the LM curve, the
whole economy must move towards the single
point at which the two curves meet.
Hicks then went on to show how the
differences between Keynesian economists
and classical economists arose from
different assumptions about the two curves.
If the LM curve was flat rather than steeply
sloped, fiscal policy (or a shift in the IS
curve) would be needed to expand
employment and we are in the world
described by Keynesian economists. On the
other hand, if the IS curve were flat,
monetary policy (or a shift in the LM curve)
would be needed to expand output and
employment, and we are in the world
described by the classical economists.
A second macroeconomic contribution due
to Hicks involves the term structure of interest
rates. Economists frequently talk about “the
rate of interest” as if there were only one rate
of interest existing in the economy. But as
everyone knows, there are many different rates
of interest at any given time. Rates on credit
cards are higher than rates for home
mortgages, and rates are higher for fixed rate
mortgages than for variable rate mortgages.
Interest rate theory attempts to explain the
relationship among all these different rates.
Economists have devised two ways to
make sense of the vast array of interest rates.
One focuses on the risk of lending money and
the other on the length of time for which
money is lent. The greater the risk to the
lender, the higher the rate of interest needs to
be. More interest is required to compensate
Figure 13 The yield curve
the lender for the greater probability that the
loan will not be repaid.
The yield curve is a graphic device for looking
at the rate of interest on loans made for different
lengths of time. These loans take the form of
people and businesses purchasing government (or
corporate) bonds. A yield curve might show that
a three-month loan to the US government pays
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JOHN HICKS
4.4 percent, a two-year loan pays 5.5 percent, a
10-year loan pays 7 percent, and a 30-year loan
pays 8 percent (see Figure 13).
One question that arises concerning the
yield curve is whether there is any linkage
among interest rates for assets with different
maturities—say 6-month and 1-year
government bonds. Hicks (1939, Chs 11–13)
answered this question with a resounding
“yes,” and developed the expectations
hypothesis to explain the relationship among
assets with different maturity lengths.
Hicks reasoned that if a 6-month bond
paid 5 percent now and a-year bond paid
5.5 percent now, then investors must expect
that six months from right now the rate on
a 6-month bond will be 6 percent. Investors
earn 5.5 percent either way. They can earn
5.5 percent over the whole year by
purchasing a 1-year bond now; alternatively,
they can earn 5 percent for the first six
months of the year, and 6 percent for the
second six months of the year. This averages
out to the same 5.5 percent that could be
earned from a 1-year bond. In general, the
expectations hypothesis holds that returns
on assets of longer maturities will equal the
average of the current return on shorter-term
assets and the expected return on shorter-
term assets in the future.
Hicks then went on to explain why the
expectations hypothesis had to be true. This
explanation essentially relies on the process
of arbitrage (see also COURNOT). If a 1-
year bond paid 5.5 percent when a 6-month
bond paid 5 percent and was expected to
pay 5.5 percent at 6 months in the future,
no one would want to own 6-month bonds
and no one would buy them. Over a 1-year
time period, two 6-month bonds are
expected to earn only 5.25 percent. People
would prefer to have 1-year bonds paying
5.5 percent; so they will sell their 6-month
bonds and buy 1-year bonds. This drives
down the price of the 6-month bond and
drives up the price of the 1-year bond. Since
bond prices are inversely related to interest
rates, the interest rate on the 6-month bond
will rise and the interest rate on the 1-year
bond will fall. This process will continue
until the equilibrium condition identified by
the expectations hypothesis is finally
achieved—the rate on a 1-year bond will be
equal to the average of the rate on a 6-month
bond and the rate expected on a 6-month
bond a half year from now.
While Hicks made many contributions as
a macroeconomist, it is as a microeconomist
that Hicks first achieved fame. Although
Edgeworth drew the first indifference curve
diagrams, it was Hicks (1934) who
incorporated indifference curve analysis into
standard microeconomic theory. He showed
how indifference curves could be used to
construct a downward sloping demand curve
for any good. He then used indifference curves
to separate the income effect of a price change
from the substitution effect of a price change.
Figure 14 Indifference curve and budget
constraint
The key to this analysis is the introduction
of a budget line. This line represents how
much of each good a consumer could purchase
given their current income and the current
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JOHN HICKS
prices of goods. For example, with $10 and
with pretzels and beer each costing $1, a
consumer can buy any combination of pretzels
and beer that adds up to 10. This is shown by
the negatively sloped line in Figure 14. At one
extreme, the consumer can buy 10 bags of
pretzels and no beer. At the other extreme the
consumer can buy 10 beers and no pretzels.
Figure 15 Income and substitution effects
In between these extremes many
combinations are possible. All of these
possibilities are show by the budget line.
Hicks next added indifference curves (see
also EDGEWORTH) to this diagram in order
to explain consumer behavior. Consumers
would choose the combination of pretzels and
beer that yielded the highest utility, or which
was the highest on the diagram (point A).
Hicks then looked at the effects of a change
in price. Suppose that the price of a beer were
to increase to $2. With the price of beer
relatively higher, people will want to purchase
more pretzels and less beer. This is the
substitution effect, whereby an increase in the
price of a good reduces demand for that good
and increases demand for most other goods (all
goods that are not complementary goods). Yet,
there is also an income effect. When beer costs
more, consumer income can buy less of
everything. Spending on both beer and pretzels
will fall due to the income effect. Together, the
two effects together change spending from 5
beers and 5 pretzels to 1.5 beers and 7 pretzels.
These effects are shown by the rotation of the
budget line. Due to this rotation, point C is now
where our consumer gets the greatest utility.
Hicks then figured out an ingeneous way
to separate the income and substitution effects.
The slope of the budget line represents the
relative prices of the two goods. If there were
a substitution effect, but no income effect, we
should be on our original indifference curve,
but choosing different combinations of pretzels
and beer based on the new $2 price of beer or
the new budget line. Hicks suggested that we
show the income effect by taking the old budget
line and moving it up the graph until it is just
tanget to the original indifference curve. This
is shown as the dashed line on Figure 15. At
point B the relative prices of beer and pretzels
are the same. It thus shows the change in
consumer spending habits must therefore be
due to the income effect alone.
Because the income effect and the
substitution effect each reduce the consumption
of beer, it follows that when the price of beer
rises, people buy less beer. The demand curve
for beer must therefore slope downward—as
the price of beer rises, the quantity consumed
falls and conversely as the price of beer falls,
the quantity consumed will increase.
Finally, Hicks (1932) is responsible for
introducing the notion of the elasticity of
substitution, a natural extension of Marshall’s
notion of elasticity. Marshall applied the notion
of elasticity to consumer demand and producer
supply, and studied how much more consumers
would buy and how much more producers
would sell given some change in price. Hicks
took this elasticity notion and applied it to the
decisions businesses had to make about
production.
From a firm’s point of view, goods can be
produced in several different ways, each using
different combinations of labor and capital. A
more labor-intensive production process would
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OSKAR LANGE
employ less capital and more labor, and a more
capital-intensive production process would use
less labor and more capital. In general, firms
face a trade-off in production—each additional
worker employed requires less machinery, and
each additional machine used in production
requires fewer workers. The elasticity of
substitution measures how much machinery
could be dispensed with if one more worker
were used in producing goods, or alternatively
how many workers could be dispensed with
by purchasing and using one more machine.
Hicks pointed out that workers should not
necessarily oppose labor-saving technical
change since it could lead to higher wages. This
would arise if the elasticity of substitution
between labor and capital is large, and it is easy
to substitute capital for labor. With more
capital, workers will be more productive and
thus will be paid more.
Hicks has justly been called (Hamouda
1993) “the economist’s economist.” Writing
exclusively for his professional colleagues, he
developed numerous tools and diagrams that
have enabled economists to depict the
principles of economic analysis more clearly
and concisely. Hicks showed how to combine
an analysis of the money market with an
analysis of the goods market, how to
understand the relationships between interest
rates of different maturities, and how to
combine utility theory and the theory of
demand. For his many advances and for the
many areas in which he made important
contributions, Hicks must be regarded as one
of the half dozen most important twentieth-
century economists.
“Mr. Keynes and the ‘Classics’: A Suggested
Interpretation,” Econometrica, 5 (April 1937),
pp. 147–59. Reprinted in Hicks (1967)
Value and Capital: An Inquiry into Some
Fundamental Principles of Economic Theory,
Oxford, Clarendon Press, 1939
Capital and Growth, Oxford, Clarendon Press,
1965
Critical Essays in Monetary Theory, Oxford,
Oxford University Press, 1967
Collected Essays on Economic Theory, 3 vols.,
Oxford, Basil Blackwell, 1981–3
Works about Hicks
Baumol, William, “John R.Hicks’ Contribution
to Economics,” Swedish Journal of
Economics, 74 (1972), pp. 503–72
Hagemann, Harold and Hamouda, Omar F., The
Legacy of Hicks: His Contributions to
Economic Analysis, London and New York,
Routledge, 1994
Hamouda, Omar F., John R.Hicks: The
Economist’s Economist, Oxford, Blackwell,
1993
Klamer, Arjo, “An Accountant Among
Economists: Conversations with Sir John
R.Hicks,” Journal of Economic Perspectives,
3, 4 (Fall 1989), pp. 167–80
Morgan, Brian, “Sir John Hick Contribution to
Economic Theory,” in J.R.Shackleton and G.
Locksley (eds.) Twelve Contemporary
Economists, London, Macmillan, 1981, pp.
OSKAR LANGE (1904–65)
Works by Hicks
The Theory of Wages, London, Macmillan, 1932
“A Reconsideration of the Theory of Value,”
Economica, 1 (February and May 1934), pp.
52–76, 196–219, with R.D.G.Allen
“A Suggestion for Simplifying the Theory of
Money,” Economica, 2 (February 1935), pp.
1–19. Reprinted in Hicks (1967)
Oskar Lange (pronounced LANG-ga) is best
known for his work on economic planning and
the economics of socialism. This work
explained how socialist economies could
allocate resources efficiently despite the fact
that prices were set by bureaucrats rather than
by the market. It also explained how less
developed countries could use the tools of
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economic planning to grow more quickly and
efficiently. Less well-known is the work that
Lange did on capitalist economies. This work
explained why market economies went through
regular business cycles, and why the standard
policies to deal with high unemployment were
inadequate.
Lange was born in the town of Tomaszów
Mazowiecki, in western Poland, in 1904. His
father was a German textile manufacturer who
produced goods for sale in eastern Europe.
Proceeds from the business allowed the Langes
to live a middle-class lifestyle until shortly
before World War I; at that time the business
went bankrupt and the family economic
circumstances became difficult.
Lange developed interests in biology,
mathematics and the social sciences while he
was growing up. When the time came to choose
a path of study, he had difficulty deciding
between the biological sciences and the social
sciences. After much anguish Lange opted for
the latter, and enrolled at the University of
Krakow to study mathematics, statistics, law,
and economics. He received his doctorate in
1928 for a study of business cycles in Poland,
and then obtained a position as lecturer in
statistics at the University.
During the 1930s and early 1940s Lange
visited England and then the US as a
Rockefeller Foundation Fellow. During this
time he studied with Joseph Schumpeter at
Harvard; then he held teaching positions at the
University of Michigan, Stanford University,
and the University of Chicago. In the later war
years Lange worked to set up a new Polish
government. After World War II he served the
Polish government as ambassador to the United
States, Polish delegate to the UN Security
Council, member of Parliament, and member
of the Central Committee of the Polish
Worker’s Party. In 1948 Lange returned to
academic life, teaching at the Central School
of Planning and Statistics in Warsaw and then
at the University of Warsaw.
The economic work of Lange was
concerned primarily with the theoretical and
practical problems of a planned or socialist
economy. He studied questions such as whether
centrally planned economies could be run as
efficiently as market economies, how to
provide adequate incentives to managers under
socialism, and how to find the proper balance
between centralization and decentralization. In
all his work, Lange tried to bring mathematics
and statistical analysis to bear on the planning
problem.
One of the major problems facing any
socialist economy is how to allocate resources
efficiently. In a capitalist economy this function
gets performed by markets. Those goods in
greater demand by consumers fetch higher
prices, thus signaling to producers of these
goods that they need to expand production. In
contrast, goods that consumers do not want pile
up on store shelves and in warehouses.
Businesses stop producing these items and
instead make those goods in greater demand.
Lange was instrumental in showing that just
because there was no market it did not mean
that socialism led to an inefficient allocation
of goods—producing too many things
consumers did not want and not enough of what
consumers greatly desired.
In 1908 the Italian economist Enrico Barone
attempted to show that markets were not
necessary for economic efficiency (translated
as Barone 1935). He started with a set of
mathematical equations, each representing the
supply or the demand for some particular good.
Barone used this set of equations to show that
socialist economies could set prices correctly
and efficiently allocate goods. All economic
planners had to do was solve these equations
and find the market clearing price for each
good, or the price where supply and demand
would exactly equal each other. By setting the
price of each good equal to its market clearing
price, planners would make sure that the
economy produced the goods consumers
wanted.
In the 1930s, Friedrich Hayek and Lionel
Robbins, two economists teaching at the
London School of Economics, raised a rather
obvious objection against this scheme. They
argued that the procedure envisioned by Barone
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was possible in theory, but impossible in
practice; before making any decision, a
socialist government or ministry of economic
planning would have to gather an immense
amount of information, and derive hundreds
of thousands (Hayek 1935), or maybe even
millions (Robbins 1934) of equations. They
would then have to solve all these equations in
order to find the set of market clearing prices.
Moreover, as Robbins (1934, p. 151) pointed
out, by the time this set of equations was solved
mathematically the economy would have
changed, and the information upon which the
solution was based would be obsolete. Planners
would thus have to re-estimate all the equations
and solve this new set of equations. Of course,
by the time this was done, the economy would
have changed again, and the prices set by an
economic planning board would again be out
of date.
In 1938 Lange (1964) responded to these
objections and demonstrated that an efficient
socialism was possible. He showed that it was
not necessary for economic planners to know
thousands upon thousands of mathematical
equations; nor was it necessary for them to
solve all these equations in order to get prices
right. All that was needed, Lange contended,
was for planners to follow a simple trial and
error method. Whenever shortages existed in
an economy, economic planners should raise
prices; and when surpluses existed, planners
should lower prices. By imposing these rules,
socialist planners would function just like the
market in a capitalist economy, and the socialist
economy would be able to efficiently allocate
resources. Making their job even easier,
planners would not have to start their trial-and-
error process from scratch. Rather, they would
begin with the set of efficient prices determined
by the market.
Lange (1964) also argued that this
procedure would result in an economic system
far superior to capitalism. The economy would
reach equilibrium prices more quickly, since
economic planning boards would have greater
knowledge of the whole economy than any
individual entrepreneur under a capitalist
system. Many years later Lange realized that
with the aid of a computer it would be possible
to solve thousands of equations and find
market-clearing prices for all goods in just a
few seconds (Feiwel 1972, p. 614)—much less
time than the market itself would need. By
moving to equilibrium prices more quickly,
business cycles would be shorter and milder;
therefore socialist economies would experience
less unemployment than capitalist economies.
According to Lange, a socialist economy
had other advantages. It was superior to a
capitalist economy because it had a more equal
distribution of income. In addition, socialist
economies were plagued less by the problems
of monopoly power. Under socialism firms
could not make excessive profits by restricting
output, and thus they could not wield great
political power.
Although Lange devoted much effort to
showing how socialism could be as efficient
as capitalism, socialism was not a utopian end
state for Lange. He (1964, p. 109) saw that “the
real danger of socialism is that of a
bureaucratization of economic life.” And he
worried that economic planners might act in
their own interests rather than in the interests
of the nation. But Lange also noted that the
same problems existed under monopoly
capitalism—corporate managers became
bureaucrats and did not respond to the needs
of consumers. Lange thought that decentralized
decision-making and better-educated planners
would help to mitigate these problems.
Lange’s analyses of the economic problems
that exist under capitalism constitute his second
contribution to economics. According to
Lange, in capitalist economies the market did
not play the role that economic theory gave it
because monopolies had destroyed the market
and free competition. These monopolies were
able to control prices, keep out competitors,
and influence both consumers and politicians.
Lange thus saw socialism as a way to restore
the efficiency of market pricing and
competition, as well as a means to make
economic decision-making more democratic.
Economic management would be undertaken
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by public functionaries, who were subject to
democratic control, rather than by the heads
of large and powerful enterprises that were
subject to no controls at all.
A second problem with capitalism
according to Lange (1944a) is that capitalist
economics tend to remain stuck at high levels
of unemployment. This work parallels that of
John Maynard Keynes. Lange noted that two
outcomes were possible during a recession,
only one which would lead to a growth in
employment. First, the recession could cause
prices to drop but have little effect on the
amount of money in circulation. With lower
prices, the existing money supply would allow
consumers to buy more goods and services and
businesses to purchase more plants and
equipment. Flexible prices would thus help the
economy move to full employment. This is the
traditional analysis of how economies
responded in times of high unemployment.
But Lange argued it was also possible for
the money supply to fall by more than the
decline in prices. To understand why this might
occur requires knowing that in mature
economies money gets created when banks
make loans. In a recession, banks will fear that
they may not get repaid when they lend out
money. If they call in loans and refuse to lend,
this will reduce the money supply and push up
interest rates. In this case we get even less
investment and greater unemployment.
Either of these two scenarios is possible in
practice. A monetary economy thus possesses
no automatic mechanisms, like flexible prices,
to guarantee that it will head towards full
employment equilibrium. Moreover, Lange
argued that rising monopolistic elements under
capitalism make flexible prices less likely and
the second scenario more likely.
Going even further, Lange doubted that
macroeconomic policies of the sort advocated
by Keynes could solve the unemployment
problem. Here too monopolies got in the way.
Monopolies were more likely to respond to
greater demand by raising prices than by
expanding output and hiring more workers.
This, obviously, limits the ability of greater
demand for goods to create more jobs. The only
solution to unemployment becomes curbing the
power of monopolies by having the state take
them over. In the interests of economic
performance, the state must assert democratic
control over the economy. Monopoly
capitalism thus becomes a roadway to
democratic socialism for Lange.
Lange saw socialism not as the negation of
capitalism but as its extension. He believed that
the growth of monopolies and oligopolies had
already destroyed the market and free
competition. Market socialism was a way to
restore competition and maintain democracy.
Lange was critical not only of capitalism;
he was also highly critical of the Soviet
economy. Refusing to describe it as a socialist
economy, Lange (1944b) thought the Soviet
Union was “an authoritarian economy guided
by political objectives.” Its political objectives
were to be one of the world’s leading
industrial countries and to provide adequately
for the national defense. The Soviet Union
therefore did not develop a democratic market
socialism. Rather the government diverted
resources to defense spending and investment
in large-scale manufacturing. It did this by
reducing the quantity of goods available to
other sectors. Consumers were starved for
goods and had to spend hours waiting in line
to buy them. Agriculture was hindered in order
to develop a manufacturing sector. And
materials were always in short supply.
Likewise, the emphasis on quantity (rather
than market-clearing prices) by Soviet
economic planners hurt quality. In order to
meet the quantity goals imposed by planners,
firms would make the cheapest goods
possible. Because goods were always in short
supply, no matter how shoddy the goods were,
they would be bought by someone.
The work of Lange should be viewed as an
attempt to combine the best aspects of
socialism (democracy in economic decision-
making) with the best aspects of capitalism
(efficiency). He advocated government
ownership of large, monopolistic firms and also
advocated using the price mechanism to insure
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that the economic system produce goods that
satisfy consumer needs. He sought to combine
central planning with decentralized
management, and he sought to make planners
more efficient through better education and by
providing them with the modern tools of
analysis and forecasting. If the countries of
Central and Eastern Europe begin to look for
some middle ground between survival-of-the-
fittest capitalism and total government control
over all economic activity, it is certain that the
economic thought of Lange will take on
increasing importance.
Contributions,” Kyklos 25, 3 (1972), pp. 601–
18
Fisher, Walter D., “Oskar Ryszard Lange, 1904–
1965,” Econometrica 34, 4 (October 1966),
pp. 733–8
Rider, Christine, “Oskar Lange’s Dissent from
Market Capitalism and State Socialism,” in
Economics and its Discontents, ed. Richard
P.F. Holt and Steven Pressman, Cheltenham,
UK & Northampton, Massachusetts, Edward
Elgar, 1998, pp. 165–82
Kowalik, Tadeusz, “Oskar Lange’s Market
Socialism,” Dissent, 38, 1 (Winter 1991), pp.
86–95
Works by Lange
“Say’s Law: A Restatement and Criticism,” in
Studies in Mathematical Economics and
Econometrics-in Memory of Henry Schultz,
Chicago, University of Chicago Press, 1942,
pp. 49–68
“The Theory of the Multiplier,” Econometrica, 11
(July-October 1943), pp. 227–45
Price Flexibility and Employment, Bloomington,
Indiana, Principia Press, 1944a
Working Principles of the Soviet Economy, New
York, Research Bureau for Postwar
Economics, 1944b
“Economic Controls After the War,” Political
Science Quarterly, 60 (1945), pp. 1–13
Some Problems Relating to the Polish Road to
Socialism, Warsaw, Polonia Publishing House,
1957
Economic Development, Planning and
International Cooperation, New York,
Monthly Review Press, 1963
On The Economic Theory of Socialism, New York,
McGraw Hill, 1964, with Fred M.Taylor
Economic Theory and Market Socialism: Selected
Essays of Oskar Lange, ed. Tadeusz Kowalik,
Hants, Edward Elgar, 1994
Works about Lange
Feiwel, George R., “On the Economic Theory of
Socialism: Some Reflection on Lange’s
Other references
Barone, Enrico, “The Ministry of Production in
the Collectivist State,” in Collectivist
Economic Planning, ed. F.A.Hayek, London:
Routledge, 1935, pp. 245–90
Robbins, Lionel, The Great Depression, London:
Macmillan, 1934
Hayek, Friedrich A., “The Nature and History of
the Problem,” in Collectivist Economic
Planning, ed. F.A.Hayek, London, Routledge,
1935, pp.
WASSILY LEONTIEF (1906–99)
Wassily Leontief (pronounced LAY-yon-TEE-
F) is best known for developing input-output
analysis. This technique, which describes the
interrelationships among the different sectors
or industries of an economy, has a number of
important applications and provides broad
insights into how economies work. Input-
output analysis has been used to understand
how production bottlenecks might arise when
economies expand, and how the inflationary
process gets distributed and diffused
throughout the economy (Leontief 1946). The
technique was also used by socialist economies
and by developing economies after World War
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WASSILY LEONTIEF
II for constructing five-year economic plans.
Leontief was born into an educated and
wealthy family in St Petersburg, Russia in
1906. His father taught labor economics at the
University of St Petersburg, and his mother was
an art historian. Somewhat of a child prodigy,
Leontief entered the university when only 15
years old. There he studied philosophy,
sociology, and then economics. Leontief
frequently got into trouble for criticizing the
new Communist government, and was jailed
several times while attending the university.
In 1925, at the age of 18, Leontief received
an MA in Social Science with the title
“Learned Economist.” The Leontief family
then left Russia because of their differences
with the Communist government and settled
in Germany. Leontief enrolled at the
University of Berlin to continue his studies
in economics, and in 1928 he received his
Ph.D. A chance encounter in a Berlin cafe with
Chinese visitors led to a job as consultant and
advisor to the Minister of Railways in China.
In this capacity Leontief spent a year traveling
through China collecting data to help plan the
Chinese railway network. This work provided
the insights about economic
interrelationships, and the opportunity to map
out these relationships using real world data.
In 1931, Leontief came to the United
States. He worked first as a research associate
at the National Bureau of Economic Research
in New York, then for many years at Harvard
University. It was at Harvard in the 1930s that
Leontief began developing his input-output
model for the US economy. In the decades
since, he further refined and expanded this
model, and found many ways to use the model
for studying real world economic problems.
Leontief left Harvard in 1975 to assume a
position at the Institute of Economic Research
at New York University.
Over the years, Leontief received many
accolades and awards. In 1970, he served as
President of the American Economic
Association. In 1973 he was awarded the
Nobel Prize in economics. In selecting
Leontief for this prize, the Nobel Committee
cited his work in input-output analysis. This
undoubtedly constitutes Leontief’s major
contribution to economics.
Although the vision of the economy as a
set of interrelated sectors, with one sector
buying goods from other sectors, and with
money flowing from sector to sector and back
again, was originally set forth by Cantillon
and Quesnay, it was Leontief who put these
relationships into mathematical terms and
gathered the data necessary to construct real
world input-output tables. It was also Leontief
who drew out the policy implications of the
mathematical representation of the economy
that he developed. This tool allows an analyst
to work out how the changes in any one sector
or industry of the economy will affect every
other sector or industry. Moreover, input-
output analysis allows for comprehensive
government planning, something Leontief
regarded as the next stage of capitalist
development.
The major insight behind input-output
analysis is that if an economy is to produce
more of one good, say automobiles, it will
need to be sure to have all of the inputs or
parts that are needed to build another car. Thus
more tires, more hubcaps, more axles, more
glass windows, more engines etc. will be
required. In turn, producing each part will
require other parts. Tires will require more
rubber, more machinery etc. Making things
even more complicated, to produce more
engines or hubcaps or axles the economy will
need to produce more cars, since vehicles are
needed to transport parts and raw materials.
To produce the additional cars, of course, will
require more of all the inputs necessary for
car production.
Labor inputs are easily handled in this
framework. The workers who assemble
automobiles are viewed as an input that
requires other inputs. Workers will thus need
food, clothing, shelter, and yes, cars to get
them to and from work, if they are to help
produce cars. And what is true of these
assembly workers is true of all other workers
in the economy.
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Through extensive study of production and
the technological needs of numerous US
industries, Leontief (1941) was able to
represent the technical production relationships
for major industries in mathematical form. This
accounting-like framework specified all other
goods in the economy that were needed to
produce any particular good. This gave
Leontief a large set of mathematical equations,
one for each good produced in the economy.
With aid of a computer, Leontief was able to
solve this set of equations. His solution told
him how much more of all other goods had to
be produced in order to get one more car. If
these other goods were not produced as needed,
production bottlenecks would arise; there
would be shortages of engines, or tires, or
window glass, and the extra car could not be
made. On the other hand, if all the inputs were
produced in the required amounts, there would
be just enough parts and materials available to
get one more car.
Input-output models are not merely
technological relationships. They also allow
policy makers to determine the consequences
of changing economic policy. For example,
reduced government spending on defense
inevitably hurts the armament industry, their
suppliers, and all their suppliers’ suppliers. In
contrast, greater spending on infrastructure
(such as roads, bridges, and railways) aids the
construction industry, their suppliers, and their
suppliers’ suppliers. Putting these two sets of
changes together would allow the government
to calculate the total impact of military
reconversion on different geographic areas in
the country and on different industries or
sectors of the economy (see Leontief 1961;
1965; 1986, Chs 9 and 10).
Leontief (1986, Ch. 5, 6) demonstrated how
input-output techniques could be used to test
economic theories when he studied US trade
relations with other nations. Surprisingly, he
found that American exports used less capital
and more labor in their production than
American imports. This contradicted traditional
trade theory, which held that a capital-rich
country (like the US) should export capital-
intensive goods and import labor-intensive
goods. The result has come to be known as the
Leontief Paradox. Leontief’s finding has led
to numerous efforts to revise trade theory in
order to account for these real world findings.
Another real world application of input-
output analysis stems from work Leontief
(1977; 1986, Ch. 11, 12) did for the United
Nations beginning in 1973. This work has
attempted to develop a world input-output
model that incorporates the environment as an
“economic sector.” One can think of economic
sectors producing not only their normal output,
such as cars, but also a number of pollutants.
Likewise, one can think of a pollution-
abatement sector, whose inputs are the
pollutants produced by other sectors. This
sector destroys these pollutants and returns the
environment to its original state or quality.
Leontief has used this model to study the
environmental impact of expanding production
as well as the costs of economic growth with
limited additional environmental pollution (i.e.
the inputs needed for the pollution-abatement
sector).
From the 1940s to the 1960s there was a
great deal of interest in input-output analysis
worldwide. The development of the computer
meant that increasingly complex and realistic
input-output models could be developed for
every country. During World War II,
governments used input-output analysis to
determine which sectors of the economy were
likely to experience shortages, and to develop
policies that would expand production by these
sectors. Furthermore, after World War II nations
became interested in taking charge of their own
economic future rather than leaving it to the
whimsical forces of the market. Planning
agencies and bureaucracies arose in both
developed countries and developing countries,
and input-output models provided a simple and
useful tool to assist in this endeavor.
However, during the 1970s interest in input-
output analysis began to wane. First, the mood
at the time was shifting away from planning
and back towards allowing the market to
determine the pace and direction of
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WASSILY LEONTIEF
development. Second, some limitations of
input-output analysis became apparent.
Because it is both difficult and expensive to
estimate all the actual input-output
relationships for a large, complex economy,
national governments infrequently revise the
national input-output model. Consequently,
policy analysis using input-output tools would
rely on considerably out of date data (Marshall
1989, p. 162).
Third and most important, in the real world,
growth and development has been associated
with changes in technology and the means of
production. Technological improvement has
meant that production can take place with fewer
inputs (especially labor requirements). That
means input— output relationships are always
changing. Input-output analysis, however, takes
these relationships as fixed.
Besides input-output analysis, Leontief has
also been concerned with the methodology of
economic science and the everyday practices
of contemporary economists. Here Leontief has
shifted from being a model builder, interested
in establishing empirical relationships, to being
a sharp critic of professional practices. His first
critique of the methodology of economics
(Leontief 1937) attacked Keynes and his
followers for constructing abstract, theoretical
models whose conclusion was already built
into the premise of the model. Leontief felt that
without good empirical estimates of the way
an economy actually worked, such model
building, could shed no light on the problems
facing real economies. The nature of this
criticism is essentially that economics has
ceased to be an empirical science and instead
has become too theoretical.
In his Presidential address to the American
Economic Association, Leontief (1971)
continued his criticism of how his colleagues
actually did economics. This time his
complaint was about the mathematical
formalism dominating the economics
profession. He argued that economists have
become intrigued with developing formal
models and then logically deducing the
characteristics or properties of that model
without bothering to ask whether or not the
assumptions of these models were realistic. The
conclusions of these mathematical derivations
were irrelevant, Leontief asserted, because they
began with assumptions that are not true (see
also SAMUELSON).
Leontief also criticized his fellow
economists for performing sophisticated
statistical analysis on data of questionable
meaning and validity. More positively, he
recommended that economists devote more
time and attention to gathering data and spend
less time developing sophisticated testing
techniques. Finally, Leontief argued that
economic relationships, unlike relationships in
the physical sciences, change over time because
the individual behaviors on which these
relationships depend, also change.
Econometric testing, which assumes that
economic relationships always stay the same,
is therefore misplaced, and helps disguise the
weaknesses in the data sets and the fact that
economic relationships do change over time.
This argument anticipates the Lucas Critique
of macroeconomic model building (see also
LUCAS).
In an even more positive vein, Leontief has
urged economists to engage in the sort of
“systematic fact-finding, traditionally imposed
on and accepted by their colleagues in the
natural and historical sciences” (1983, p. viii).
He has also called for economists to be more
interdisciplinary—by studying and working
with sociologists, engineers, and management
scientists. These areas give more value to
empirical and practical work, and their
practitioners are knowledgeable and skilled in
data gathering and analysis. These other
disciplines can therefore teach economists a
great deal about the use and importance of data
collection and theory testing.
While similar criticisms have been made by
others about the everyday practices of
economists (see Mayer 1993), none of these
critics has the prestige of Leontief or the broad
experience that comes from years of doing
empirical economics. Unfortunately, these
criticisms have fallen on deaf ears within the
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NICHOLAS KALDOR
economics profession. Even worse, much of
the profession remains unaware of this line of
criticism coming from such a prestigious
figure.
The one unifying theme in all of Leontief’s
work is that economics should be an empirical
and practical science, devoted to gathering data
and solving problems through the application
of analytical tools to real world data. Input-
output analysis is about seeing how the
economy really works, and using that
knowledge to improve economic performance.
Leontief’s methodological complaint is that
economists are not doing this any more.
Works by Leontief
“Implicit Theorizing: A Methodological Criticism
of the Neo-Cambridge School,” Quarterly
Journal of Economics 51, 1 (1937), pp. 337–
51
The Structure of the American Economy, 1919–
1929: An Empirical Application of
Equilibrium Analysis, Cambridge, Harvard
University Press, 1941
“Wages, Profits, and Prices,” Quarterly Journal
of Economics 61, 1 (1946), pp. 26–39
Studies in the Structure of the American
Economy, New York, Oxford University
Press, 1953
“The Economic Effects of Disarmament,”
Scientific American, 204, 4 (1961), pp. 47–
55 with M. Hoffenberg
“The Economic Impact-Industrial and
Regional— of an Arms Cut,” Review of
Economics and Statistics, 47, 3 (1965), pp.
217–41, with others
“Theoretical Assumptions and Nonobservable
Facts,” American Economic Review, 61
(March 1971), pp. 1–7
The Future of the World Economy, New York,
Oxford University Press, 1977
“Foreword” in Why Economics Is Not Yet A
Science, ed. Alfred Eichner, Armonk, M.E.
Sharpe, 1983, pp.vi–xi
Input-Output Economics (1966), 2nd edn., New
York, Oxford University Press, 1986
Works about Leontief
Cave, Martin, “Wassily Leontief: Input-Output
and Economic Planning” in Twelve
Contemporary Economists, ed. J.R.Shakleton
and G. Locksley, New York, Wiley 1981, pp.
160–82
Dorfman, Robert, “Wassily Leontief’s
Contributions to Economics,” Swedish Journal
of Economics, 79 (1977), pp. 430–49
Marshall, James N., “Wassily Leontief 1973,” in
Nobel Laureates in Economic Sciences: A
Biographical Dictionary, ed. Bernard S.Katz,
New York and London, Garland Publishing,
1989, pp. 160–73
Other references
Mayer, Thomas, Truth versus Precision in
Economics, Hants, Edward Elgar, 1993
NICHOLAS KALDOR (1908–86)
Nicholas Kaldor spent most of his career
devising policies to improve economic
performance. He argued for taxing spending
rather than income, and taxes that would
favor and spur production in the
manufacturing sector of developed
economies. Kaldor also opposed tight
money policy as a means of controlling
inflation; instead, he advocated policies to
control the wage-price spiral that caused
inflationary pressures.
Kaldor was born in Budapest, Hungary
in 1908. His father was a criminal lawyer
and legal consultant; his mother came from
a wealthy family of businessmen and
bankers. Kaldor thus grew up in fairly
affluent surroundings and received an
excellent education. He attended a model
high school in Budapest that was famous
for using the Socratic method of teaching.
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Although his father wanted him to study
law, Kaldor became interested in economics.
In part, this stemmed from his interest in
politics; but he was also fascinated by the
German hyperinflation of 1923, which he had
witnessed first-hand while on vacation in the
Bavarian Alps.
In 1925 Kaldor enrolled at the University
of Berlin. Two years later he went to the
London School of Economics (LSE), where
he studied under Friedrich Hayek. Graduating
in 1930, Kaldor accepted a teaching job at the
LSE but left in 1947 to become Director of
the Research and Planning Division for the
European Economic Commission. Kaldor
returned to academia in 1949, accepting a
position at King’s College in Cambridge,
home to the followers of Keynes. Throughout
the 1950s and 1960s, Kaldor served as an
advisor to both British and foreign
governments. He was a special advisor to the
Chancellor of the Exchequer from 1964–8 and
again from 1974–6.
When he began teaching at Cambridge,
Kaldor shifted from his early focus on
economic theory to a focus on economic policy.
He also rejected his earlier views that
economies work best when left alone by the
government and adopted a more activist policy
orientation. In particular, he developed several
tax policies to improve overall economic
performance. Also, in the 1970s and early
1980s Kaldor advocated active government
intervention to control price inflation.
In 1951 Kaldor was appointed to a Royal
Commission on the Taxation of Profits and
Income. This committee was charged with
examining the British tax system and making
recommendations for improving it. Kaldor
found himself in the opposition during the
Commission hearings. He was also opposed to
the main Commission recommendations and
wrote a lengthy minority report. This was then
expanded into a book (Kaldor 1955) that
advanced a radical plan to tax spending rather
than income. Throughout the 1950s Kaldor
(1960–80, Vols. 1 (Part 3), 7, 8) pushed
expenditure taxation on both developed and
developing countries (advising the
governments of India, Sri Lanka, Guyana,
Turkey, Iran, Venezuela, and Ghana).
Kaldor (1955) was opposed to the income
tax for several reasons. First, income does not
adequately measure the ability of an individual
to pay taxes. To cite just one glaring problem,
capital gains are taxed only when assets get
sold; unrealized gains remain untaxed with an
income tax. As a result, income from property
escapes taxation and the income tax treats
wealthy individuals too leniently. Moreover,
the very wealthy have inherited most of their
wealth and do not earn much additional
income. Taxing income allows these
individuals to virtually escape taxation.
Second, Kaldor noted serious economic
defects with the income tax. Because interest
and profits are subject to taxation, the income
tax discourages the savings and investment that
are required to receive such income. In
addition, because returns to successful risk-
taking get taxed at very high rates, income
taxation discourages this important engine for
economic growth.
To remedy these problems, Kaldor
proposed converting the income tax into an
expenditure tax. One should think of the
expenditure or consumption tax as an
income tax that allows all new savings to
be deducted from taxable income. New
savings can easily be measured as additions
to stock portfolios and bank balances. If a
household dissaves, or uses its wealth to
finance current spending, that household
would be taxed on its negative savings for
the year (which gets used for consumption).
A “new savings” tax deduction allows
annual savings to escape taxation, and so
only spending gets taxed. Of course, a tax
deduction for savings will cause tax
collections to fall unless higher tax rates are
imposed. Also, to keep the income tax a
progressive tax despite large deductions for
savings by wealthy families, very high tax
rates will have to be imposed for high levels
of consumption. Kaldor himself (1955, p.
241) suggested that the highest tax rate on
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expenditures would have to be set above
100 percent, and possibly as high as 300
percent.
The major benefit of moving from
income to expenditure taxation is that
savings would be encouraged. People would
save more because spending would be
highly penalized by high taxes while saving
escapes taxation. More savings, in turn, will
lead to technological improvements,
productivity growth, greater incomes, and
even more savings and investment.
Although Kaldor served as an economic
advisor to two British Labour governments,
and as an advisor to several developing
countries, few countries followed his tax
policy prescription. Britain never adopted
an expenditure tax, and developing
countries were reluctant to embrace this
proposal. The two nations that Kaldor did
convince to follow his advice experienced
popular uprisings against the expenditure
tax. As a result, both countries (India and
Sri Lanka) abandoned the expenditure tax
soon after it was implemented (see
Pressman 1995).
Following these failures, Kaldor took a
new approach to tax policy. He suggested
that taxation should be structured to help
particular industries or economic sectors.
Kaldor wanted to develop England’s
more productive economic sectors, an
idea that harkens back to Quesnay’s
distinction between productive and
unproductive economic sectors. Kaldor
(1981) placed great emphasis on
increasing returns to scale as a factor
contributing to economic growth.
Increasing returns means that as firms
produce more of some good, each worker
becomes more productive. Improved
productivity spurs both domestic
expansion and greater competitiveness in
a global economy (Kaldor 1981).
Kaldor (1967) was convinced that
increasing returns ruled in the manufacturing
sector. His belief stemmed from three empirical
regularities that he found when looking at the
growth experiences of various developed
countries (see Thirlwall 1983). First, Kaldor
found a high correlation between economic
growth and the growth of manufacturing output
for twelve industrial countries during the 1950s
and 1960s. He argued that aggregate growth
rates were dependent upon manufacturing
growth rates (rather than vice versa), and that
this could be explained by increasing returns
to scale in industrial activities.
Second, Kaldor found a high correlation
between productivity growth in the
manufacturing sector and the growth of
manufacturing output. Here, he argued that
productivity growth in manufacturing was
dependent on the growth of manufacturing
output. When people want more manufactured
goods, the firms producing those goods will
expand production. Due to economies of scale,
productivity growth accelerates and costs fall
because of the greater demand for
manufactured goods.
Third, Kaldor found that the growth of a
country’s manufacturing output was
correlated with the growth of productivity in
other economic sectors. He argued that as the
manufacturing sector grows, it is able to
absorb surplus agricultural labor.
Consequently, productivity and living
standards rise in the agricultural sector. In
addition, “industrialization tends to
accelerate the rate of change of technology,
not just in one sector, but in the economy as
a whole” (Kaldor 1967, p. 23). Hence,
productivity rises in all economic sectors,
and living standards improve throughout the
nation.
From these facts Kaldor concluded that
economic growth depends first and foremost
on the growth of an industrial sector. A healthy
and thriving manufacturing sector means rapid
economic growth and rising standards of living.
The policy conclusion that Kaldor drew from
this analysis is that governments must support
domestic manufacturing industries.
Governments can do this through the direct
purchase of manufactured goods, or by
supporting manufacturing industries with tax
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breaks, regulatory relief, and other incentives
or assistance.
A particular policy proposal that followed
from this analysis was the selective
employment tax. Kaldor (1960–80, Vol. 7, pp.
200–29; 1966, Ch. 7) proposed that firms in
the service sector should be taxed based upon
the number of workers they employed. This
would encourage employment in
manufacturing industries experiencing
increasing returns to scale and discourage
employment outside manufacturing.
During the 1970s, as inflation became the
main economic problem in the world economy,
Kaldor changed the focus of his attention and
policy efforts. But first he had to contend with
the rising tide of monetarism.
Modern monetarism (see also FRIEDMAN)
holds that changes in the supply of money are
the cause of higher prices. The way to control
inflation was to make sure the money supply
grows at a constant and slow rate, 3–5 percent
per year, which monetarists took to be the rate
at which the economic output grows from year
to year.
Kaldor (1982) raised several objections
against monetarism. First, he noted that
according to the equation of exchange,
MV=PQ (see also FISHER), more money leads
to greater inflation only if the velocity of money
(V) is stable. Kaldor denied that the velocity
of money was constant, and produced
substantial empirical evidence to show how the
velocity of money changed over time and
differed from country to country.
Second, Kaldor held that the direction of
causation was actually the reverse of that
claimed by the monetarists. For Kaldor, a rise
in economic activity or a rise in prices causes
a rise in the money supply. In modern
economies money is created when banks make
loans. When economic activity expands, firms
and individuals want to borrow money. It is
this borrowing that causes the money supply
to rise. In contrast, when economic activity
slows down, there is less demand for borrowed
funds. As banks stop making new loans, the
money supply stops growing.
Finally, Kaldor felt that slow money growth
would create too much unemployment. He
objected to the constant harping about inflation
by monetarists. He noted that even for the
monetarists themselves there are relatively few
costs to inflation, since inflation was by
definition a general rise in the price level. When
all prices and all incomes go up by roughly
the same proportion, there are only trivial costs
to the economy, essentially the time and
expense of having to increase prices (these
costs are sometimes called “menu change
costs”). Creating unemployment, on the other
hand, creates severe hardship for those thrown
out of work. Advocating joblessness in order
to avoid the trivial costs of inflation, as
monetarists did, was clearly a bad policy
prescription.
Rejecting tight monetary policy to control
inflation, Kaldor (1982, pp. 61–5) argued for
an incomes policy to replace the current wage
bargaining system. According to Kaldor,
inflation was not caused by too much money,
but rather was caused by costs and prices
pushing each other up in an endless spiral.
Workers would demand pay increases to keep
their wages up in the face of higher prices. But
higher wages means higher costs for
businesses, which get passed on to consumers
in the form of higher prices, starting another
cycle.
Kaldor suggested that government get into
the wage bargaining process in order to stop
this inflationary spiral. It could do this either
by freezing all wages and prices, or it could
get labor and business to sit down together and
co-operate on keeping inflation under control.
Labor, for example, would agree to keep its
wage increases in line with productivity
improvements (and thus not contribute to rising
costs); business, in turn, would agree not to
raise prices.
Kaldor developed a name and reputation for
himself by developing policy proposals to
improve the market system by using economic
incentives. If saving was good for the economy
and spending was bad for the economy, then
spending should be penalized through higher
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taxes. Likewise, if manufacturing production
was good and a large service sector led to
slower growth, the government should tax the
latter sector and provide tax breaks for the
former sector. This focus on developing
economic policies to improve economic
outcomes makes Kaldor (along with Joan
Robinson) one of the founders of the Post
Keynesian School of Economics.
Works by Kaldor
Pressman, Steven, “The Feasibility of An
Expenditure Tax,” International Journal of
Social Economics, 22, 8 (1995), pp. 3–15
Thirlwall, Anthony P., “A Plain Man’s Guide to
Kaldor’s Growth Laws,” Journal of Post
Keynesian Economics, 5, 3 (Spring 1983), pp.
345–58
Thirlwall, Anthony P., Nicholas Kaldor, New
York, New York University Press, 1987
Turner, Marjorie S. Nicholas Kaldor and the Real
World, Armonk, New York, M.E.Sharpe, 1993
An Expenditure Tax, London, Allen & Unwin,
1955
Causes of the Slow Rate of Economic Growth of
the United Kingdom, Cambridge, Cambridge
University Press, 1966. Reprinted in Kaldor
1960–80 , Vol. 5, pp. 100–38
Strategic Factors in Economic Development,
Ithaca, New York State School of Industrial
and Labor Relations, 1967
“The Irrelevance of Equilibrium Economics,”
Economic Journal, 82 (December 1972), pp.
1,237–55
“The Role of Increasing Returns, Technical
Progress and Cumulative Causation in the
Theory of International Trade and Economic
Growth,” Economie Appliqué, 34, 4 (1981),
pp. 593–617
The Scourge of Monetarism, Oxford, Oxford
University Press, 1982
Economics without Equilibrium, Armonk, New-
York, M.E.Sharpe, 1985
“The Economics of the Selective Employment
Tax,” in Collected Economic Essays, Vol. 7,
pp. 200–29
Collected Economic Essays, 8 vols., New York,
Holmes & Meier, 1960–80
Works about Kaldor
Blaug, Mark, “Nicholas Kaldor 1908–86,” in
Pioneers of Modern Economics in Britain,
Vol. 2, ed. David Greenway and John
R.Presley, New York, St. Martin’s Press,
1989, pp. 68–95
JOHN KENNETH GALBRAITH
(1908–)
The economics of John Kenneth Galbraith has
had both a negative side and a positive side.
On the negative side Galbraith has been a
gadfly, highly critical of traditional economic
theory. He has criticized economic theory for
assuming perfect competition and ignoring the
economic power accumulated by large
corporations. He has criticized politicians for
caving in to the power of large corporations
rather than acting in the public interest. And
he has criticized his fellow economists as idiot
savants, who can do sophisticated
mathematical analysis but fail to understand the
real economic world. On the positive side,
Galbraith has emphasized the importance of
bringing power and power relationships into
economic analysis if we are going to
understand how economies actually work.
Galbraith was born in Iona Station, a small
town on the northern shore of Lake Erie, in
1908; and he grew up in Southern Ontario, part
of Scotch Canada. Galbraith (1981) regrets that
his schooling was interrupted frequently by
farm work and that his academic record was
undistinguished.
In 1926, Galbraith enrolled at Ontario
Agricultural College to study agricultural
economics. He then did graduate work in
agricultural economics at Berkeley. His Ph.D.
thesis on the expenditures of California counties
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JOHN KENNETH GALBRAITH
“was without distinction…. The purpose was to
get the degree” (Galbraith 1981, p. 22).
After receiving his degree Galbraith
accepted a teaching job at Harvard University.
He spent the rest of his academic life at
Harvard, although taking much time off to
pursue his political interests. In 1941 he
became deputy administrator of the Office of
Price Administration, which gave him control
over the prices of most US goods until 1943.
During the 1950s and 1960s Galbraith was
especially active in politics. He was an adviser
and speechwriter in the Presidential campaigns
of Adlai Stevenson and John Kennedy. In 1961
Galbraith was made Ambassador to India, a
position he held until 1963 (see Galbraith
1969). During 1968 he worked in the
Presidential campaign of Senator Eugene
McCarthy and during 1972 he worked in the
Presidential campaign of Senator George
McGovern.
The economic work of Galbraith has been
concerned primarily with the question of
economic power. Galbraith has written about
the tendency for firms to acquire economic
power, the consequences of this, and the need
for government intervention to counter the
power of business interests and assert the
public interest.
Galbraith (1967) argues that the industrial
sector of the US economy is not at all as it is
portrayed in economics textbooks. We do not
have competitive markets with a large number
of firms subject to the will of the people.
Rather, we have non-competitive markets and
large firms that control the market. Large,
monopolistic firms do not attempt to maximize
the profits of shareholders; rather, they attempt
to make the market more reliable and
predictable.
Large firms plan because they must plan.
The market and the forces of competition
contain too much uncertainty for the firm.
Investment in new technology is very
costly; hence the firm cannot risk that, after
undertaking expensive investment, there
will be no demand for the goods they
produce. To thrive, firms must eliminate
market forces wherever they arise; they
must attempt to control the market rather
than be controlled by it.
The large corporation frees itself from the
market in several ways. Through vertical
integration it takes over suppliers and outlet
sources. By developing many diverse products,
the firm can absorb the consequences of a
drastic change in consumer tastes or the
aversion of consumers to a particular product.
By spending money on advertising the firm
controls consumer tastes. Finally, long-term
contracts between producers and suppliers
attempt to eliminate the uncertainty of short-
term market fluctuations.
Traditional economic theory assumes that
the firm is run by the owner. Galbraith thinks
this view is severely antiquated. The firms that
produce most of the goods and services we
buy are run by professional managers. Those
managers are the decision-makers for the firm,
whom Galbraith calls “the technostructure.”
It is here that corporate power lies.
Professional managers have usurped power
from the entrepreneurial owner because the
important decisions of the large modern firm
require the technical and scientific knowledge
of many individuals. One person cannot be
familiar with all the aspects of engineering,
procurement, quality control, labor relations,
and marketing necessary for doing business.
As group decision-making and technical
expertise become more important, power
passes from the individual owner to the group
that runs the firm.
But unlike owners, who have a vested
interest in maximizing profits, professional
managers gain little from profit maximization.
Rather, members of the technostructure desire
survival, growth, and technical virtuosity.
Survival means a minimum amount of earnings
so that the independence of the decision-
makers can be maintained. Growth prevents
firing members of the technostructure as a cost-
saving measure. Growth also serves the
psychological needs of the technostructure—
prestige comes from working for a large well-
known firm. Finally, technical virtuosity means
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JOHN KENNETH GALBRAITH
more jobs and promotions for members of the
technostructure.
Galbraith (1958) has also examined the
power held by large corporations over
consumers. He has attacked the doctrine of
consumer sovereignty, which holds that
consumers know what they want and that
businesses produce goods to meet consumer
needs. This, Galbraith argues, runs counter to
common sense and counter to what we know
occurs all the time in the real world. Demand
does not originate with the consumer; it is
contrived for the consumer by the firm through
advertising. Large firms have thus developed
power over consumer spending.
If consumers decide on their own that they
want certain goods this would indicate some
primacy for the goods that businesses produce.
But since demand is contrived there is no
primacy for goods produced by the business
sector of the economy. Public goods may be
equally important. Moreover, many of the
goods produced by businesses are quite
frivolous and not of paramount importance.
Even the economic principle of diminishing
marginal utility recognizes that as we consume
more and more of the goods produced by the
private sector we receive less and less
satisfaction from each additional good.
Years of favoring private production and
neglecting the provision of public goods have
created a situation of private affluence and
public squalor. A much-quoted passage
(Galbraith 1958, pp. 98f.) describes this
contrast:
The family which takes its mauve and
cerise, air-conditioned, power-steered and
power-braked automobile out for a tour passes
through cities that are badly paved, made
hideous by litter, blighted buildings, billboards,
and posts for wires that should long since have
been put underground. …They picnic on
exquisitely packaged food from a portable
icebox by a polluted stream and go on to spend
the night at a park which is a menace to public
health and morals. Just before dozing off on
an air mattress, beneath a nylon tent, amid the
stench of decaying refuse, they may reflect
vaguely on the curious unevenness of their
blessings.
To redress this imbalance the state must
provide more public goods. Of necessity, this
will mean higher taxes. Funds must be diverted
from private hands, where they will purchase
less needed commodities, to the public treasury,
where they will satisfy public needs.
Galbraith’s Presidential address to the
American Economic Association (in Sharpe
1973) criticized economists for ignoring power
relationships. Economic thinking removes
power from the realm of discourse by denying
its existence and by assuming that the market
will mitigate the power of the firm. Yet, the
most serious problems of modern society—
war, inequality, and environmental decay—
stem from power struggles between
corporations wanting growth and profits, and
public concerns about economic security, the
environment, and the arms race. By ignoring
these power struggles, Galbraith claims,
economics has become increasingly irrelevant.
When important economic and social issues
are viewed as conflicts between two competing
powers, the state comes to acquire an additional
function. The state must side with the public
purpose in order to counter the power of the
large corporation. This theme gets developed
further in Economics and the Public Purpose
(Galbraith 1973), which argues that the US
economy has become bifurcated. Large firms,
part of what Galbraith calls the “planning
system,” have acquired enormous economic
power. They have the power to control prices,
and they have the resources to mold public
opinion. Advertising by the large firm equates
happiness with goods produced by the private
sector of the economy. Advertising can also
urge the public that environmental damage is
imaginary, benign or being eliminated. Finally,
large firms can influence the political process
to their advantage.
In contrast, small firms are subject to the
dictates of the market. They have little
economic power and little ability to sway
public opinion or the political process. They
are thus at a competitive disadvantage relative
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JOHN KENNETH GALBRAITH
to the planning system. The result is unequal
economic development—the planning system
produces too many goods and the market
system produces an inadequate supply of
goods.
Power between the planning and the market
systems must be made more equal according
to Galbraith. Income must be redistributed from
the planning system to the market system. Price
controls, minimum wage legislation,
guaranteed minimum incomes, protective
tariffs, and support for small businesses are
among the policies required.
For a long time Galbraith (1952b) has
supported controls on wages and prices in order
to control inflation. Controls are required
because inflation is caused primarily by the
pressures of higher incomes on prices and of
higher prices on incomes. The only practical
solution is for the government to prevent the
market power of labor unions and the market
power of large businesses from generating
inflation.
Most economists hold that the most efficient
way to allocate goods and services is to let the
free market set prices and wages. On this view,
government-administered pricing and
government interference in the labor market
misallocates resources. Most economists also
contend that controls create a needless
bureaucracy to monitor compliance, and that
they would require rationing of goods. In
contrast, A Theory of Price Control argues that
oligopolistic firms do not take prices that are
set in the market. Firms in the oligopolistic
sector of the economy are price makers rather
than price takers, and “it is relatively easy to
fix prices that are already fixed” (Galbraith
1952b, p. 17).
In imperfect markets there is a strong
element of convention, with prices habitually
set by a mark-up on costs of production.
Moreover, the mark-up itself is conventional.
Government controls on prices attempt to
change conventions, thereby leading to a more
desirable outcome—less inflation. Monitoring
price controls is made easier, according to
Galbraith, by the fact that prices need to be
controlled only in the oligopolistic sector of
the economy, since market power exists only
in this sector. Consequently, only a thousand
or so firms need to be monitored. And
enforcement is assisted by the fact that large
oligopolistic firms are all in the public eye.
Several themes stand out in the work of
Galbraith. First, large firms have substantial
economic power, which they use to
dominate modern economies. Second, this
power encourages technological
development and contributes importantly to
economic well-being; hence, it is better to
counter the power of the large firm than to
eliminate that power by breaking up large
firms. Governments must therefore help to
develop countervailing power in the private
sector of the economy through supporting
labor unions and smaller competitive
businesses. Finally, the government must
itself counter the power of the large
corporation by providing an adequate
supply of public goods, protecting the
environment, resisting the arms race,
assuring employment and decent incomes
to all workers, and controlling prices.
Galbraith is certainly not an economist’s
economist. In fact, many economists probably
would claim that Galbraith is not really an
economist at all. Nonetheless, his work is
important for its focus on economic power and
on the role of government policy as a means to
control that power.
Works by Galbraith
American Capitalism, Boston, Massachusetts,
Houghton Mifflin, 1952a
A Theory of Price Control, Cambridge,
Massachusetts, Harvard University Press,
1952b
The Great Crash 1929, Boston, Massachusetts,
Houghton Mifflin, 1954
The Affluent Society, Boston, Massachusetts,
Houghton Mifflin, 1958
The New Industrial State, New York, New
American Library, 1967
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Ambassador’s Journal, New York, New American
Library, 1969
Economics and the Public Purpose, New York,
New American Library, 1973
A Life in Our Times, Boston, Houghton Mifflin,
1981
Works about Galbraith
Hession, Charles, John Kenneth Galbraith and His
Critics, New York, New American Library,
1972
Reisman, David, Galbraith and Market
Capitalism, New York, New York University
Press, 1980
Sharpe, M.E., John Kenneth Galbraith and the
Lower Economics, White Plains, International
Arts and Sciences Press, 1973
Stanfield, James R., John Kenneth Galbraith, New
York, St Martin’s Press, 1996
MILTON FRIEDMAN (1912–)
The two main themes in the work of Friedman
are that money matters and that freedom
matters. Money matters because only changes
in the money supply can affect economic
activity. Money also matters because inflation
results from too much money in the economy.
Freedom matters because economies run better
when governments do not attempt to control
prices, exchange rates or entry into professions.
And freedom is also important as an end in
itself.
Friedman was born to poor Jewish
immigrants in Brooklyn, New York in 1912.
His parents were immigrants from the Austro-
Hungarian Empire. Shortly after he was born,
his parents moved to Rahway, New Jersey,
which is where Friedman grew up. At Rahway
High School, Friedman developed a love for
mathematics and planned to be an insurance
actuary. But while attending Rutgers College
(then a small private school and now a large
State University in New Jersey), he developed
an interest in economics, and decided to major
in both economics and mathematics.
After receiving his bachelor’s degree in
1933, Friedman went to the University of
Chicago to pursue graduate work in economics.
However, a generous fellowship led him to
transfer to Columbia University the following
year. When Friedman completed all his course
work at Columbia, he returned to the University
of Chicago, where he worked as a research
assistant to Henry Schultz. He then went to
work in Washington, first providing
consumption statistics as part of Roosevelt’s
New Deal administration and then working for
the National Bureau of Economic Research. At
the National Bureau, Friedman teamed up with
Simon Kuznets to study the market for
independent professionals such as lawyers,
doctors and accountants. This study eventually
became his Ph.D. dissertation from Columbia
and a book (Friedman 1946). One finding of
this work—that physicians earn high salaries
because the medical profession was able to
impose high entry barriers and reduce the
supply of doctors—was regarded as highly
controversial and delayed the publication
Friedman’s book.
After teaching briefly at the University of
Minnesota, Friedman returned to the University
of Chicago in 1946, where, with George
Stigler, he developed the Chicago School of
Economics (Reder 1980). Regular Newsweek
columns from 1966 to 1984 (some of which
are collected in Friedman 1975), a best selling
economics book (Friedman 1962a), and a ten-
part TV series (Friedman 1980), have helped
make “Milton Friedman” a household name for
over thirty years
In 1967 Friedman became President of the
American Economic Association, and in 1976
he received the Nobel Prize in Economics. The
award committee singled out three aspects of
Friedman’s work for special mention—his
study of the consumption function, his
arguments about the difficulties and problems
with employing stabilization policy, and his
contributions to monetary theory and history.
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Friedman retired from Chicago in 1977 to
become a senior scholar at the Hoover Institute
in California.
Among economists Friedman is best
known for his crusade against the Keynesian
revolution. This involved arguing against
the use of stabilization policies to control
either inflation or unemployment. For a
number of reasons, Friedman held that fiscal
policy would not work and active monetary
policy would worsen the business cycle and
lead to greater inflation. Friedman’s work
on the consumption function, the role of
money in the economy, and the natural rate
of unemployment all had the effect of
countering the interventionist vision of
Keynes and his followers. It also supported
his own vision of an economy that functions
best without outside interference by
economic policy makers.
The simple theory of consumption,
outlined by Keynes, held that consumer
spending was mainly influenced by current
income. Friedman’s alternative, known as
the permanent income hypothesis, held that
consumers geared spending to their
expectations about income over a longer
time period. Friedman (1957) provided
substantial empirical support for this
hypothesis. The hypothesis itself also
allowed Friedman to solve a number of
puzzles that stemmed from the simple
Keynesian consumption function. One
implication of the simple Keynesian theory
was that the fraction of income consumed
should fall, and the fraction saved should
rise, as incomes increased. Studies of
income, consumption, and savings for the
US done by Kuznets found this not to be
true. The fraction of income saved has
stayed the same in the US over many
decades, despite large increases in income.
Recognizing that spending depends on
expected future income helps explain this fact.
Whenever my income rises, I am likely to
expect more pay increases in the future. As a
result, I need to save less money now for future
consumption.
The permanent income hypothesis also
explains why some groups, such as small
business owners, sometimes save large
fractions of their income and at other times
reduce their savings balances. This would not
occur if savings depends on current income,
but is quite plausible if actual spending depends
on average income over a number of years.
Furthermore, the permanent income
hypothesis has important policy implications
that contradict the policy prescriptions of
Keynes. Keynes advocated fiscal policy to
generate additional spending and employment
during a recession. But if attempts by the
government to generate additional incomes
lead to little additional spending (because
people view their additional income as
temporary rather than permanent), fiscal policy
will have little economic impact.
In contrast to the emphasis on fiscal policy
by Keynesian economists, Friedman (1962,
1963) argued that money and monetary policy
play the major role in determining economic
activity. His argument for the importance of
money stems from the quantity theory of money
(MV=PQ), which holds that the amount of
money in the economy (M) times the number
of times each dollar is used in a year to buy
goods (V) must equal economic output sold
during the year (PQ).
In contrast to classical monetary theorists,
who took the velocity of money (V) as
institutionally determined (see also FISHER),
Friedman acknowledged that velocity could
depend on economic factors such as interest
rates and expected inflation. In addition,
Friedman recognized that people might want
to hold money for reasons other than buying
goods, namely for security or because they
thought that stock prices and other asset prices
were likely to fall. However, empirical studies
by Friedman (1963) found that these economic
factors had only a small impact on velocity and
that their impact tended to decline over time.
Since the velocity of money was relatively
stable, it was the quantity of money that
primarily affected the level of economic
activity.
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Going even further, Friedman held that
while money might be able to affect economic
activity in the short run, in the long run money
must be neutral and can have no economic
impact. More money would affect the level of
output with a lag of around 6 to 9 months. But
6 to 9 months after that, the impact of money
would be only on prices. Thus, 12 to 18 months
after any increase in the money supply, prices
would start to rise and inflation would become
a problem. While economists have traditionally
distinguished cost-push from demand-pull
inflation, Friedman has argued that all inflation
stems from too much demand for goods, and
that there is too much demand when too much
money gets created.
Since inflation for Friedman is solely a
monetary phenomenon, the only solution to the
inflation problem must be to restrain the growth
of the money supply. Towards this end,
Friedman has proposed that the central bank
be required to increase the supply of money
by around 3 to 5 percent every year, the normal
growth rate of the US economy. This would
provide the needed money to purchase
additional goods, but not so much money that
it would cause inflation.
Friedman (1963, 1992) showed that
monetary authorities have produced
depressions, inflation, and other undesirable
economic results through their misguided
attempts to manage the money supply. He
blames the Great Depression on the Federal
Reserve, showing how they first tightened
the money supply because of their fears
about stock market speculation, then did
nothing from 1930 to 1931 when depositors
came running to banks to withdraw their
money, and finally raised interest rates when
Britain left the gold standard in September
1931. All these actions led to a sharp drop
in the US money supply, reduced spending,
and created a Depression. Because the
central bank cannot be trusted to put the right
policy into effect, Friedman argues, central
banks should be forced to follow a monetary
rule rather than being allowed to continually
mismanage the money supply.
Monetary policy frequently goes wrong,
Friedman says, because of the long and variable
lags between current economic problems and
when any change in the money supply will
affect the economy. Friedman (1953, pp. 144–
8) identifies three such lags. It will take time
for the central bank to recognize that an
economic problem exists. It will take time to
actually change the money supply. And it will
take time for any change in the money supply
to impact the economy. As a result of these lags,
monetary policy is not likely to be of the right
magnitude. Nor is it likely to be the right sort
of policy, for by the time any policy starts to
affect the economy, the problem it was
designed to address is no longer likely to exist.
Friedman (1962b) also claims that monetary
authorities are unduly influenced by fiscal
authorities and the national Treasury. Central
banks heads are appointed by the head of the
government and approved by legislative bodies.
Whenever government officials want to expand
the money supply and inflate the economy, the
central bank invariably caves in to political
pressure. Again, the solution is to tie the hands
of central bankers and force them to increase
the money supply by 3 to 5 percent every year.
The natural rate of unemployment was an
idea that Friedman (1968) introduced in his
Presidential address to the American Economic
Association. He held that there was an
equilibrium rate of unemployment in the
economy. Everyone will not always have a job.
There will always be some people in between
jobs, and new labor force entrants will not
immediately find work. The equilibrium or
natural rate of unemployment, Friedman
suggested, depended upon various structural
characteristics of the labor force and the labor
market that left some people without jobs. For
example, the availability of unemployment
benefits and other social programs allow people
to spend a longer period of time looking for
work. Having a working spouse allows for
longer job searches. Any attempt to reduce
unemployment below the natural or
equilibrium rate would soon generate ever
rising inflation, according to Friedman. But
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with higher prices for goods, people will be
able to buy less. As spending falls, so too will
production and employment. This eventually
will lead to an economic contraction and a
return to the natural rate.
The natural rate hypothesis also challenged
one very important idea from Keynesian
economics—the existence of a trade-off between
inflation and unemployment or the Phillips
Curve (see also SAMUELSON). Friedman held
that there was no such trade-off in the long run.
Attempts to lower unemployment would
generate higher inflation, yet unemployment
would always return to the natural rate. In the
long run, therefore, the Phillips Curve was really
a vertical line at the natural rate of
unemployment. Policy makers could do little or
nothing to permanently lower unemployment;
but in a vain desire to reduce unemployment,
they would only increase inflation.
Taking this argument one step further,
Friedman (1977) contended that higher
inflation would cause greater volatility in the
inflation rate and thus lead to greater economic
uncertainty. This, he contended, might even
lead to a higher natural rate of unemployment.
Thus, not only was there no trade-off between
inflation and unemployment, but the two might
move together in the same direction. Keynesian
attempts to lower the rate of unemployment not
only would fail in their objective, and not only
would contribute to inflation, but they might
also have the perverse effect of increasing
unemployment. Friedman thus ultimately
blames the stagflation of the 1970s on the bad
ideas about economic policy that came out of
Keynesian economics.
In the international realm, as well as in the
domestic realm, Friedman set his sights against
Keynesian orthodoxy. Keynes, as we have seen,
favored fixed exchange rates rather than
flexible exchange rates, and was responsible
for helping set up a system of fixed exchange
rates after World War II. In contrast, Friedman
(1953, pp. 157–203; 1967) argued that flexible
exchange rates were preferable to fixed rates
on several grounds. First, with fixed exchange
rates, countries would have to use monetary
policy to keep the national currency at its fixed
rate. Central banks would be forced to create
too much money in an attempt to buy foreign
currencies and maintain fixed exchange rates.
In contrast, floating rates let monetary
authorities concentrate on monetary policy
without worrying about the value of the
national currency.
Second, Friedman argues that flexible
exchange rates help promote trade among
nations. With fixed rates, trade restrictions
become a common response to trade problems;
with flexible rates, the rate adjusts
automatically in response to a trade deficit.
Finally, flexible exchange rates keep
inflation from being exported from one country
to another. Under a system of fixed exchange
rates, countries experiencing inflation will buy
more foreign-made goods because they are
cheaper. This will increase the spending for
goods in other nations and will lead to greater
inflation in other nations. With flexible
exchange rates, this would not happen.
Countries experiencing inflation would see the
value of their currency fall, and so foreign
goods would not become any cheaper.
In addition to these many contributions to
macroeconomics, Friedman has made several
other important contributions to economics. He
was involved in one of the two main
methodological or philosophical disputes in the
history of economics (for details on the other
methodological dispute see also MENGER).
One frequent criticism made about economists
is that they always make unrealistic
assumptions whenever they study the economy.
And one favorite joke about economists
concerns several professionals stranded on a
deserted island with many cans of food, but
no way to open them up. After all the other
castaways fail to use their professional know-
how to open the cans, the economist bravely
comes to the rescue: “Let’s assume we have a
can opener,” he proclaims.
In a controversial essay, Friedman (1953,
pp. 3–43) defends this methodology and argues
that the realism of assumptions does not matter
in scientific analysis. According to Friedman,
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MILTON FRIEDMAN
all theory involves abstraction, and so all the
assumptions of a theory have to be, in one
sense, unrealistic. The only important thing,
according to Friedman, is whether the
implications of the theory are true; that is,
whether the theory works and makes good
predictions. If the theory is supported by the
data it does not matter whether the assumptions
of the theory are completely accurate. On the
other hand, if data does not support the theory,
the theory has to be discarded even if it employs
realistic assumptions. Although many
economists have raised objections against this
position, Boland (1979) has persuasively made
the case that Friedman was right in arguing that
theories are meant to be tools and that
economic assumptions can be unrealistic as
long as they work well and help to predict
economic performance.
As noted earlier, Friedman’s work has not
only been directed at fellow economists. He
has also written extensively for a larger
audience. This work has argued for individual
freedom and against all forms of government
intervention in the economy. Friedman (1962a,
1979) argues that capitalism is the best
economic system because it promotes political
freedom, and because the market can help
offset political power.
Friedman’s more popular writings have
also had a clear policy slant. He has opposed
all government programs that are obtrusive
to individual decision-making. Friedman
(1975) has argued against wage and price
controls, against minimum wage laws,
against social security (because it breaks
down family bonds and is actually a transfer
from the less well-off to the wealthy who
tend to live longer and therefore collect
benefits for longer), and against government
support for higher education (because the
money primarily benefits those who are well
off). On the other hand, he has supported the
all-volunteer army (Friedman 1975, Ch. 8)
and has advocated that all parents be given
vouchers and allowed to select the school
where they will send their children
(Friedman 1979, Ch. 4).
Milton Friedman is the rare economist
who has managed to span two very
different worlds. On the one hand, he is
regarded a giant within the economics
profession, and is one of the two or three
most referenced and revered economic
figures in the twentieth century. This work
has stressed the importance of money and
the importance of markets to improve
economic well-being. At the same time
Friedman has written voluminously for the
general public. This work has stressed the
importance of individual decision-making
and freedom, and has made Friedman one
of the two or three best known and most
recognized economists of the late twentieth
century.
Works by Friedman
Income from Independent Professional Practice,
New York, National Bureau of Economic
Research, 1946, with Simon Kuznets
Essays in Positive Economics, Chicago, Illinois,
University of Chicago Press, 1953
Studies in the Quantity Theory of Money, Chicago,
Illinois, University of Chicago Press, 1956
A Theory of the Consumption Function, Princeton,
New Jersey, Princeton University Press, 1957
Capitalism and Freedom, Chicago, Illinois,
University of Chicago Press, 1962a
“Should There Be an Independent Monetary
Authority,” in In Search of A Monetary
Constitution, ed. Leland B.Yeager, Cambridge,
Massachusetts, Harvard University Press,
1962b
A Monetary History of the United States,
Princeton, New Jersey, Princeton University
Press, 1963, with Anna J.Schwartz
The Balance of Payments: Free Versus Flexible
Exchange Rates, Washington, D.C., American
Enterprise Institute, 1967, with Robert
V.Roosa
“The Role of Monetary Policy,” American
Economic Review, 58 (1968), pp. 4–17
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There’s No Such Thing as a Free Lunch, Lasalle,
Illinois, Open Court, 1975. Reprinted and
updated as Bright Promises, Performance: An
Economist’s Protest, San Diego & New York,
Harcourt Brace Jovanovich, 1983
“Nobel Lecture: Inflation and
Unemployment,” Journal of Political
Economy, 85 (1977), pp. 451–72
Free to Choose, New York, Avon, 1980, with
Rose Friedman
Tyranny of the Status, New York, San Diego
and London, Harcourt Brace Jovanovich,
1984, with Rose Friedman
Money Mischief: Episodes in Monetary
History, New York, San Diego and London,
Harcourt Brace Jovanovich, 1992
Works about Friedman
Burton, John, “Positively Milton Friedman,”
in J.R.Shackleton and G.Locksley (eds.)
Twelve Contemporary Economists, London,
Macmillan, 1981, pp. 53–69
Butler, Eamonn, Milton Friedman: A Guide to
His Economic Thought, New York,
Universe Books, 1985
Hirsch, Abraham and de Marchi, Neil, Milton
Friedman: Economics in Theory and
Practice, Ann Arbor, Michigan, University
of Michigan Press, 1990
Walters, Alan, “Milton Friedman,” The New
Palgrave: A Dictionary of Economics, ed.
J. Eatwell, M.Migate and P.Newman, New
York, Stockton Press, 1987, pp. 422–7
Other references
Boland, Lawrence A., “A Critique of
Friedman’s Critics,” Journal of Economic
Literature, 17 (June 1979), pp. 503–22
Reder, Melvin W., “Chicago Economics:
Performance and Change,” Journal of
Economics Literature, 20, 1 (March 1982),
pp. 1–38
PAUL SAMUELSON (1915–)
Paul Samuelson is a paradoxical figure. More
than anyone else he bears responsibility for the
mathematical bent of economics in the late
twentieth century. Yet Samuelson made a name
for himself, and a great deal of money, by
writing an immensely successful introductory
economics textbook (Samuelson 1947a). Yet
again, Samuelson has written on virtually every
area within economics. For someone so
mathematical, such breadth is both remarkable
and unique.
Samuelson was born in 1915 in Gary,
Indiana; but his parents soon moved to
Chicago, so Samuelson was educated in the
Chicago public school system. He then enrolled
at the University of Chicago. Intending to major
in mathematics, Samuelson took a course in
economics and immediately recognized how
mathematics could revolutionize economics.
As a result of winning a Social Science
Research Council Fellowship, Samuelson had
his graduate education paid for; yet there was
a price to be paid. According to the fellowship
rules he could not continue at the University
of Chicago. Samuelson chose to attend
Harvard, which awarded him a Ph.D. in 1941.
His doctoral dissertation (Samuelson 1947b)
is regarded by most economists as providing
the mathematical foundations for
contemporary economics.
Samuelson liked Harvard, and he wanted
the school to offer him a full-time teaching
position. But Harvard decided not to keep him
on. Determined to stay in Cambridge,
Samuelson accepted a position at the
Massachusetts Institute of Technology (MIT).
He remained at MIT for his entire professional
career, becoming a full professor at the age of
32. In 1947 Samuelson received the first John
Bates Clark Medal from the American
Economic Association, awarded annually to the
most promising economist under the age of 40.
During 1951 he served as President of the
Econometric Society, and during 1961 he
served as President of the American Economic
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PAUL SAMUELSON
Association. In 1970 Samuelson was awarded
the Nobel Prize in Economics.
In all his professional work, Samuelson
sought to provide mathematical underpinning
for economic ideas, believing that economic
theory without formalization was unsystematic
and unclear. Unlike Marshall, who felt that
converting prose into mathematical equations
was a waste of time, Samuelson (1947b, p. 6)
held the reverse to be true—converting
mathematical equations into prose was
wasteful. Mathematical formalism for
Samuelson clarified the nature of models and
arguments, and established the validity of
economic theories. Through the influence of
Samuelson (1947b, 1958), economic
instruction at the graduate level has
increasingly come to employ the tools and
techniques of linear algebra plus differential
and integral calculus, and communication
among economists has become increasingly
mathematical.
Yet Samuelson has not supported rigor for
the sake of rigor, or formalism for the sake of
formalism. Rather, he has looked at
mathematics as a tool. Mathematics illuminates
arguments and proves economic theorems that
can be empirically tested.
Concern with the relevance and testability
of economic theories underlied the
methodological dispute between Samuelson
and Milton Friedman in the post-war years.
Friedman (1953) had argued that the truth of
economic assumptions was unimportant; the
only thing that mattered was whether the
predictions made by these assumptions were
correct. Samuelson (1963) responded that the
factual inaccuracy of assumptions could never
be a virtue in science. He also showed that the
distinction between assumptions and
predictions is never very clear; what counts as
an assumption and what counts as the
consequence of some assumption is quite
arbitrary. The unrealistic assumptions praised
by Friedman could therefore be thought of as
unrealistic or false predictions derived from a
different set of assumptions. Finally,
Samuelson pointed out that, according to the
principles of logic, true premises can only
produce true conclusions, but false premises
could produce both, and what one wants in
economics is true conclusions.
Although this methodological dispute
might seem abstract, important real world
issues were at stake. For years Friedman had
been using the model of a perfectly competitive
economy to argue that the absence of any
government intervention yields the best
economic outcomes. In contrast, Samuelson
was a proponent of Keynesian economics and
had been advocating greater government
intervention to improve economic outcomes.
The Friedman-Samuelson debate therefore was
not just about how to do economics, but also
about the justification for using government
policy to improve economic performance. In
defending the assumption of perfect
competition Friedman was opposing
government intervention; by arguing that
economic assumptions must be realistic,
Samuelson opened the door for Keynesian
macroeconomic policies.
The five-volume Collected Scientific
Papers of Samuelson (1966–77) contain
388 essays written over a 50-year period,
and cover virtually every topic within
economics. The papers in this volume
contain many substantive advances in
economics. From this prolific output, three
areas stand out as being those where
Samuelson has made his mark the most—
consumer choice, international trade, and
macroeconomics.
Samuelson’s work on consumer choice
attempted to make the assumptions of
microeconomics empirical and testable. It thus
followed from his methodological precepts.
Samuelson wanted to remove demand theory
from the arena of psychological introspection
and to get away from the untestable assumption
that consumers maximized utility. He also saw
that the traditional theory of consumer behavior
was tautological. Consumers, by definition,
bought the goods they wanted most; hence
whatever consumers bought maximized their
utility.
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Consequently, consumer behavior is
explained in terms of preferences, which are
in turn defined only by behavior. The result can
very easily be circular, and in many
formulations undoubtedly is. Often nothing
more is stated than the conclusion that people
behave as they behave, a theorem which has
no empirical implications, since it contains no
hypothesis and is consistent with all
conceivable behavior, while refutable by none
(Samuelson 1947b, pp. 91–2).
To escape from this circle, Samuelson
(1938) argued that observed consumer
spending could be used to reveal consumer
preferences regarding the utility they received
from different goods. This data could then be
used to test various assumptions about
consumer behavior. For example, economic
theory holds that consumer preferences will be
consistent and transitive. Consider a consumer
faced with three goods costing the same
amount of money. If the consumer buys good
A rather than good B, and B rather than good
C, then that the consumer should purchase A
rather than C. This is something that could be
tested experimentally, and indeed has been
tested. Most tests have found consumer
preferences to be consistent and transitive, and
have thus confirmed the assumptions
economists make about consumer preferences
(see Caldwell 1982, pp. 150ff.).
A second area where Samuelson has made
important contributions is international trade
theory. This work examined the economic
consequences of free trade and protectionism.
Samuelson (1948, 1949) showed that even if
it is hard for people to migrate, and even if it is
hard for capital to move around the world in
search of the highest rate of return, free trade
will make the rewards going to factors of
production in different countries more equal.
Consider potato chips made almost entirely by
hand. If wages in the US are much higher than
wages in France, French workers will be able
to make potato chips at lower cost. When there
is free trade between the US and France, French
potato chips will be exported and sold in the
US. This increased demand will increase the
price received by French potato chip makers
and, according to the marginal productivity
theory of distribution (see also CLARK), this
should raise the wages of French workers
making potato chips. In contrast, American
potato chip makers, facing greater competition
from abroad, will be forced to lower their prices
and reduce workers’ wages. The wages of
French and American workers thus tend to
become more equal due to free trade.
This result, which has come to be known
as the “factor price equalization theorem,” has
quite important policy implications for an
increasingly global economy. One
consequence of the theorem is that free trade
arrangements between the US and Mexico
should tend to equalize the wages received by
Mexican workers and by unskilled American
workers. NAFTA should therefore tend to raise
the wages of Mexican workers and lower the
wages of American workers.
The Samuelson-Stolper theorem examined
the impact of imposing a tariff on some
imported good. Samuelson and Stolper (1941)
showed that a tariff will increase the incomes
of inputs used to a large extent in domestic
industries that compete with the foreign good
on which the tariff was placed. However, the
tariff will reduce the incomes of everyone else.
For example, a tariff on foreign automobiles
will raise the price of foreign cars. This, in turn,
will raise the price of domestically produced
cars, since higher prices for imports spur
greater demand for domestic cars. The greatest
American beneficiaries of this tariff will be
those factors of production or inputs used most
in automobile manufacturing. If automobile
production is capital intensive (i.e. if it uses
relatively large amounts of machinery),
business owners will gain; but everyone else
will lose because of the higher car prices they
will have to pay. On the other hand, if
automobile production uses a good deal of
skilled labor, then skilled workers will benefit
from the tariff at the expense of everyone else.
Samuelson was also instrumental in
bringing Keynesian economics to America.
This was done, in part, through his popular
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introductory economics textbook (Samuelson
1947a), which introduced to American
economists and students Keynesian notions
like the consumption function, the multiplier,
and fiscal policy (see also KEYNES).
Samuelson also wrote many articles for
newspapers and magazines that explained
Keynes to the non-economist. And he served
as an economic advisor to Presidents Kennedy
and Johnson, explaining to them the
importance of expansionary macroeconomic
policies to lower unemployment.
Within macroeconomic circles at the time
there was much debate about the relative
effectiveness of fiscal and monetary policies.
Monetarists, led by Milton Friedman, argued
that only monetary policy could affect
economic performance. They looked upon
fiscal policy as a circuitous route to have banks
create more money. On the other side of the
debate, Keynesians like John Kenneth
Galbraith described monetary policy as a
string; no matter how hard we push on this
string, they argued, we could not create more
jobs. Samuelson adopted a middle position,
insisting that both fiscal and monetary policies
would be effective in expanding the US
economy and arguing that both policies had to
be used for stabilization purposes. He also
adopted a middle position regarding the form
that expansionary fiscal policy should take.
While Galbraith pressured President Kennedy
to increase government spending, and while
conservative Keynesians urged tax cuts,
Samuelson argued for both an expansion of
government programs and a sizeable tax cut.
Samuelson also made his own contributions
to the development of Keynesian economics.
Keynes showed that additional spending has a
multiplied impact on the overall economy and
he held that investment was driven by the
expectations of businessmen. But Keynes did
not analyze the interactions between the
multiplier and business investment. Samuelson
developed the notion of the accelerator to show
that as the economy expanded businesses’
decision-makers would become more
optimistic and would accelerate, or increase,
their investment spending.
Samuelson (1939a, 1939b) formalized the
accelerator notion and derived mathematically
the combined economic impact of the
multiplier and accelerator processes—with the
multiplier expanding output, and with
expanding output leading to improved
expectations, more investment, and a new
multiplier process. He also demonstrated the
formal conditions under which the multiplier-
accelerator process would lead to economic
instability (either too much growth or to a sharp
decline in economic activity as less spending
reduced the desire of business firms to invest).
Finally, he drew out the policy implications of
the accelerator— because it made the economy
more unstable, government intervention to
stabilize the economy was needed even more.
In another contribution to Keynesian
macroeconomics, Samuelson (1960) and his
MIT colleague Robert Solow developed the
famous Phillips Curve relationship. A.W.
Phillips (1958), in an extensive study of wage
increases and unemployment in Great Britain,
found that small increases in money wages
were associated with high rates of
unemployment and vice versa. Samuelson and
Solow reasoned that since wages were a major
component of costs (60 to 70 percent for most
developed countries) and since higher costs get
reflected in higher prices, the rate of inflation
should also be inversely related to the
unemployment rate. The higher the rate of
inflation, the lower the rate of unemployment;
and the lower the inflation rate, the higher the
rate of unemployment would be. Looking at
US data from 1933 to 1958, Samuelson and
Solow indeed found such a trade-off, and in
honor of Phillips, named it “the Phillips
Curve.”
Samuelson regarded the Phillips Curve as a
tool that could identify the policy options
available to government officials. If concerned
about unemployment, macroeconomic policy
could expand the economy; but this would also
move the economy along its Phillips Curve and
lead to a higher rate of inflation. On the other
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PAUL SAMUELSON
hand, if policy makers were concerned with
inflation, they could slow down the economy, but
at the cost of higher unemployment. Good policy
making thus became a job of selecting the best
point on the Phillips Curve, or making the best
of the given inflation-unemployment trade-off.
As Linbeck (1970, p. 353) has noted,
Samuelson “set the style” for professional
economic discourse in the last half of the
twentieth century. But Samuelson also made
many substantive, technical contributions as
well, and he made them in virtually every area
of economics. His most important
contributions have been in the areas of
macroeconomics and international trade. They
have involved explaining how domestic
economies worked, how they were impacted
by engaging in trade with other nations, and
how economic policies could be used to
improve economic performance. For very
many reasons, Samuelson became one of the
two or three best-known and most respected
economists during the last half of the
twentieth century.
Works by Samuelson
“A Note on the Pure Theory of Consumer’s
Behavior,” Economica, 5 (February 1938),
pp. 61–71
“Interactions between the Multiplier Analysis
and the Principle of Acceleration,” Review
of Economics and Statistics, 21 (May
1939a), pp. 75–8
“A Synthesis of the Principle of Acceleration
and the Multiplier,” Journal of Political
Economy, 47 (December 1939b), pp. 786–
97
“Protection and Real Wages,” Review of
Economic Studies, 9 (November 1941), pp.
58–73, with Wolfgang Stolper
Economics, 1st edn., New York, McGraw Hill,
1947a; 15th edn. with William D.Nordhaus
and Michael J.Mandel, New York, McGraw
Hill, 1995
Foundations of Economic Analysis, Cambridge,
Harvard University Press, 1947b
“International Trade and Equalisation of Factor
Prices,” Economic Journal, 58 (June 1948),
pp. 163–84
Linear Programming and Economic Analysis
(1958), with Robert Dorfman and Robert
Solow
“Analytical Aspects of Anti-Inflation Policy,”
American Economic Review 50 (May 1960),
pp. 177–94 with Robert Solow
“Problems of Methodology—Discussion,”
American Economic Review 53 (May 1963),
pp. 231–6
The Collected Scientific Papers of Paul
A.Samuelson, 5 vols., Cambridge, MIT
Press, 1966–77
Works about Samuelson
Breit, William and Ransom, Roger L., “Paul A.
Samuelson—Economic Wunderkind as
Policy Maker,” in The Academic Scribblers
by W.Breit and R.L.Ransom, New York,
Holt, Rinehart and Winston, 1971, pp. 111–
38
Brown, E.Cary and Solow, Robert M., eds. Paul
Samuelson and Modern Economic Theory,
New York, McGraw Hill, 1983
Feiwel, George (ed.) Samuelson and
Neoclassical Economics, Boston,
Massachusetts, Kluwer-Nijhoff, 1982
Kendry, Andrian, “Paul Samuelson and the
Scientific Awakening of Economics,” in
Twelve Contemporary Economists, ed.
J.R.Shackleton and Gareth Locksley, New
York, Wiley, 1981, pp. 219–39
Lindbeck, Assar, “Paul Anthony Samuelson’s
Contribution to Economics,” Swedish
Journal of Economics, 72, 4 (December
1970), pp. 342–54
Other references
Caldwell, Bruce, Beyond Positivism: Economic
Methodology in the Twentieth Century,
London, Allen & Unwin, 1982
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Friedman, Milton, “The Methodology of Positive
Economics” in Essays in Positive Economics,
Chicago, University of Chicago Press, 1953,
pp. 3–43
Phillips, A.W., “The Relation Between
Unemployment and the Rate of Change in
Money Wage Rates in the United Kingdom,
1861–1957,” Economica, 25 (1958), pp. 283–
300
FRANCO MODIGLIANI (1918–)
Franco Modigliani (pronounced mo-DIG-
LEE-yani) is best known for two innovations
in macroeconomics. To explain total consumer
spending, Modigliani developed the life-cycle
theory of household savings and consumption.
To explain business investment, Modigliani
helped formulate the famous Modigliani-Miller
theorems. These theorems explain why
corporate decisions about obtaining funds for
investment, and about repaying investors,
should not affect the market value of a firm.
Modigliani was born in Rome, Italy in 1918
to Jewish parents. His father was a doctor and
Modigliani, wanting to follow in his father’s
footsteps, enrolled at the University of Rome
to study medicine. Realizing that he could not
stand the sight of blood, he decided to switch
from the study of medicine to the study of law.
Finding the law curriculum relatively easy,
Modigliani earned extra money translating
economic articles from German into Italian. A
national essay competition on price control
sparked his interest because he had previously
translated several articles on this subject.
Modigliani entered the contest. Not only did
the essay win first prize; the judges were so
impressed with his essay that they told him he
would make an excellent economist.
After receiving his law degree in 1939
Modigliani decided to leave Italy, primarily
because of the conflict between his beliefs and
the Fascist government of Mussolini. After a
short stay in France, he arrived in the United
States and enrolled in the social science Ph.D.
program at the New School for Social
Research. The New School was a refuge for
intellectuals fleeing the tyranny of Europe in
the 1930s and early 1940s, and became known
as a sort of “university in exile” (Rutkoff 1986).
While at the New School, Modigliani came
under the influence of Jacob Marschak, who
taught him macroeconomic theory as well as
the importance of formulating testable
economic hypotheses. Modigliani gained his
Ph.D. in 1944 and then taught economics for
several years at the New School.
In 1949 Modigliani accepted a job at the
University of Illinois, and in 1952 he went to
the Carnegie Institute of Technology. After
several visiting professorships in the late 1950s,
Modigliani finally settled down at MIT, where
he taught from 1962 until his retirement. In
1976 Modigliani was elected President of the
American Economic Association, and in 1985
he was awarded the Nobel Prize in Economics.
The Nobel committee cited the life-cycle
hypothesis and the Modigliani-Miller theorems
as his most significant contributions.
Modigliani formulated the life-cycle
hypothesis with Richard Brumberg while re-
turning to Illinois following a conference on
savings at the University of Minnesota.
Brumberg, a graduate student of Modigliani’s,
died of a brain tumor shortly after their famous
paper (Modigliani & Brumberg 1954a) was
published; thus Modigliani (1963) was forced
to develop and test the hypothesis on his own.
The key assumption of the life-cycle theory
is that rational individuals will try to keep their
level of consumption fairly constant from year
to year. Personal income, of course, will vary
due to changing circumstances; in good
economic times people will make more money,
in bad economic times and during retirement
people will earn much less. Even though
income changes from year to year, people want
to keep their lifestyle from changing every year.
This requires that people gear their
consumption to their expected lifetime income
(or the expected average income over their life).
They will thus save larger fractions of their
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income when they make relatively more money
and will save little in years when their income
is relatively low.
Supporting the work of Keynes, the life-
cycle hypothesis can explain why improved
expectations about future income will increase
consumption and poor expectations, or worries
about the possibility of lay-offs, will reduce
consumer spending. In the former case, people
spend more money now, believing they will be
able to pay back any borrowing they do in the
future (when their income is greater). Also, in
good times, people will spend more—believing
that they do not need to save for the proverbial
rainy day—because the future looks so good.
In contrast, when people expect economic
problems in the future, they spend less and save
more now so that they have money in reserve
in case they are laid off from their jobs.
One important implication of the life-cycle
hypothesis is that economic growth is the main
determinant of the national savings rate. When
the economy is growing rapidly people will do
not feel the need to save for the future, since
incomes will be greater in the future. Savings
rates thus plummet. In contrast, when incomes
and economic output grow slowly, people must
save more money out of their income and
savings rates are higher.
A second implication of the life-cycle
theory is that wealth needs to be considered
when attempting to explain and predict
consumer spending. For any person, the value
of wealth is nothing but the future returns
expected from that wealth. Thus wealth can be
used to measure one part of expected future
earnings and will affect both household
spending and savings behavior. Large changes
in aggregate wealth (for example, a sharp
increase in stock prices or real estate values)
will mean that people have more wealth and
need to save less money for retirement.
The life-cycle hypothesis can also explain
why temporary policy changes will have little
impact on either spending or overall economic
activity. A temporary change in taxation may
have a large impact on current income, but it
will have little impact on lifetime income.
Therefore, temporary changes in taxation
should affect consumer spending very little.
The 1968 tax surcharge in the US provides
considerable support for this view (Springer
1975). Contrary to the expectations of many
economists at the time, this tax increase did
not reduce spending by much and did not help
reduce inflation. The life-cycle view, however,
predicts that this tax surcharge should have
virtually no impact on spending, precisely
because it was temporary and therefore had
little effect on lifetime incomes.
The life-cycle hypothesis remains a useful
theoretical tool in macroeconomic analysis
because it allows economists to take factors
such as wealth and expectations about future
income into consideration when attempting to
explain and predict the consumption decisions
made by households. It is for this reason that
when economists try to understand aggregate
consumption and savings behavior they start
from the life-cycle theory.
The second major innovation pioneered
by Modigliani established the modern theory
of finance. Finance studies the decisions
made by business firms about borrowing
money to undertake investment as well as
decisions about repaying investors. In
general, the chief financial officer of a
corporation must decide whether to finance
investment by borrowing (debt financing) or
by printing up stock certificates and allowing
investors to own part of the company (equity
financing). Financial officers must also
decide whether to pay all earnings to
shareholders in the form of dividends, or to
retain some earnings for emergencies and
future expansion.
Modigliani and Miller (1958) showed that
(ignoring taxes and financial market
imperfections) the cost of capital for a firm
does not depend on its capital structure or
how the firm obtains money. In the 1950s,
most economists thought that there was an
optimal percentage of debt financing that
firms should incur. Small amounts of debt
provided insufficient leveraging and large
amounts of debt led to difficulties repaying
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FRANCO MODIGLIANI
that debt. High debt levels increased the risk
of default, leading lenders to demand a
greater return to compensate them for greater
risk; but with higher interest rates, firms were
less able to repay their debt.
Modigliani and Miller showed that it
made no difference whether a firm used debt
financing or equity financing, and that there
was no optimal percentage of debt financing
for a firm. All investors, they noted, carry a
large portfolio of assets with various degrees
of risk. As a result, investors should not be
concerned if one portion of their portfolio
becomes riskier because one firm relies
heavily on debt financing. Even if investors
do become concerned about the added risk
of lending to one firm with a high debt ratio,
they can always compensate for this by
adding low-risk investments like bank
deposits or government bonds to their total
investment portfolio.
In a latter paper, Modigliani and Miller
(1961) argued that corporate dividend
policy should not affect the value of
corporate stock. As a result, the value of a
corporation should be independent of its
choice between retained earnings and
paying dividends to shareholders. Two
firms, identical in all respects except for the
percentage of profits they pay out as
dividends, should have the same market
value. This, too, contradicted the beliefs of
most economists in the 1950s, who saw
corporate dividend policy as a sign of future
expected profits, and thus as related to stock
prices of the firm. Modigliani and Miller
argued that (in the absence of differential
tax treatment) it should not matter whether
profits are paid out in the form of dividends,
or get re-invested in the firm and paid to
investors in the form of capital gains and
future dividend payments.
Modigliani’s work in corporate finance
has one important implication. Instead of
focusing on the financial structure of their
firm, management should focus on
maximizing market value for existing
stockholders.
Modigliani has made several
contributions to economics that go beyond
these two key advances in consumption
theory and corporate finance. In the 1960s,
Modigliani and other economists began
constructing large econometric models of
the US economy. These models were
mathematical equations expressing the
relationships among the many parts of the
whole economy (see also TINBERGEN).
They allowed economists and policy makers
to determine the precise effects of any
policy change or shock to the economy, and
they supported the use of Keynesian
economic policies to fine tune the national
economy. Macroeconomic models let
economists figure out the amount that taxes
must be cut in order to put the unemployed
to work, or the decline in interest rates
required to spur needed investment and
employment during a recession.
Modigliani defended these models against
some very sharp criticism that has been
raised against them. In particular, Modigliani
(1954b) responded to those objecting to
macroeconomic modeling and forecasting
because individuals would react to any
forecasts, thereby immediately invalidating
them. He thus provided a response to what
has become known as the Lucas Critique. His
response was that forecasters needed to take
into account the effect of any forecast on
economic behavior. When this is done, and
included in macroeconomic models, good
forecasting is possible. One important
implication of this work is that if economic
forecasts are poor, it is the forecaster that
should be blamed rather than the behavior
of people.
Probably no economist is more
responsible for extending Keynesian
macroeconomics than Modigliani. He
developed the contemporary theories of
consumption and business investment, and
he developed the macroeconometric models
that assisted in implementing Keynesian
economic policy. Virtually every aspect of
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JAMES M.BUCHANAN
contemporary macroeconomic analysis has
been improved by his insights and his work.
Works by Modigliani
“Liquidity Preference and the Theory of Interest
and Money,” Econometrica, 12, 1 (January
1944), pp. 45–88
“Utility Analysis and the Consumption Function:
An Interpretation of Cross-Section Data,” in
Post-Keynesian Economics, ed. K.K.Kurihara,
New Brunswick, Rutgers University Press,
1954a, pp. 388–436, with Richard Brumberg
“The Predictability of Economic Events,” Journal
of Political Economy, 62 (1958b), pp. 465–78
with Emile Grunberg
“The Cost of Capital, Corporation Finance and
The Theory of Investment,” American
Economic Review, 48, 3 (June 1958), pp. 261–
97, with Merton Miller
“Dividend Policy, Growth, and the Valuation of
Shares,” Journal of Business, 34, 4 (October
1961), pp. 411–33, with Merton Miller
“Corporate Income Taxes and the Cost of Capital:
A Correction,” American Economic Review,
53 (1963), pp. 433–43
“The ‘Life Cycle’ Hypothesis of Saving:
Aggregate Implications and Tests,” American
Economic Review, 53, 1 (March 1963), pp. 55–
84, with Albert Ando
“The Monetarist Controversy or, Should We Forsake
Stabilization Policies,” American Economic
Review, 67, 1 (March 1977), pp. 1–19
The Debate Over Stabilization Policy, Cambridge,
Cambridge University Press, 1986
“Ruminations on My Professional Life,” in Lives of
the Laureates: Thirteen Nobel Economists, 3rd
edn., ed. William Breit and Roger W.Spencer,
Cambridge, MIT Press, 1995, pp. 139–64
Works about Modigliani
Bhattacharya, Sudipto, “Corporate Finance and
the Legacy of Miller and Modigliani,” Journal
of Economic Perspectives, 2, 4 (Fall 1988), pp.
135–47
Samuelson, Paul A., “The 1985 Nobel Prize in
Economics,” in Macroeconomics and Finance:
Essays in Honor of Franco Modigliani, ed.
Rudiger Dornbusch, Stanley Fischer, and John
Bossons, Cambridge, MA and London, MIT
Press, 1987, pp. 29–35
Seyedian, Mojtaba, “Franco Modigliani 1985,” in
Nobel Laureates in Economic Sciences: A
Biographical Dictionary, ed. Bernard S.Katz, New
York, Garland Publishing, 1989, pp. 203–17
Other references
Rutkoff, Peter M., New School: A History of the
New School for Social Research, New York,
Free Press, 1986
Springer, W.L., “Did the 1968 Surcharge Really
Work?,” American Economic Review, 65, 4
(September 1975), pp. 644–59
JAMES M.BUCHANAN (1919–)
James Buchanan is an important figure in
economics because of his role in developing
the field of public choice, which examines the
linkages between economics and politics.
Buchanan has employed economic analysis to
study politicians and political decision-making.
At the same time he has stressed that
understanding the political process is important
for the study of economics.
Buchanan was born into a poor rural family
in the village of Gum, Tennessee in 1919. His
grandfather was elected Governor of Tennessee
in 1891 on the populist Farmers’ Alliance
ticket. Buchanan (1992) credits his mother, a
voracious reader, with developing his academic
abilities through home instruction and by
helping him with his homework assignments.
Buchanan planned to attend Vanderbilt
University and become a lawyer, but the Great
Depression destroyed these dreams. Middle
Tennessee State Teacher’s College, in nearby
Murfreesboro, was the only school he could
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JAMES M.BUCHANAN
afford. Buchanan majored in mathematics,
English literature, and social science, and then
pursued graduate work in Economics at the
University of Tennessee in Knoxville.
Following a brief stint in the Navy, he enrolled
at the University of Chicago to pursue a Ph.D.
in Economics. Had it not been for his
experiences at officer training school in New
York, Buchanan would have probably attended
Columbia rather than Chicago. His feeling that
“the Eastern Establishment” discriminated
against outsiders (especially poor Southerners)
led him to spurn Columbia in favor of Chicago
(Buchanan 1992, p. 4).
In 1948 Buchanan received his Ph.D. and
a teaching job at the University of Tennessee.
Since then he has held positions at a number
of US and European institutions including
UCLA, the University of California at Santa
Barbara, the London School of Economics,
and Cambridge University. But Buchanan has
spent most of his adult life teaching at three
schools in Virginia. From 1958 to 1969 he
taught at the University of Virginia and
established the Thomas Jefferson Center for
Political Economy there. From 1969 to 1983,
he taught at Virginia Polytechnic Institute and
founded the Center for the Study of Public
Choice. Then Buchanan moved his center to
George Mason University, where it has
remained ever since. In 1986, he was awarded
the Nobel Prize in Economics, primarily for
changing the way that economists study
government and politicians.
Buchanan’s major contribution to
economics is his role in developing the area
of public choice, a study of exchange in the
political realm. Public choice emerged out
of the field of public finance, which studies
the relationship between governments and
individuals. Just as economists assume that
economic man is rational and seeks to
maximize utility, the public choice school
holds that politicians and government
bureaucrats should be viewed in the same
light. Political exchange, like economic
exchange, will be made with the expectation
of gain.
It is perhaps easiest to understand the
significance of his economic contributions by
starting where Buchanan began, with Keynes.
Keynes, as we saw, argued that market
economies frequently experience problems,
and that economic policy tools should be used
to remedy these problems. Buchanan did not
dispute the fact that market economies can
malfunction; in fact his personal experiences
during the Great Depression support this
analysis. What Buchanan disputed was the
policy solution advanced by Keynes. He denied
that government officials can improve upon
market outcomes. His case consists of two
parts—one philosophical and one economic.
Philosophically, Buchanan begins from a
position of radical subjectivism—a belief that
only individuals can know what is good for
them and what benefits them. This perspective
denies that any outside party or body could
determine objectively what is good for people.
In particular, governments and government
bureaucrats cannot distinguish what is good for
society from what is bad for society; nor can
they promote the public good through
economic policy making.
Radical subjectivism entails rejecting
modern welfare economics (see also PIGOU),
which seeks to improve national economic
welfare by contributing to a more efficient
allocation of resources. More importantly,
radical subjectivism entails rejecting Keynesian
economics. Buchanan has been highly critical
of Keynesian economics (Buchanan and
Wagner 1977; Buchanan, Burton, and Wagner
1978), claiming that bureaucrats are unable to
make choices that maximize anything for
society since the whole notion of maximizing
benefits for society makes no sense. To the
contrary, by attempting to promote the public
good, governments restrict individual freedom
and choice, and thus reduce the welfare of its
citizens.
But there is also an important economic case
against government intervention. By explaining
how economic forces affect policy makers,
Buchanan has shown how the desire to make
things better will likely fail and lead to even
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worse problems. This is the essence of the
public choice argument against Keynes and
against traditional economic policy making.
Buchanan (1977) contends that Keynesian
macroeconomic policy depends on the
assumption that policy makers will act in the
public interest rather than in their own interest.
But since all policy makers are human,
Buchanan claims, they will behave like other
human beings; they will attempt to maximize
their own utility rather than behaving
altruistically and enacting legislation and
policies that are best for the whole nation. Thus,
politicians will act in ways that further their
election (and continued employment) rather
than in ways that promote the welfare of their
constituents.
In addition, Buchanan notes that
politicians are unlikely to be drawn from
those who prefer a minimal role for
government, for such people are unlikely to
be attracted to government service. Rather,
politicians will be interested in social
engineering or in improving social well-
being. This will require large budgets. Also,
politicians will need to be re-elected
periodically. Control of large budgets
enables politicians to pass out the largesse
that improves their chances of reelection.
Likewise, unelected public employees will
recommend and propose large budgets,
since this will create jobs for them, and also
give them more people to supervise and
greater incomes. The system is thus biased
towards large budgets and large government
according to Buchanan. Finally, because of
its large size and scope, government will
face difficult and complex decisions. Expert
economists will need to be hired, who will
point out instances of market failure as the
cause of particular problems and
recommend an even greater role for
government.
Going even further, Buchanan (1980)
identifies another sort of wastefulness that
stems from big government and government
policy making. When government forms a
large part of the national economy, any
decision they make will have a large impact
on business firms. Firms will, of necessity,
be extremely concerned with government
policy and will try to influence policy
makers. In their attempt to influence
government decisions, businesses will
devote enormous resources to lobbying
government officials. This takes away from
the resources that they could put into the
production of goods.
Rather than a mechanism to improve
economic performance, Buchanan (1978)
sees Keynesian economics as “a disease that
over the long run can prove fatal for the
survival of democracy.” It leads to
permanent government deficits and a public
debt that gets rationalized with the motto
“we owe it to ourselves, so it is okay.”
Keynesian economics is also a disease,
according to Buchanan (1977, p. 4), because
it has ended the moral restraint on
politicians to behave in ways that are
fiscally responsible; in particular Keynesian
economics has led politicians away from
balanced budgets.
Buchanan (1958, 1977) has argued
vigorously against government deficits and
public debt. He contends that public deficits
have many negative effects. They reduce the
capital of the nation. When the government
sells bonds to finance its debt, it competes
with private sellers of debt and pushes up the
cost of borrowing (interest rates). As a result,
private investment declines. In the long run,
problems are even greater. A rising debt, with
rising interest burdens, increases the
likelihood of a government default. In
addition, Buchanan (1986) has argued that
future generations suffer from the deficit
because they must pay higher taxes, whose
burden is not offset by interest payments to
bond holders.
As noted earlier, Buchanan does not deny
that economic outcomes can be less than
ideal. In contrast to Keynes, however, he
contends that sub-optimal outcomes always
arise because individuals cannot benefit from
trade. Government policies that further
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JAMES M.BUCHANAN
constrain individual action is thus not the
solution. Rather, the solution must involve
creating opportunities for mutually beneficial
trade. This involves changing the rules of the
economic game by finding institutional,
organizational or constitutional changes that
will allow such trade to flourish. Buchanan
sees the political economist as someone who
identifies rule changes and makes everyone
aware of the benefits that would follow from
them.
Thus, his solution to the problems of
excessive government is a “constitution
revolution” (Buchanan and de Pierro 1969),
which reassesses and changes the rules of
government. Without constitutional limits,
democratic governments expand too much
and become too intrusive. Constitutional
constraints must be placed on governments
to keep them from trampling on individual
rights, while at the same time channeling
individual self-interest towards the common
good. Frameworks, institutions or rules must
be developed that limit the ability of
politicians to act in ways that advance their
own interests but not the public interest.
One institutional change that Buchanan
has long advocated is a constitutional
amendment for a balanced budget. He
believes that only through a change in the
constitutional framework can fiscal
responsibility and economic health be
restored. “Just as an alcoholic might embrace
Alcoholics Anonymous, so might a nation
drunk on deficits and gorged with
government embrace a balanced budget…”
(Buchanan 1977, p. 159).
Constitutional rules are also important
because they keep a bare majority of the
nation from imposing costs on everyone
else. For example, a simple majority, by
imposing higher taxes on others, could
benefit themselves at the expense of a large
minority. The way to prevent such a
tyranny of the majority is to change the
rules, or the national constitution, and
require that all tax increases be approved
by large majorities (say, two-thirds of
elected representatives).
While other economists tend not to rate
Buchanan highly (he does not have an Ivy
League education and does not do highly
mathematical economics), Buchanan has
had a policy impact that goes far beyond
that of any late twentieth-century
economist, with the possible exception of
Milton Friedman. Rising dissatisfaction
with government, public support for tax
reductions and reductions in government
spending, and balanced budget
amendments can all be seen as instances
of the influence that Buchanan has had in
the policy arena. Nonetheless, his greatest
contribution is undoubtedly the public
choice perspective, which has forced
economists to take a more complex and
realistic view of political agents and policy
makers.
Works by Buchanan
Public Principles of Public Debt, Homewood,
Illinois, Richard D.Irwin, 1958
The Calculus of Consent: Logical Foundation
of Constitutional Democracy, Ann Arbor,
Michigan, University of Michigan Press,
1962, with G. Tullock
“Pragmatic Reform and Constitutional
Revolution,” Ethics, 17 (1969), pp. 95–104,
with A.de Pierro
The Limits of Liberty: Between Anarchy and the
Leviathan, Chicago, University of Chicago
Press, 1975
Democracy in Deficit: The Political Legacy of
Lord Keynes, New York, Academic Press,
1977, with R.E.Wagner
The Consequences of Mr. Keynes, Institute of
Economic Affairs, 1978, with J.Burton &
R.E. Wagner
Essays on the Political Economy, Honolulu,
University of Hawaii Press, 1989
Better than Plowing and Other Personal Essays,
Chicago, University of Chicago Press, 1992
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Works about Buchanan
Atkinson, Anthony, “James M.Buchanan’s
Contributions to Economics,” Scandinavian
Journal of Economics, 89, 1 (1987), pp. 5–15
Locksley, Gareth, “Individuals, Contracts and
Constitutions: The Political Economy of
James M.Buchanan,” in Twelve
Contemporary Economists, ed.
J.R.Shakleton and G.Locksley, New York,
Wiley, 1981, pp. 33–52
Reisman, David, The Political Economy of James
Buchanan, London, Macmillan, 1990
Romer, Thomas, “On James Buchanan’s
Contributions to Public Economics,” Journal
of Economic Perspectives, 2, 4 (Fall 1988),
pp. 165–79
DOUGLASS CECIL NORTH (1920–)
Douglass North has made contributions to
three areas of economics. He has brought
statistical methods to the study of economic
history. He has examined and explained the role
of institutions in regulating human behavior.
And he has attempted to understand the
historical forces that make economies rich or
poor. These three lines of research are not quite
as diverse as they might first appear. North has
explained economic growth in terms of
adopting the right institutions. He has also used
statistical techniques to test his institutional
theories about the causes of economic growth.
North was born in Cambridge,
Massachusetts in 1920. His father, a manager
for the Metropolitan Life Insurance
Company, was transferred frequently while
North was growing up. As a result, North
went to school in Connecticut, Ottawa,
Lausanne, New York City, and on Long
Island. He attended college at the University
of California in Berkeley because his father
had been transferred to San Francisco and
North did not want to be far from his family.
At Berkeley, North triple majored in
political science, economics, and philosophy.
He seriously considered going to law school
after graduation, but the start of World War II
put this plan on hold. North (1995, p. 253)
claims that because of “the strong feeling that
I did not want to kill anybody, I joined the
Merchant Marine.” Three years at sea gave
North the opportunity to do a great deal of
reading and reflecting, and he decided to
become an economist rather than a lawyer.
Returning to Berkeley after the war, North
received his Ph.D. in 1952, writing a
dissertation on the history of life insurance in
the United States. From the 1950s until 1983
North taught at the University of Washington.
He then became Professor of Economics and
History at Washington University in St. Louis.
In 1993, North and Robert Fogel were made
joint recipients of the Nobel Prize in Economic
Science.
In announcing this award the Nobel Prize
committee cited the pioneering work of North
and Fogel in the development of cliometrics,
which involves the application of mathematical
and statistical methods to the study of
economic history. Until the late twentieth
century, economic history was primarily a
descriptive area within economics, one
shunning statistical analysis. Consequently,
North and Fogel encountered great resistance
when, during the 1960s, they brought
mathematical methods to this field. But they
continued to push their project and eventually
succeeded in revolutionizing the study of
economy history. North and Fogel required that
all work in economic history yield testable or
refutable predictions, and that these predictions
actually be tested against an alternative, null
hypothesis that some factor was not important.
This was to be done by gathering relevant
historical data and then analyzing this data with
the same statistical tools used by all other
economists.
Some of the earliest cliometric work by
North and Fogel studied the causes of
economic growth. North (1961) examined the
extent to which trade among the South, the
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North and the West was responsible for US
economic growth. He argued that advances in
transportation (canals linking the West and the
North; ocean transport linking the North, and
the South; and steamboats linking the South
and the West) created three different, yet
interrelated, economic regions of the US. Each
area had a different specialization—the South
produced cotton, the North became the
financial and manufacturing center, and the
West specialized in animal skin and food
products. Furthermore, each area depended
upon goods from the other two areas.
North then performed a sort of controlled
experiment. He tested the hypothesis that
regional specialization led to faster economic
growth against the alternative hypothesis that
regional division was not responsible for
growth. He found that the three different
regions did tend to expand and contract
together. Moreover, he found that this was
primarily due to the fact that growth in one
region led to demand for goods in the other
regions.
North (1977, p. 192) later came to recognize
that while cliometrics can test proposed
explanations for historical change, it cannot
provide any new explanations for economic
growth. Another approach was therefore
necessary, and so he began to study institutions
and social rules. North (1990) defined
institutions as constraints devised by people
and imposed on their political, economic and
social behavior; they include habits and
customs as well as formal constraints such as
laws. He then tried to explain the impact of
these institutions on individual behavior and
economic performance, as well as the reasons
that certain institutions come into existence at
certain times in history. This line of inquiry
makes North one of the founding fathers of the
new institutionalist economics.
Most economists take economic institutions
and rules as given; for example, they assume
markets exist, but say nothing about how
markets develop and evolve. Institutions,
however, affect both economic performance
and the market because institutions are all about
human beings—how they interact with one
another and how they structure their world.
These institutions affect the costs of producing
goods, the ability to sell goods, and thus
economic growth rates.
For North, institutions matter in three
critical ways. First, they establish property
rights and economic incentives. Without some
agreement about who owns things, people will
not produce and will not attempt to better
themselves economically. With property rights
come incentives to acquire new technology and
to employ more efficient production methods.
For example, without patent laws there would
be little incentive for an individual or a firm to
spend money on research and development.
Those who had not invested so heavily in
research and development would be able to
copy and cheaply reproduce any discovery.
These copycats would gain from the new
discovery without paying the research and
development costs needed to make the
discovery. As a result, it would not pay for firms
to engage in research activities and have
competitors merely copy the results; each firm
would wait and let others spend the money to
make the new discoveries. But under such
economic rules, everyone loses since virtually
no one engages in research and development
spending and there will be few new discoveries.
Second, institutions matter for North
because they must enforce the rules of the
economic game. Here the state becomes an
important economic actor, an actor that faces
key trade-offs.
On the one hand, the state must not let
people cheat and get away with cheating. At
the simplest possible level, the state must
protect citizens and businesses from robbery
and from extortion, for no one would work
and produce if their gains were likely to be
stolen by someone else. At a more complex
level, the state must make sure that rules are
not broken that will harm economic
performance. The state must ensure that
people do not cheat on their taxes, that firms
do not conspire to raise prices and reduce
quality, and that firms do not engage in
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deceptive or dangerous practices. Successful
cheating by some will encourage cheating by
others, and thus reduces the economic
incentives to work hard, which is a necessary
ingredient for a successful, thriving economy.
On the other hand, monitoring and
enforcement costs rise as the state tries to
prevent more and more cheating. This will
require higher taxes and lead to greater
dissatisfaction with government meddling in
private affairs. Consider the costs of ensuring
that everyone complies with income tax laws.
If no one gets audited, many people will cheat;
but if everyone gets audited, the cost to the
government becomes extremely high and the
public becomes extremely dissatisfied with the
tax laws. The state must walk a fine line
between allowing some cheating on taxes and
eliminating almost all cheating through greater
monitoring and higher taxes, which itself
creates economic disincentives and slower
economic growth. This decision should create
an institutional framework or set of rules in
which businesses and people are mostly honest
about paying the taxes they owe the
government. In more general terms,
governments must establish an environment in
which most everyone plays by the economic
rules, but the rules are not oppressive to
economic actors.
Third, institutions matter according to North
because they are closely related to ideology,
or the psychological and social make-up of an
economic community. Institutions help
determine how people view fairness and correct
behavior. These factors, in turn, affect how
people will react to different situations. In
contrast to traditional economic theory, which
sees individuals as always acting rationally
based upon their own self-interest, North
(1994, p. 3) sees individuals as uncertain about
what to do and unclear about what is in their
own self-interest. Consequently, they fall back
on myths, ideologies, popular beliefs, and
habits. For example, if workers believe they are
treated well, they will work hard and be
productive; if citizens believe in political
democracy they will vote; and if people believe
that the government guarantees the quality of
goods they will purchase more goods. Contrary
to Gary Becker, who believes that penalties and
rewards imposed on individuals are more
important than institutional ideology, North
holds that if people believe the economic
system is fair, there is less chance they will
steal; and if people have faith in their
government they will be less likely to cheat on
their taxes and more likely to vote. In fact, for
North excessive penalties may increase
undesirable behavior if people come to believe
that the system is not fair and that penalties
are far out of proportion to the seriousness of
crimes.
As such, institutions are important because
they can keep economies from reaching their
growth potential. This will occur when
institutions provide incentives to engage in
unproductive activities. If people view
institutional rewards as arbitrary and unfair,
and therefore fail to work hard, this will slow
down economic growth. If firms lobby
government officials for special benefits,
rather than create goods and services,
economic growth will suffer.
Conversely, the right set of institutions will
lead to greater economic growth and benefit
everyone. North (1981, Ch. 5) argues that
ideology or belief systems may reduce
undesirable behavior (like stealing) by
imposing extra-legal penalties on thieves. As a
result, individuals will be less likely to engage
in behaviors that undermine the foundations
of the economic system.
One question frequently asked of North is
why “inefficient” rules or institutions would
continue to exist. North (1981) has answered
that political markets are inefficient. Special
interest groups have an incentive to organize
and get the government to pass favorable
legislation; but since the loss to everyone else
from these benefits is small, they have little
incentive to organize and oppose special
interest groups. Voters have little incentive to
be informed since there is really no chance that
one single vote will determine the outcome of
any selection. In addition, issues tend to be
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KENNETH J.ARROW
complex, which leads voters to ignore the
issues. As a result, ideology takes over—people
vote for simple but wrong-headed ideas, for
candidates with charisma but no substance, and
for the status quo. This analysis also helps
explain why voters are so dissatisfied with the
candidates they must continually vote for as
well as the level of political campaigning.
The new institutionalism of North straddles
both traditional economics and traditional
institutional economics (see also VEBLEN).
Yet, it occupies an uneasy place relative to both.
The behavioral assumptions that North
employs are quite different from the
assumptions made by most economists. For
North, individuals are socialized to behave
according to rules, and these institutional
constraints are an important influence on
behavior. This view has made traditional
economists uneasy with his work. On the other
hand, the work of North is highly quantitative
and formal. This had made traditional
institutionalists skeptical of his work.
Although he has caused unease in many
corners, North has been a creative and
pioneering economist. He is one of few
twentieth-century economists who has dared
to ask big questions like “what causes
economies to grow and decline?” And he has
attempted to provide a big answer to this
question, one that recognizes the uneasy
relationship between social institutions and
individual self-interest.
Structure and Change in Economic History, New
York, W.W.Norton, 1981
Institutions, Institutional Change and Economic
Performance, Cambridge, Cambridge
University Press, 1990
“Shared Mental Models: Ideologies and
Institutions,” Kyklos, 47, 1 (1994), pp. 3–31,
with Arthur T.Denzau
“Douglass C.North,” in Lives of the Laureates:
Thirteen Nobel Economists, 3rd edn., ed.
William Breit and Roger W.Spencer,
Cambridge, MIT Press, 1995, pp. 251–67
Works about North
Goldin, Claudia, “Cliometrics and the Nobel,”
Journal of Economic Perspectives, 9, 2 (Spring
1995), pp. 191–208
Libecap, Gary D., “Douglass C.North,” in New
Horizons in Economic Thought: Appraisals of
Leading Economists, ed. Warren J.Samuels,
Hants, Edward Elgar, 1992, pp. 227–48
Johan Myhrman and Barry R.Weingast,
“Douglass C.North’s Contributions to
Economics and Economic History,”
Scandinavian Journal of Economics, 96, 2
(1994), pp. 185–93
Richard Sutch, “Douglass North and the New
Economic History,” in Explorations in the New
Economic History, ed. Roger L.Ransom,
Richard Sutch, and Gary M.Walton, New York,
Academic Press, 1982, pp. 13–38
Works by North
The Economic Growth of the United States, 1790–
1860, New York, Prentice Hall, 1961
Institutional Change and American Economic
Growth, Cambridge, Cambridge University
Press, 1971, with Lance E.Davis
The Rise of the Western World: A New Economic
History, Cambridge, Cambridge University
Press, 1973, with Robert Paul Thomas
“The New Economic History After Twenty
Years,” American Behavioral Scientist, 21
(December 1977), pp. 187–200
KENNETH J.ARROW (1921–)
Kenneth Arrow is best known as a theoretical
economist with extremely broad and diverse
interests. His many important contributions
have gone beyond economics proper, to include
mathematical programming, social and
political philosophy, and health care. Yet Arrow
is best known for two very technical
contributions—his impossibility theorem,
which established social choice as a field within
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KENNETH J.ARROW
economics, and his proof of the existence of
general equilibrium. Arrow was born in New
York City in 1921 to a middle-class family of
Romanian-Jewish origins. A voracious reader
as a child,
Arrow preferred to stay home and read
rather than play outside with friends. This
presented a problem for his mother when he
misbehaved.
At first, she would send him to his room, but
soon realized that nothing suited Kenneth
better. He would trudge away with a volume
of the encyclopedia under his arm and enjoy
himself immensely. She then reversed the
procedure: Kenneth’s punishment was to be
sent out to play.
(Feiwel 1987, pp.
Through exposure to the works of
Bertrand Russell, Arrow developed interests
in mathematics and mathematical logic in
high school. He attended the City College
of New York, mainly because it was free:
his father, whose business was highly
successful in the 1920s, had lost everything
during the Depression of the 1930s. At City
College Arrow studied mathematics, logic,
and statistics. He graduated in 1940 with
the Gold Pell Medal, awarded for the
highest grades in the graduating class.
Arrow intended to be a high school
teacher, but with no employment prospects
he enrolled at Columbia University to study
mathematical statistics with Harold
Hotelling. Hotelling’s course in
mathematical economics provided Arrow
with his first exposure to economics. In
1941, Arrow received an MA in
mathematics and then went off to serve in
World War II. After the war, he returned to
Columbia to continue his studies in
mathematics and statistics. Flaunting a
fellowship, Hotelling enticed Arrow to
enroll in the Ph.D. program in economics.
Arrow then became interested in the logic
of social decisions. His dissertation, Social
Choice and Individual Values (Arrow 1951),
was completed in 1951.
Upon completing his Ph.D., Arrow accepted
a position at Stanford University. Four years
later he became a full professor there. In 1968,
he accepted a position at Harvard, but returned
to Stanford in 1979. Arrow was awarded the
Nobel Prize in Economic Science in 1972.
Arrow’s major contribution to economics
is the proof of the impossibility theorem in his
doctoral dissertation. This contribution
revolves around the notion of how groups of
individuals, such as family members or the
owners of a firm, make decisions or choose
among alternatives. When analyzing individual
choice, economists assume that each individual
is rational and can rank order the different
alternatives available to them (see also
EDGEWORTH). Specifically, rational choice
requires that individual preferences among
alternatives are consistent and transitive. To be
consistent, an individual choosing good A over
good B, cannot also choose good B over good
A. For transitivity, an individual who prefers a
good A to good B, and also prefers good B to
good C, must also prefer A to C.
Arrow proved that social choice, or social
decision making, is not rational. In particular,
he demonstrated that the decisions made by
groups of people will not necessarily follow
the transitivity principle. Consider, for
example, the choices that have to be made by
a family. To keep things simple we assume
three choices (A, B, and C). To keep things
concrete we can think of the choices as three
movies that a family considers renting—
Aladdin, Barney, and Cinderella. Three
children have to choose among these
alternatives; they cannot see all three movies.
Each child wants to maximize his or her utility.
If all the children agree on which movie they
want to see, there is no problem. However,
many times this does not happen and the
children have different preferences among the
three movies.
In particular, suppose that child #1 prefers
Aladdin to Barney and Barney to Cinderella;
that child #2 prefers Barney to Cinderella and
Cinderella to Aladdin; and that child #3 prefers
Cinderella to Aladdin and Aladdin to Barney.
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KENNETH J.ARROW
Each child has consistent and transitive
preferences, as defined above. But problems
arise when the children get together and must
decide which movie to watch. Taken together,
the three children together prefer Aladdin to
Barney since child #1 and child #3 both prefer
Aladdin to Barney. They also prefer Barney to
Cinderella, since child #1 and child #2 prefer
Barney to Cinderella. The transitivity principle
requires that Aladdin is preferred to Cinderella.
However, child #2 and child #3 prefer
Cinderella to Aladdin, thus violating the
transitivity principle. The implication Arrow
drew from this analysis was that social choice
could not be rational because it violates the
transitivity principle. Put another way, it is
impossible (hence, the “impossibility
theorem”) to derive a social or group choice
from individual preferences. Put yet another
way, “there cannot be a completely consistent
meaning to collective rationality. We have at
some point a relation of pure power” (Arrow
1974, p. 25). What this all means is that while
economics can explain individual choices, it
cannot explain group decision making.
Robert Paul Wolff (1970) has drawn out the
implications of the impossibility theorem for
political philosophy. In the example given
above, if A, B, and C refer to different bills
before the legislative branch, or different
candidates for elected office (rather than
different movies), it turns out that the order in
which A, B, and C are presented will determine
the final outcome. If the first choice is A versus
B, A will win since legislator #1 and legislator
#3 will vote for A over B. Then when A goes
up against C, C will win since legislator # 1
and legislator #2 prefer C to A. But suppose
we made the first choice A versus C. Now C
wins since legislator #2 and legislator #3 will
vote for C over A. But B will win against C,
because of votes from legislators #1 and #2.
Finally, let B versus C be the first choice.
Legislators #1 and #2 both prefer B to C, so
they each vote for B. But when B comes up
for a vote against A, A will win based upon
votes from legislator #1 and #3. Thus, the order
in which bills (or candidates) get presented to
voters ultimately determines the winner.
Winners are thus determined arbitrarily in the
political arena. Wolff argues that by removing
the philosophical backing for democratic
decision making Arrow has inadvertently
provided a philosophical justification for
political anarchism.
A second major contribution by Arrow was
to prove mathematically that a general
equilibrium existed. As far back as Walras and
Pareto, and possibly as far back as Quesnay,
economists recognized the possibility of
describing equilibrium for an entire economic
system. Within this system, each market would
clear at the equilibrium price for that market.
What was missing from this vision was a proof
that there could actually be one set of
equilibrium prices to clear all markets
simultaneously. It is this proof that Arrow (and
Debreu 1954; and Hahn 1971) set forth in
mathematical terms. This proof required four
assumptions: (1) Households supply labor
services and consume goods; (2) Households
know what they want, know the utility they will
get from different choices, and make rational
choices about consumption and work; (3)
Firms transform inputs into outputs using the
best technology available: and (4) Households
receive profits from production.
Proving a general equilibrium exists also
required two behavioral assumptions and
stipulated two conditions. The behavioral
assumptions are that firms maximize profits and
that individuals maximize utility. The two
conditions Arrow stipulated were that there could
be no negative prices, and that any good for which
an excess supply existed had a price of zero (see
also VON NEUMANN). From all this, Arrow
was able to prove mathematically the existence
of a competitive equilibrium; that is, he showed
that there was a set of prices for all goods and
services such that the supply and demand for all
goods and services were equal to one another.
The entire economic system thus could thus be
shown to exist in a state of equilibrium.
While this proof will likely appear to be
abstract and pointless to the non-economist, it
was important because it helped to convince
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KENNETH J.ARROW
economists of the viability of general
equilibrium analysis. General equilibrium was
not just some theoretical idea, but was a real
possibility, and economies could be thought of
as moving to this general equilibrium.
Economists thus moved further away from the
partial equilibrium method of Marshall, and
began to study the impact of all economic
changes on all markets in the economy. This
proof was also important because it confirmed
for many economists the insight of Adam
Smith that the free market could allocate
resources efficiently and lead to a highly
desirable outcome. If markets were allowed to
operate without hindrance, all markets would
clear and consumers would maximize utility
(given the resources they began with).
One important assumption made in the
proof of general equilibrium was contained
in (2) above. For households to maximize
their utility, they have to know whether to
buy various goods today or to wait and buy
these goods in the future. This decision
requires the existence of forward markets.
Forward markets occur where we pay today
in order to obtain delivery of some good(s)
in the future, or the promise of repayment in
the future. The simplest future market that
most people are familiar with is the
certificate of deposit offered by banks. Banks
take your money today and promise to
deliver more money to you in the future. For
many goods, however, no future markets
exist. Future markets exist for foreign
currency, but only for a few months into the
future. For most goods there are no future
markets at all. Certainly, it would be hard to
find someone willing to sell me food or oil
10 years from now at some agreed upon
price. The lack of future markets disturbed
Arrow and much of his subsequent work
(1971, with Hahn) has attempted to show that
general equilibrium results still held in a
world without complete markets.
The lack of complete markets has also been
a theme of Arrow’s work in the economics of
health care. Arrow began with the observation
that health economics had to be studied from
the standpoint of uncertainty. This uncertainty
leads to a less than perfect outcome in the
health sector of an economy (Arrow 1983–5,
Vol. 6, Chs 3, 7,15).
A first problem is that individuals do not
have knowledge about the quality of care they
will receive from doctors, especially when
specialists are involved. It is important to find
good doctors, since an incompetent doctor can
cost you your life. But finding good doctors
is timely and difficult for consumers. In such
cases, Arrow sees entry barriers as the only
means to reduce uncertainty. Licensing
requirements guarantee to consumers that
doctors have some medical training and
possess competence in medical matters. In
contrast to Milton Friedman, who sees
licensing requirements as government-
mandated monopoly power (which reduces
supply and increases prices) and who believes
that market forces would drive out
incompetent doctors, Arrow views an
unregulated medical market as a game of
Russian roulette that fails to benefit society.
A second problem in the health care
market is what economists refer to as
“moral hazard.” The idea behind this
notion is that insurance changes individual
behavior. Fire insurance makes people less
careful around the home because they have
insurance to pay the costs of any fire. This
attitude, though, will lead to more fires.
Similarly, people with health insurance are
more likely to behave in ways that increase
their risks of getting certain diseases or
disabilities because their medical expenses
will be paid for by someone else. As a result
of moral hazard, the demand for health
services will rise and health care spending
will soar. Arrow (1971) has shown that the
solution to the moral hazard problem is co-
insurance, where individuals pay a large
proportion of their health bill. When people
are forced to pay more for their health
problems, they will behave in less risky
ways, have fewer health problems, and
health care spending in the nation is brought
under control.
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A final problem in the health care market is
adverse selection. Naturally, individuals know
more about their own health than any insurer
does. Insurers can obtain additional
information, but only at great cost. Moreover,
people who are great health risks, and who will
cost the insurance company more money, have
strong economic incentives to hide their health
problems from the insurance company
(because this would entail greater insurance
premiums). This uncertainty about the health
risks of different individuals creates a problem
for insurers. If insurance companies set rates
based upon average risks, high-risk groups will
purchase a lot of insurance and low-risk groups
will buy little or no insurance. The insurance
company will therefore lose money and have
to raise rates. But this will drive out even more
low-risk groups. Premiums will continue to
rise, while more and more people will opt out
of insurance coverage. Arrow showed that these
problems disappear with a single-payer system.
If everyone is covered by health insurance, no
one can attempt to provide plans that appeal to
only low-risk groups and insurance companies
do not have to worry abut low-risk individuals
dropping out of the system and significantly
raising the average costs of insuring people.
Rather than writing for the general public,
and rather than providing economic advice to
politicians, Arrow has written primarily for his
fellow economists. He has studied the logic of
group decision-making, the logic of general
equilibrium analysis, and the logic of a health
care market that is plagued by uncertainty. The
breadth of Arrow’s interests, and the
penetrating insights that result whenever he
studies a specific problem, make him one of
the half dozen most important economists in
the late twentieth century.
“Existence of Equilibrium for a Competitive
Economy,” Econometrica, 23 (July 1954), pp.
265–90, with G.Debreu
“Uncertainty and the Welfare Economics of
Medical Care,” American Economic Review,
53 (1963), pp. 941–69. Reprinted in Arrow (
1983–5 ) Vol. 6, pp. 15–50
Essays in the Theory of Risk-Bearing, Amsterdam
and London, North-Holland; Chicago,
Markham, 1971.
General Competitive Analysis, San Francisco,
Holden-Day, 1971, with F.H.Hahn
The Limits of Organization, New York, Norton,
1974.
Collected Papers, 6 vols., Cambridge, Harvard
University Press, 1983–5
Works about Arrow
Breit, William and Spencer, Roger W. (eds.), Lives
of the Laureates: Seven Nobel Economists,
Cambridge, MIT Press, 1986
Feiwel, George R. (ed.), Arrow and the
Foundations of the Theory of Economic Policy,
London, Macmillan, 1987
Heller, Walter P., Starr, Ross M. and Starrett,
David A. (eds.), Social Choice and Public
Decision Making: Essays in Honor of Kenneth
J.Arrow, 3 vols., Cambridge, Cambridge
University Press, 1986
von Weizsäcker, Carl Christian, “Kenneth Arrow’s
Contribution to Economics,” Swedish Journal
of Economics, 74 (1972), pp. 488–502
Other references
Wolff, Robert Paul, In Defense of Anarchism, New
York, Harper & Row, 1970
Works by Arrow
BARBARA R.BERGMANN (1927–)
Social Choice and Individual Values, New York,
Wiley, 1951.
Barbara Bergmann spent her career studying
how labor markets work. These studies
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BARBARA R.BERGMANN
examined the causes of unemployment and
poverty as well as the potential cures for these
problems. They also examined why women
receive such low wages. Bergmann identified
discrimination in the labor market, mainly due
to excluding women from certain jobs, as a
major cause of low wages for women and child
poverty. To remedy these problems, she has
advocated a strong affirmative action program.
Bergmann was born in New York City in
1927 and grew up in the Bronx. Her father left
the family while Bergmann was still a child,
instilling in her a strong belief that women
“should have their own money” (King,
forthcoming). But after receiving a BA in
mathematics and economics from Cornell in
1948, she could not get a job. At the suggestion
of her mother, she enrolled at Teacher’s
College, Columbia University. One year later
she accepted a job offer from the Bureau of
Labor Statistics. Encouraged by the economists
at the Bureau to pursue graduate study,
Bergmann was accepted by both Harvard and
Cornell. She chose Harvard, and received a
Ph.D. in economics in 1959.
In the early 1960s, Bergmann spent two
years as a Senior Staff Economist on Council
of Economic Advisors and three years at the
Brookings Institution, a prestigious
Washington think tank. From 1965 to 1988 she
taught at the University of Maryland before
being hired by the American University in
Washington, D.C., where she taught until her
retirement. In the early 1970s she helped found
the Eastern Economic Association and in 1974
she became its first President.
Bergmann has made two main contributions
to economics. First, she has argued that
discrimination is a pervasive characteristic of
labor markets. Second, she has argued against
the traditional economic methodology of
drawing conclusions from a set of unrealistic
assumptions. Instead she has argued that
economists need to go out into the real world
and find out how economies actually work.
It is well known that female workers earn
on average much less than male workers. Ever
since income data was first collected in the late
nineteenth century, the numbers revealed that
full-time female employees in the US earn
around 60 percent of full-time male employees
(Smith & Ward 1984; Golden 1990). While
these facts are not in dispute, it is a matter of
great contention why women earn so much less
than men. Feminist economics (see Ferber &
Nelson 1993) sees this pay differential as
evidence of women’s second class economic
status. It also seeks to understand the causes
of women’s inferior economic status.
Bergmann has been a pioneer of feminist
economics; and she has identified exclusion,
or occupational segregation, as a major cause
of women’s low wages. Furthermore, she has
blamed the methodology of her fellow labor
economists for failing to see this fact.
Occupational segregation involves keeping
some jobs open primarily to women while
excluding women from another set of jobs.
Usually women get excluded from high-paying
jobs and are concentrated in relatively low-
paying jobs. For example, men comprise most
doctors, while women are more likely to be
nurses; men are more likely to be bank
managers, while women are more likely to be
bank tellers. Bergmann has pointed out that
occupational segregation also frequently occurs
within occupations. Consider food service jobs.
“Men who wait tables generally work in
expensive restaurants where the tips are high
and no women are hired. Women tend to work
in the cheaper restaurants, with no male
colleagues” (Bergmann 1996a, p. 42).
Although the phenomenon of occupational
crowding or segregation was originally noticed
by Edgeworth (1922), it was Bergmann (1971,
1974) who first explained why such
discrimination was prevalent. According to
standard economic theory, discrimination should
be eliminated by the market because it is not
profitable for firms to discriminate (see also
BECKER); non-discriminating firms pay lower
wages, earn higher profits and will eventually
drive discriminating firms out of business.
Bergmann has pointed to substantial
evidence that the real world is not like the world
of standard economic theory. Court cases
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against large firms like Hertz, Pizza Hut, and
Chase Manhattan all demonstrate the existence
of discrimination against women. However,
these firms have not been hurt through lower
profits and they have not been driven out of
business by their less bigoted competitors
(Bergmann 1986, p. 139). In addition,
traditional economic theory focuses primarily
on wage discrimination, or why two people
with identical skills and abilities might be paid
different wages. It says little about
discrimination that systematically excludes
women from occupations paying relatively
high wages.
Bergmann has also explained why firms
discriminate against women and minorities,
and why they tend to hire white men at higher
wages. This explanation has focused on other
employees rather than employers. For example,
if white male workers feel uncomfortable
having women or minorities as their peers or
colleagues, they may not train them and may
not assist them with difficult work-related
problems. Or, morale problems (as a result of
having to work with women) may lower the
productivity of white males. To avoid these
possible “costs,” employers may decide not to
hire either women or minorities.
Going even further, Bergmann (1971) has
explained how advantaged groups gain at the
expense of disadvantaged groups due to
occupational segregation. If women can only be
secretaries (and a few other things), but cannot
hold managerial positions, there will be more
job applicants for secretarial positions than the
number of available jobs. This pushes down
wages for secretaries. Moreover, even when
women get offered non-secretarial jobs, they will
receive meager pay offers since employers know
that their main option is likely to be a low-wage
secretarial job. In contrast, wages will be higher
in managerial jobs because, by excluding
women from these positions, there will be fewer
job applicants and so greater incentives will be
necessary to attract workers.
To remedy the problem of occupational sex
segregation Bergmann (1996a) has advanced
a strong program of affirmative action. She
notes that affirmative action is not meant to
remedy past wrongs; it is meant to deal with
current practices. Discrimination continues to
exist in the workplace today. Women are paid
less than men, even after controlling for such
factors as education and experience levels.
Occupational sex segregation also shows that
women are currently discriminated against in
the labor market. A final piece of evidence that
discrimination exists today comes from
controlled experiments in which closely
matched pairs of individuals applied for actual
jobs. These studies found that both women and
minorities were less likely than white males to
progress in the hiring process (EEA
Symposium; Turner et al. 1991).
Bergmann (1996a) has argued that the
benefits of affirmative action exceed the costs
of imposing this policy on business firms. One
important benefit is that affirmative action leads
to more qualified people being hired. This
increases economic efficiency. Another benefit
from affirmative action is greater workplace
diversity. Moreover, Bergmann claims that
there are many ways to measure quality or
merit; judgments about quality are inherently
subjective and are affected by factors such as
the gender, race and age of the candidate. In
many instances, there is not one unambiguous
best candidate for a job. In these cases,
affirmative action says that firms should hire
women and minorities.
Bergmann has stressed that numerical goals
for affirmative action are important because,
in the absence of such goals, firms will promise
to do better but will not hire more women or
minorities. Only affirmative action will work
to end discrimination. The alternative, legal
action to prevent discrimination, is both
lengthy and costly. In addition, individuals
discriminated against in the hiring process are
not in a position to know this or prove this.
For example, job applicants can hardly be
expected to know that all female candidates,
no matter what their qualifications, were denied
an interview for a particular position.
Reinforcing her work in feminist
economics, Bergmann has advocated the use
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of alternative research methodologies in
economics. Her Presidential address to the
Eastern Economic Association (Bergmann
1974) criticized economists who sit in their
ivory towers and maintain limited contact with
the real world. These economists study the
economy either through introspection or
through performing statistical tests of
economic theories using data compiled by the
government. These methods, Bergmann
claims, are inadequate because they are too
divorced from the real world and therefore
cannot help understand how the real world
works.
The work of Robert Lucas provides one
good illustration of this problem. Lucas has
held that unemployment is the result of a choice
that people make about leisure and labor; we
choose leisure over work whenever current
wages are too low. Bergmann (1989) contends
that Lucas made a number of highly unrealistic
assumptions about the rationality of laid-off
workers and the way that labor markets work
in order to reach this conclusion. Moreover, he
failed to test any of these assumptions.
In place of deducing the consequences that
follow from unrealistic or false assumptions,
Bergmann (1973, 1990; and Bennett 1986) has
advocated that economists go out into the world
and begin collecting information. One way to
do this is to actually survey people. Another
approach would be to perform controlled
experiments, like those showing qualified
women and minorities do not progress as well
as white males in the hiring process. Finally,
economists can perform computer simulations
of labor markets. The basic idea behind this
approach is to use the computer to model
individual, firm, and government behavior in
response to various changes. But to do this, we
need to find out how workers respond to wage
cuts and how firms respond when workers
demand higher wages. Only then is it possible
to determine the impact of wage changes on
employment.
For example, interviewing workers who
have just been laid off would help economists
understand how these individuals think about
their options. It would help economists
understand why laid-off workers do not
immediately apply for cashier openings at the
local fast food restaurant. Surveys would also
help understand why managers of fast food
establishments are unable to find employees
at the given wage despite the existence of
people looking for work, and why these
managers do not increase wages to attract more
applicants. Interviews might also allow
economists to discern how the manager of a
fast food restaurant would view the
employment application of someone who has
recently lost a high-paying job. Only after
conducting these interviews and simulating the
behavior of individuals in response to changing
circumstances would economists understand
whether people are out of work because there
are not enough jobs, or because workers prefer
leisure to labor, or for other, more complex,
reasons. This more adequate and more
scientific approach would also enable
economists to explain how labor markets
actually work and to understand the causes of
unemployment.
Bergmann has yet to receive the highest
accolades and awards possible for an
economist. She has not been made President
of the American Economic Association and she
has yet to make the list of Nobel Prize finalists.
Part of this neglect certainly stems from the
fact that she is a woman (see also ROBINSON).
Another likely factor is a feminist orientation
that makes her male economists rather
uncomfortable. Nonetheless, Bergmann has
helped set the agenda for feminist economics,
and her work has forced traditional labor
economists to sit up and take notice.
Works by Bergmann
“The Effect of White Incomes on Discrimination
in Employment,” Journal of Political
Economy, 79 (March/April 1971), pp. 294–313
“Combining Microsimulation and Regression,”
Econometrica, 41, 5 (September 1973), pp.
955–63
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“Occupational Segregation, Wages and Profits
When Employees Discriminate by Race or
Sex,” Eastern Economic Journal, 1 (April-July
1974), pp. 103–10
The Economic Emergence of Women, New York,
Basic Books, 1986
A Microsimulated Transactions Model of the
United States Economy, Baltimore, Maryland,
Johns Hopkins University Press, 1986, with
Robert L.Bennett
“Women’s Roles in The Economy: Teaching The
Issues,” Journal of Economic Education, 18,
4 (Fall 1987), pp. 393–407
“Why Do Most Economists Know So Little About
the Economy?,” in Unconventional Wisdom:
Essays in Honor of John Kenneth Galbraith,
ed. Samuel Bowles, Richard Edwards &
William G. Shepherd, Boston, Massachusetts,
Houghton Mifflin Company, 1989, pp. 29–37
“Micro-to-Macro Simulation: A Primer with a
Labor Market Example,” Journal of Economic
Perspectives, 4, 1 (Winter 1990), pp. 99–116
“Curing Child Poverty in the United States,”
American Economic Review, 84, 2 (May
1994), pp. 76–80
A Defense of Affirmative Action, New York, Basic
Books, 1996a
Saving Our Children from Poverty: What the
United States Can Learn from France, New
York, Russell Sage, 1996b
Cheltenham, UK, Edward Elgar 1998, pp.
104–17.
Other references
(EEA Symposium) “Symposium: Race, Gender
and Discrimination,” Eastern Economic
Journal, 21, 3 (Summer 1995), pp. 339–98
Edgeworth, Francis Y., “Equal Pay to Men and
Women,” Economic Journal (December
1922), pp. 431–57
Ferber, Marianne A. and Nelson, Julie A. (eds.),
Beyond Economic Man: Feminist Theory and
Economics, Chicago, & London, University of
Chicago Press, 1993
Goldin, Claudia, Understanding the Gender Gap:
An Economic History of American Women,
New York, Oxford University Press, 1990
Smith, James P. and Ward, Michael P., Women’s
Wages and Work in the Twentieth Century,
Santa Monica, California, Rand Corporation,
1984
Turner, Margery Austin; Fix, Michael and Struyk,
Raymond J. , Opportunities Denied,
Opportunities Diminished: Racial
Discrimination in Hiring, Washington, D.C.,
Urban Institute Press, 1991
Works about Bergmann
GARY BECKER (1930–)
King, Mary, “An Interview with Barbara
Bergmann,” Review of Political Economy
(forthcoming)
Paulin, Elizabeth “The Seditious Dissent of
Barbara Bergmann” in Richard P.F.Holt and
Steven Pressman (eds), Economics and Its
Discontents, Northampton, Massachusetts &
Cheltenham, UK, Edward Elgar, 1998, pp. 1–
19
Polkington, Betty and Thomson, Dorothy
Lampen, Adam Smith’s Daughters: Eight
Prominent Women Economists from the
Eighteenth Century to the Present,
Gary Becker is among the most original
economists of the late twentieth century. His
unique approach involves taking the economic
assumption of rationality and applying it to a
large number of social problems normally not
studied by economists. This approach has led
to many new areas of specialization within
economics—the economics of crime and
punishment, the economics of addiction, the
economics of the family, human capital
theory, and the economics of discrimination.
Becker was born in Pottsville,
Pennsylvania in 1930 and grew up in
Brooklyn, New York. His father was a small-
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business owner. After graduating from high
school he went to Princeton University, where
he received a BA in economics. Becker was
dissatisfied with his economic education at
Princeton because “it didn’t seem to be
handling real problems” (Current Biography
Yearbook 1993, p. 41). He then did graduate
work in economics at the University of
Chicago, where he studied under Milton
Friedman. Becker received an MA in 1953
and a Ph.D. from the University of Chicago
in 1955. His doctoral dissertation (Becker
1957) on the economics of discrimination was
supervised by Friedman and was cited by the
Nobel Prize Committee as an especially
important contribution to economics.
Becker taught at the University of Chicago
from 1954 to 1957 and then accepted a
position at Columbia University. In 1969 he
returned to the University of Chicago as
Professor of Economics and Sociology. Since
1985 Becker has written a regular economics
column in Business Week, explaining
economic analysis and ideas to the general
public. In 1992 he was awarded the Nobel
Prize in economic science.
Becker has made two key
contributions to economics. First, he has
taken the assumptions economists make
about human rationality and applied
them to all forms of behavior, including
non-economic matters or subjects that do
not involve market transactions between
individuals. Starting with the
assumptions that human beings act
rationally and attempt to maximize
utility, Becker has analyzed decisions
regarding fertility, marriage and divorce
(Becker 1973, 1974, 1977), crime and
punishment (Becker 1968), and addiction
(Becker 1988, 1991, 1992). Second,
Becker has been instrumental in
explaining the way that labor markets
work. He has helped develop the notion
of human capital (Becker 1964) and he
has helped economists to better
understand discrimination in labor
markets (Becker 1957).
Becker analyzes marriage decisions and
family relationships in a manner analogous
to the traditional theory of the business firm.
Individuals spend time searching for the
spouse who will provide them with the
maximum amount of utility just as firms
search for the best possible employee. Longer
searches lead to better information about
whether any possible spouse would be the
most desirable one. Consequently, this theory
predicts that those marrying young would be
more likely to get divorced, a prediction that
receives considerable support from data on
marital stability. Also, the theory predicts that
disappointments regarding expectations, and
changes in expectations, will lead to divorce.
And like a firm wanting to maximize profits,
a family can maximize utility through
specialization; thus the husband typically
specializes in market production and the wife
typically specializes in household production.
One consequence of such specialization is that
women will receive lower market wages.
According to Becker, this is due not to
discrimination, but results from decisions
made within the household about which jobs
will be performed by different family
members.
Family decisions about having children
can also be analyzed using the logic of
economic analysis. In contrast to Malthus,
who held that people could not control their
reproductive urges, Becker looks at the
decision to have children as analogous to
consumer decisions about purchasing goods
like cars and vacations. Raising children
involves many costs. Parents must pay for
food, shelter, clothing, toys, and education.
Most important of all, the parent must spend
time raising the child, which reduces the time
available to earn income and consume goods.
Parents must be compensated for these losses
with greater utility or pleasure from their
children, otherwise they will not choose to
have children. This compensation can come
from the joy of having and raising children,
the desire for offspring, or the desire to have
someone care for you in your old age. But
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GARY BECKER
whatever the cause of this additional utility,
according to Becker children must compete
with cars and vacations (which also give
pleasure) for each dollar of family income.
Given this perspective, it is possible to
formulate many testable hypotheses about
birth rates. Greater costs of child rearing
should reduce fertility; greater family incomes
should allow the family to purchase more of
everything, including children. Higher
incomes for women will increase the costs of
rearing children, because the time spent at
home with children results in a greater income
loss, and will therefore reduce fertility.
Finally, government income guarantees to the
elderly should reduce fertility rates, since one
benefit of children is that they will be around
to support you in your old age.
The economics of crime and punishment
is another area where Becker has taken the
rationality assumption, applied it to a new and
different arena, and pushed out the boundaries
of economics. One popular view in the 1950s
and 1960s was that criminal behavior resulted
from mental illness or social oppression. In
contrast, Becker assumed that potential
criminals behave rationally, and were affected
by the expected rewards and costs of criminal
activity. Putting more money into law
enforcement should raise the probability of
being caught, increase the costs of criminal
activity, and reduce crime. Likewise, if
penalties are increased, the expected cost of
criminal actions would rise, and crime rates
would fall. Similarly, if more jobs were
available, and if the financial rewards from
these jobs were to increase, employment
begins to look relatively better when
compared to criminal activity. As the relative
gains from criminal activity fall, crime should
be less prevalent. Further offshoots of this
approach have looked at how firm compliance
with government regulations and individual
compliance with tax laws depends upon the
penalties and the likelihood of detection.
Empirical studies carried out by both
economists and criminologists (see Heineke
1978) provide a good deal of support for the
theories of Becker on the determinants of
criminal activities.
Further drawing out the consequences of
the rationality assumption, Becker has argued
that drug and alcohol addiction can be viewed
as rational behavior. Becker starts by noting
that habits can be either good or bad. They
are good if they increase future well-being.
Habits such as regular exercise, eating well,
and wearing seat belts all fall into this
category. On the other hand, habits that reduce
future well-being, such as smoking cigarettes
and experimenting with drugs, are harmful.
But, Becker argues, people who develop bad
habits are not necessarily irrational; they
merely prefer current pleasures to future well-
being. An addiction, according to Becker, is
just a strong habit and thus also the result of
rationally balancing expected present and
future pleasures. This analysis leads to the
conclusion that drug use should be made legal
in order to allow each individual to maximize
his or her own well-being. However, Becker
does introduce some qualifications to this
conclusion. He notes that some habits, like
drug use, can reduce our concern for future
consequences and thus lead to powerful
addictions. Furthermore, legalizing drugs may
lead to a sharp increase in drug addiction since
the negative consequences of drug taking are
less severe because with legalization the price
of drugs will fall. Moreover, peer pressure
may rise with legalization, leading to further
drug use and greater likelihood of addiction.
Becker has also made significant
contributions in the area of labor economics.
Becker (1962) was one of the pioneers who
developed the notion of human capital and
then used this notion to help economists
understand how labor markets worked.
Analogous to physical capital, like machinery
and plants, people can invest in themselves
through education, through training, and
through developing new skills. In fact, the
concept of human capital is even broader than
this, and encompasses the purchase of health
care, time spent searching for better jobs, and
migrating to other areas in search of better
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employment. Like new plants and machinery,
these human investments will yield a flow of
future income.
But also like physical capital investment,
human investment involves a cost. Perhaps the
most important of these will be the lost
earnings due to the time spent acquiring
human capital. In addition, the difficulty of
acquiring new skills and knowledge imposes
a cost on the individual. People will invest in
themselves, according to Becker, as long as
the future gains exceed the present costs. Most
empirical studies of human capital theory have
focused on comparing the costs and the
returns to schooling, especially a college
education. Empirical tests of human capital
theory have found that human capital
investment does increase with greater returns
and does fall with greater costs (Mincer 1974).
Several important and controversial points
about economic inequality and discrimination
follow from the theory of human capital. First,
Becker (1971) has pointed out that inequality
between two groups (such as men and women,
or blacks and whites) does not show that the
group receiving lower earnings is
discriminated against. Earning differences
will depend on differences in factors such as
education, skills, and experience (or the
human capital accumulated by members of
each group). Only after we factor out the effect
of these differences in human capital on
earnings are we left with earning differences
reflecting discrimination.
Second, Becker contends that the desire to
discriminate is a kind of taste or preference
held by employers just like the desire to have
Grape Nuts cereal for breakfast every morning
is a taste or preference. Moreover, Becker
(1993) contends that discrimination depends
more on the tastes and attitudes of consumers
and employees than on the attitudes and
beliefs of employers. Consumers may not
want to deal with minority salesmen; and
current employees may not want to work with
women or blacks. In such cases, firms will
not tend to hire qualified women and qualified
blacks, since such hiring will reduce sales or
worker productivity and thus be costly to the
firm.
Third, Becker notes that discrimination
costs employers money. If an employer could
hire a woman or a black, but wants to
discriminate against members of this group,
the employer will have to pay a price for
indulging this taste. The price paid is the wage
difference between the white male hired and
the woman or minority not hired. This means
that in competitive markets discrimination
will be less likely to occur since firms that do
discriminate will face higher costs and firms
that do not discriminate will face lower costs.
Non-discriminating firms will tend to force
discriminating firms out of existence. These
hypotheses regarding discrimination have
been the subject of much criticism and debate
(see also BERGMANN).
Becker has expanded the range of
economic analysis by looking at all individual
choice as a form of rational decision-making.
He has thus pioneered the study of
discrimination, crime, education, and
marriage by economists. Every time that he
has ventured outside the traditional
boundaries of economics he turns up unique
and interesting results with clear and testable
predictions. More important, his approach has
opened up new avenues of research and new
ways of viewing non-market human activities.
For these reasons Becker remains the most
creative economist of the late twentieth
century, as well as the most influential. His
influence can be measured by the large
number of citations to his work. Medoff
(1989) ranked Becker first among economists
under the age of 65 based upon the total
number of citations in the Social Science
Citation Index.
Works by Becker
The Economics of Discrimination (1957),
Chicago, Illinois, University of Chicago Press,
2nd edn., 1971
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AMARTYA SEN
“Investment in Human Capital: A Theoretical
Analysis,” Journal of Political Economy, 70,
5 (October 1962), pp. 9–49
Human Capital, New York, Columbia University
Press, 1964
“Crime and Punishment: An Economic
Approach,” Journal of Political Economy, 76,
2(March/April 1968), pp. 167–217
“A Theory of Marriage: Part I,” Journal of
Political Economy, 81, 4 (July/August 1973),
pp. 813–46
“A Theory of Marriage: Part II,” Journal of
Political Economy, 82, 2 (March/April 1974),
Part 2, S11–S26
The Economic Approach to Human Behavior,
Chicago, Illinois, University of Chicago Press,
1976
“An Economic Analysis of Marital Instability,”
Journal of Political Economy, 85, 6 (December
1977), pp. 1, 153–89, with E.M.Landes and
R.T. Michael
A Treatise on the Family, Cambridge,
Massachusetts, Harvard University Press, 1981
“Human Capital. Effort, and the Sexual Division
of Labor,” Journal of Labor Economics, 3, 1
(January 1985), pp. 533–58
“A Theory of Rational Addiction,” Journal of
Political Economy, 96, 4 (August 1988), pp.
675–700 (with Kevin M.Murphy)
“Rational Addiction and the Effect of Price on
Consumption,” American Economic Review,
81, 2 (May 1991), pp. 237–41 (with Michael
Grossman and Kevin M.Murphy)
“Habits, Addictions, and Traditions,” Kyklos, 45,
3 (1992), pp. 327–45
“Nobel Lecture: The Economic Way of Looking
at Behavior,” Journal of Political Economy,
101, 3 (June 1993), pp. 385–409
Works about Becker
Becker, Gary S., Current Biography Yearbook 1993,
New York, H.W.Wilson, 1993, pp. 40–4
Fuchs, Victor R., “Gary S.Becker: Ideas About
Facts,” Journal of Economic Perspectives, 8,
2 (Spring 1994), pp. 183–92
Posner, Richard A., “Gary Becker’s Contributions
to Law and Economics,” Journal of Legal
Studies, 23 (June 1993), pp. 211–15
Rosen, Sherwin, “Risks and Rewards: Gary
Becker’s Contributions to Law and
Economics,” Scandinavian Journal of
Economics 95, 1 (1993), pp. 25–36
Shackleton, J.R., “Gary S.Becker: the Economist
as Empire-builder,” in Twelve Contemporary
Economists, ed. J.R.Shackleton and
G.Locksley, New York, Wiley, 1981 pp. 12–32
Other references
Heineke, J.M. (ed.), Economic Models of
Criminal Behavior, Amsterdam, North-
Holland, 1978
Medoff, Marshall H., “The Rankings of
Economists,” Journal of Economic Education,
20, 4 (Fall 1989), pp. 405–15
Mincer, Jacob, Schooling, Experience, and
Earnings, New York, Columbia University
Press, 1974
AMARTYA SEN (1933–)
Over the last quarter of the twentieth century,
Amartya Sen has been a leading figure in the
areas of welfare economics and economic
development. He has broadened economists’
notion of human “well-being” so that it
encompasses not just additional consumption
but also developing human potential. Sen has
also studied how underdevelopment adversely
affects women and has argued that economists
who study economic development need to
focus more on developing opportunities for
people.
Sen was born in the village of Santinikeran,
in Bengal, India in 1933. His father was a
professor of chemistry at Dhaka University,
which is now in Bangladesh. As a child, Sen
lived through the Great Bengal Famine of 1943.
He claims (Klamer 1989, p. 136) this event had
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AMARTYA SEN
a prolonged and lasting effect on him, and that
it sparked his interest in economic
development.
While an undergraduate at Presidency
College in Calcutta, Sen studied ethics and
political philosophy in addition to economics.
He received a BA degree in Economics from
Presidency College in 1953, and then BA, MA,
and Ph.D. degrees in Economics from Trinity
College, Cambridge. At Cambridge, he studied
economics with both Piero Sraffa and Joan
Robinson. Robinson supervised his doctoral
dissertation (Sen 1960), and attempted to move
his research away from “ethical rubbish” and
towards abstract theory (Klamer 1989, p. 139).
After graduating from Cambridge in 1959,
Sen taught at Jadaupur University, at
Cambridge University, and then at Delhi
University. In 1971 Sen returned to England,
accepting a teaching position at the London
School of Economics. Then in 1977 he moved
to Nuffield College, Oxford. Three years later
he became Drummond Professor of Political
Economy at All Souls, a position previously
held by Edgeworth and by Hicks. In 1987 Sen
moved to the US, becoming Professor of
Economics and Philosophy at Harvard
University. Sen returned to England in 1998,
this time as head of Trinity College,
Cambridge. In 1994 Sen served as President
of the American Economic Association; in
1998 he received the Nobel Prize in Economic
Science.
The main theme in the work of Sen is the
importance of developing human potential.
For Sen, economics should be about
developing the capabilities inherent in people,
and increasing the options open to them,
rather than about trying to produce more
goods or figuring out how to maximize utility.
Consequently, he has been highly critical of
traditional welfare economics, which holds
that free exchange will maximize the well-
being of rational individuals (see also
EDGEWORTH). Sen has rejected the
assumption of human rationality, and he has
rejected Pareto Optimally (see also PARETO)
as a criterion for economic well-being.
The heart of the rationality assumption is the
belief that individuals are rational utility
maximizers. Most economists believe that
individuals behave in a highly rational and
logical fashion. They see people attempting to
figure out the consequences of different possible
actions and the utility they can expect to receive
as a result of each action. They believe that
people will act to get themselves the greatest
(expected) utility, and that allowing people to
act in this manner leads to a Pareto Optimal
situation. Sen (1976–7) has criticized this view
on a number of grounds.
He contends that utility maximization
provides a bad description of how people
actually behave. To take just one example,
individuals should expect to receive no gain
from voting in political elections. The chances
that my vote will decide the outcome of any
election are minuscule. In fact, the likelihood
of my getting struck by lightning while waiting
on line to vote is greater than the probability
that my vote will decide an election.
Nonetheless, I regularly vote; and so do large
numbers of other people.
Sen also notes that if people did actually
behave according the rationality assumption
they would become “rational fools,” since acting
selfishly can lead to some rather absurd results.
“‘Where is the railway station?’ he asks me.
‘There’, I say pointing at the post office, ‘and
would you please post this letter for me on the
way?’ ‘Yes’ he says, determined to open the
envelope and check whether it contains
something valuable” (Sen 1976–7, p. 332). Left
out of this interaction is any concern for other
people, or for the sort of person one wants to be
and the sort of society one wants to be part of.
Furthermore, Sen (1985, 1987) has pointed
out problems with using Pareto Optimality as a
welfare criterion. He notes that outcomes can
be Pareto Optimal, yet disastrous. For example,
a case in which a few people are very rich and
everyone else is starving would be Pareto
Optimal, since the situation cannot be improved
without taking income from the very wealthy
and reducing their utility. However, the fact that
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many people are starving is obviously a highly
undesirable outcome.
Sen (1970) also notes that utility
maximization conflicts with liberalism, or the
belief that people should be able to do whatever
they want so long as it does not keep others from
doing what they want. If many people want
pornography to be banned, utility maximization
would require that pornography should be
banned. Similarly, if a great many people prefer
that everyone read pornographic novels, utility
maximization demands that pornography be
forced on people. Yet concern for liberty would
allow each individual to make that decision.
Since the utilitarian analysis of individual
welfare is inadequate, another perspective is
needed. Sen proposes a capabilities-centered
approach (see McPherson 1992). According to
this perspective, well-being depends upon the
things people can do and the things that they
can do well. Human well-being is maximized
when people are able to read, eat, and vote.
Literacy is important not because of the utility
it yields, but because of the sort of person that
one becomes when one can read. Eating is
valued not because people love food, but
because food is necessary for life and health.
And people vote, not to increase their utility,
but because they value a certain political system
(democracy) and certain types of political
activity.
The number of options people have and the
freedom to choose among options, is another
important part of human well-being. This means
that when a consumer buys some good but has
no option, consumer well-being could be
enhanced by giving the consumer greater choice,
even if the consumer does not get more goods
at the end.
Going even further, Sen notes that traditional
economics has gotten the relationship between
preferences and actions backwards—
preferences do not determine human actions.
People do not value illiteracy and then decide
not to learn how to read. Rather, people who
cannot read adapt their preferences and devalue
literacy. On the standard utilitarian doctrine,
because individual preferences are valued more
than anything else, welfare is maximized when
illiterate people are not encouraged to read. But
for Sen, greater literacy would improve human
welfare because it increases the opportunities
available to people and enhances their
capabilities.
Sen has applied his capabilities approach to
the area of economic development. This work
begins by distinguishing economic growth from
economic development. Growth means
producing more things regardless of what
happens to the people producing and consuming
these goods; development involves “expanding
the capabilities of people” (Sen 1984, p. 497).
Economic growth raises per capita incomes and
output. Economic development involves
improving the life expectancy, literacy, health,
and education levels of people. It means making
people part of their community and allowing
them to appear in public without shame because
they are regarded as worthwhile individuals.
Growth and development often go together.
But as the experience of countries such as China,
Sri Lanka, and Costa Rica illustrate, the right
sort of public policies can expand capabilities
and opportunities despite low rates of economic
growth. When developing countries must decide
to focus either on promoting economic growth
or the development of capabilities, Sen contends
that they should focus on the real goal, which is
the development of human potential. Moreover,
the success of a developing economy should be
judged on its growing literacy rates and life
expectancy rather than on its growth in
production or income levels.
Sen has also established that gender issues
are an integral part of the development process.
He has questioned the assumption that low levels
of economic development affect men and
women equally, and that development policy
should focus on men and women more or less
equally.
Sen (1990b) has shown how a parental
preference for sons leads to discrimination
against women in developing countries. All
families must constantly make decisions about
how to use the limited income at their disposal.
One important decision concerns how to allocate
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AMARTYA SEN
income among all family members. For more
affluent families such decisions are usually not
critical, but for poor families they can become
life and death decisions. Family members who
do not receive sufficient food will die; likewise
family members who fail to receive adequate
medical care when they are sick may die.
Sen (1993) has shown that women and men
do not have the same access to health care and
nutritious food. Women are less likely to be
taken to the hospital than men, and women have
to be sicker before they get taken to the hospital.
Women are also less likely to be given adequate
supplies of food (Sen 1984, Ch. 15).
Sen (1990b, 1993) has documented in stark
and in concrete terms the consequences of this
unequal treatment. In the developed world there
are around 105 women for every 100 men. In the
developing world, however, there are only 94
women for every 100 men. If men and women
were treated equally in developing countries,
these countries should also have a ratio of between
100 and 105 women for every 100 men. Put
another way, if women were treated by their
families in the same way that men were treated
there would be another 100 million women alive
today in developing countries.
For ethical reasons, as well as for efficiency
reasons, Sen suggests that development efforts
should focus on women. In India, for example,
direct feeding programs have been more
successful improving the nutrition of girls than
general food disbursements that families
consume at home. Programs that encourage
women to work outside the house will give
women greater status within the family, and will
enable them to claim more economic resources
within the family. Moreover, Sen argues that if
the economic contribution of women were
greater and received greater recognition, female
children would likely receive more attention and
more family resources.
Finally, Sen’s work on famines and hunger
has helped economists understand the causes of
these important real world problems. It has also
changed the way that many international
agencies approach famine prevention and relief.
Poverty and Famines (Sen 1981) points out that
famines do not occur in democracies. Sen and
Dréze (1996) point out that India has had no
famines since 1943, but that China had a
disastrous famine (with 15–30 million people
dying of starvation) from 1958 to 1961, despite
the fact that China has generally done a better
job than India in eliminating hunger. Mass
starvation has less to do with the higher output
that results from democratic forms of
government, and more to do with the fact that
democratic governments must respond to
political pressure from the electorate. Prior to
the work of Sen, development economists
assumed that famines were the result of
insufficient food production. Sen pointed out
that distribution issues were separate from, and
more important than, the question of food
supply. Famines could result from poor or
unequal distribution mechanisms; famines could
also result from great food demand in some
sectors or regions of a country and insufficient
food supplies elsewhere.
The work of Sen has attempted to broaden
the horizon of economic analysis. He has
pressed economists to take a different view of
human economic agents. He has made a strong
case that people have some intrinsic worth, and
are not just rational utility maximizers. And he
has pointed out that the goal of a well-
performing economic system is not just more
goods and services, but improving the lives of
most people. The unifying theme in the work
of Sen has been a focus on creating human
potential or capabilities, and how this leads to
greater well-being in society and within the
household. He has seen the development of
human abilities as the real end of economic
growth and the real reason to be an economist.
Works by Sen
Choice of Techniques: An Aspect of The Theory
of Planned Economic Development, Oxford,
Basil Blackwell, 1960
“The Impossibility of a Paretian Liberal,” Journal
of Political Economy, 78, 1 (January-February
1970), pp. 152–7
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ROBERT E.LUCAS, JR.
On Economic Inequality, Oxford, Clarendon
Press, 1973
“Rational Fools: A Critique of the Behavioral
Foundations of Economic Theory,” Philosophy
and Public Affairs, 6 (1976–7), pp. 317–44
Poverty and Famines: An Essay on Entitlement
and Deprivation, Oxford, Clarendon Press,
1981
Resources, Values and Development, Oxford,
Basil Blackwell, 1984
“The Moral Standing of the Market,” in Ethics
and Economics, ed. Ellen Frankel Paul, Fred
D. Miller, Jr. and Jeffrey Paul, Oxford, Basil
Blackwell, 1985, pp. 1–19
On Ethics and Economics, Oxford, Basil
Blackwell, 1987
Hunger and Public Action, Oxford, Clarendon
Press, 1989, with Jean Dréze
“Gender and Cooperative Conflicts” in Irene
Tinker (ed.) Persistent Inequalities, London,
Oxford University Press, 1990, pp. 123–49
The Political Economy of Hunger: Famine
Prevention, Oxford, Clarendon Press, 1991
Inequality Reexamined, Cambridge, Harvard
University Press, 1992a
“More than 100 Million Women Are Missing,”
New York Review of Books, 37 (December 20,
1990b), pp. 61–6
“The Economics of Life and Death,” Scientific
American, 268, 5 (May 1993), pp. 40–7
The Political Economy of Hunger Selected Essays,
Oxford, Clarendon Press, 1995, with Jean
Dréze and Arthur Hussain
India: Economic Development and Social
Opportunity, Oxford, Oxford University Press,
1996, with Jean Dréze
Works about Sen
Klamer, Arjo, “A Conversation with Amartya
Sen,” Journal of Economic Perspectives, 3, 1
(Winter 1989), pp. 135–50
McPherson, Michael, “Amartya Sen,” in New
Horizons in Economic Thought: Appraisals of
Leading Economists, ed. Warren J.Samuels,
Hants, England, Edward Elgar, 1992, pp. 294–
309
Putterman, Louis, “Amartya Sen (born 1933),”
in Biographical Dictionary of Dissenting
Economists, ed. Arestis and Sawyer, Hants,
England, Edward Elgar, 1992, pp. 498–505
ROBERT E.LUCAS, JR. (1937–)
Robert Lucas is known for developing the new
classical or rational expectations approach to
macroeconomics. This approach seeks to
provide microfoundations to macroeconomics.
It assumes that macroeconomic actors, like
microeconomic actors, are rational human
beings who use all available information when
making decisions and who attempt to anticipate
the future. When macroeconomic actors are
seen as rational agents, Keynesian economics
can be rejected —unemployment will remedy
itself and economic policy is neither necessary
nor desirable.
Lucas was born into a middle-class family
in Yakima, Washington in 1937. Shortly
thereafter the family restaurant (the Lucas Ice
Creamery) went bankrupt, a victim of the Great
Depression. Due to the personal hardships they
had to endure, Lucas’ parents, both
descendants of a long line of Republicans,
rejected their Republican leanings and became
ardent supporters of the New Deal.
Lucas attended the University of Chicago,
majoring in history. After he received his BA
degree in 1959, he began graduate study in
history at Berkeley. Recognizing that economic
factors were the key forces moving history,
Lucas shifted his focus to economic history.
He soon returned to the University of Chicago
in order to study economics with Milton
Friedman. His Ph.D. dissertation, awarded in
1964, was an econometric study of the ease
with which businesses can substitute capital
and labor in production. From 1963 to 1974
Lucas taught at Carnegie-Mellon University.
He then accepted a position at the University
of Chicago. In 1980 he became the John Dewey
Distinguished Service Professor at the
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ROBERT E.LUCAS, JR.
university. In 1995, Lucas received the Nobel
Prize in Economic Science, primarily for his
contribution to rational expectations
macroeconomics.
Beginning with Keynes, macroeconomists
recognized that expectations affect the
economy; but they had only a rudimentary
understanding of how expectations were
formed. Some macroeconomists took
expectations as static or fixed. Others saw
expectations as adapting to past changes. On
this view, if inflation had gone up 3 percent in
the past, people would expect 3 percent
inflation to continue. After a few years of 4
percent inflation, people would change their
views and expect future inflation to be 4
percent.
Lucas insisted that people were smarter than
this and more sensible when forming
expectations. With rational expectations people
look forward as well as backward. Expected
inflation depends not just on past price changes,
but on how current conditions or current
economic policies might change things. Just
because inflation has averaged 3 percent for
years does not mean it will continue to do so.
Falling unemployment and rapid money
growth, for example, might lead people to
expect that prices will start to increase more
rapidly in the future.
Although Muth (1961) first set forth the
notion of rational expectations, Lucas has
been its strongest proponent and has made this
approach widely known. It was Lucas who
insisted that rational expectations be
incorporated into macroeconomic analysis;
and it was Lucas who drew out the
consequences of this assumption for
macroeconomic theory and policy. Two main
consequences of rational expectations are that
there is no short-run trade-off between
inflation and unemployment, and that
economic policy tools are ineffective and
cannot improve economic outcomes. This
work began what has come to be called the
“new classical school” of macroeconomics
because these results return macroeconomics
to preKeynesian conclusions.
One way to see this approach is through the
conflict between the macroeconomics of
Keynes and traditional labor economics.
Keynes attempted to explain why economies
experience prolonged bouts of high
unemployment. Labor economics sees
unemployment as the consequence of too high
wages; if workers would accept pay cuts, this
would eliminate the problem.
Macroeconomists from the 1940s through the
1960s generally sided with Keynes and viewed
unemployment as primarily involuntary. Lucas
changed all that.
New classical economics barkens back to
the classical approach to macroeconomics. It
assumes that markets, including labor markets,
always reach a point at which supply equals
demand. Unemployment will therefore be the
exception rather than the norm, and will tend
to disappear as labor markets adjust.
Unemployment is looked at as a temporary,
disequilibrium phenomenon that will remedy
itself. New classical economics also attempts
to put macroeconomics on firm microeconomic
grounds. It supposes that economic actors will
be rational and will behave in ways that
maximize their well-being.
Lucas (1969b) examines the labor supply
decision as a choice that each worker makes
between labor and leisure. Workers have some
sense of the real wage they would receive from
working. They then decide whether to work or
not by comparing this real wage against the
benefits from leisure time. If expected real
wages are higher than normal, workers will
have an incentive to work more. In contrast, if
expected real wages are lower than usual,
workers will take more leisure and wait until
real wages rise before working. Within this
framework, unemployment is explained as a
voluntary choice made by workers who are
waiting for real wages to rise to its normal level.
A similar decision must be made by
business firms (Lucas 1972, 1973). When
prices rise for the goods it produces, a firm
must decide whether that price rise is due to
greater demand for what they produce (thus
necessitating additional production) or to a
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ROBERT E.LUCAS, JR.
general rise in all prices, which would not call
for greater production. Like the worker,
business owners face labor-leisure trade-offs;
and like the worker, the business firm will only
want to produce more when it gets more for
what it produces.
Because people do not have all the
information possible at their disposal, they will
make errors in their labor and production
decisions. For example, workers may assume
that a given pay increase represents an increase
in real wages, or businesses may think that a
price rise for what they produce is an increase
in the relative price for their product rather than
part of an overall price increase.
According to Lucas, unemployment results
from individual workers and businesses making
mistakes of this sort. Workers mistake the real
wage and withhold their labor by quitting their
job or turning down job offers with too low
wage offers. Businesses also make mistakes
about demand and sometimes produce too little
and hire too few workers. But because people
are rational beings, who are forward looking
in how they form expectations, mistakes will
get corrected shortly and unemployment will
disappear.
This analysis of the causes of
unemployment dovetails with a second
contribution due to Lucas, one that has come
to be known as “the Lucas Critique.” One
normal exercise in economic analysis is to
employ a macroeconomic model to study how
changing fiscal policy and/or monetary policy
impacts the whole economy. In the 1960s it
was assumed that these models could help
policy makers guide the economy towards full
employment with low inflation. In the 1970s,
stagflation seemed to show that fiscal and
monetary policies were relatively ineffective in
solving macroeconomic problems. Economists
needed some explanation for this policy failure.
Lucas provided that explanation.
Lucas (1976, 1978) criticized the use of
large-scale macroeconomic models to evaluate
the consequences of different economic
policies (see also TINBERGEN). His criticism
was that these models all assume
macroeconomic relationships will remain
unchanged in the face of any change in policy.
But this will not be true, Lucas (1978, p. 52)
contends, because “a change in policy
necessarily alters some of the structural
parameters…in a highly complex fashion….”
Without knowing which economic
relationships remain the same, which change,
and how they change, an econometric model
is of no value in assessing alternative policies.
Going even further, Lucas (1978, p. 56) claims
that the poor track record of economic
forecasting models (for example, their failure
to explain the stagflation of the 1970s) shows
that macroeconomic relationships do
frequently change.
In practice, the Lucas Critique means that
economic behavior will change in response to
a policy change. Certainly, rational individuals
who attempt to maximize their own well-being
should change their behavior in the face of
changing economic policy. These behavioral
changes, in turn, will change macroeconomic
relationships. These behavioral changes will
also make macroeconomic policies ineffective.
One example of this (pointed out by Barro
1974) concerns the effects of government debt.
According to the Keynesian view, a tax cut by
the government will lead to increased demand
for the goods and services. But tax cuts also
lead to larger government deficits. According
to rational expectations macroeconomics,
rational citizens will realize that these deficits
must be paid back in the future and that the
government must raise taxes to do so. People
will therefore save most of their tax cut so that
they can pay their higher taxes in the future.
Tax cuts no longer increase consumer spending
and employment; instead, savings is
stimulated.
Another important example of the Lucas
Critique in action concerns the Phillips Curve
(see also SAMUELSON). Lucas (1972) shows
that the traditional argument for the Phillips
Curve assumes irrational macroeconomic
actors. He then goes on to explain why the
Phillips Curve will likely be vertical in the long
run. If policy makers attempt to expand the
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ROBERT E.LUCAS, JR.
economy and lower unemployment they will
generate expectations of higher inflation
among rational economic agents. Workers will
not want to work more if they are paid less,
and so employment will not increase and
unemployment will not fall. The only impact
of stimulative demand policies is rising prices.
In the long run, then, economic policy can only
change prices or the rate of inflation; it can do
nothing about unemployment. There is no
inflation-unemployment trade-off; there is
only, following Friedman, a natural rate of
unemployment. This rate is determined by the
decisions made by workers and firms, and
cannot be modified by any economic policy.
Lucas argues that stimulative fiscal policy
can only increase employment by fooling
workers into believing that the higher wages
offered by businesses represents an increase in
their real wages. Lucas points out that workers
can be fooled once or twice, but that is it. The
next time the government tries to stimulate
employment through additional government
spending, workers will expect to see higher
inflation and no increase in their real wages. As
a result, people will not seek more work and
less leisure, and these policies will fail to
stimulate employment. This is true as well for
money policy. Central banks cannot continually
fool people about what they are doing and
thereby expand the economy. Since fiscal and
monetary policies cannot be used to improve
economic performance, Lucas (1972) advocates
fixed and predictable rules for both fiscal and
monetary policy. For fiscal policy he suggests a
balanced budget, and for monetary policy an
announced rule of money growth.
When the Royal Swedish Academy of
Sciences awarded the Nobel Prize in 1995, it
noted that no one has had a greater impact on
macroeconomics since 1970 than Lucas. Lucas
explained how economic agents form
expectations and how these expectations, in
turn, affect economic outcomes and
performance. In so doing, he has challenged
the Keynesian orthodoxy that economic policy
must be used to remedy the problem of
unemployment. As a result of his work, the new
classical or rational expectations approach
came to dominate macroeconomics in the late
twentieth century.
Works by Lucas
“Price Expectations and The Phillips Curve,”
American Economic Review, 59, 3 (June 1969a),
pp. 342–50, with Leonard A.Rapping
“Real Wages, Employment and Inflation,” Journal
of Political Economy, 77, 5 (September/October
1969b), pp. 721–54, with Leonard A.Rapping
“Expectations and the Neutrality of Money,” Journal
of Economic Theory, 4 (April 1972), pp. 103–24
“Some International Evidence on Output-Inflation
Tradeoffs,” American Economic Review, 63, 3
(June 1973), pp. 326–34
“An Equilibrium Model of the Business Cycle,”
Journal of Political Economy, 83, 6 (December
1975), pp. 1,113–44
“Econometric Policy Evaluation: A Critique” in
K.Brunner and A.Meltzer, eds. The Phillips
Curve and Labor Markets, Amsterdam, North-
Holland, 1976, pp. 19–46
“After Keynesian Macroeconomics” in After the
Phillips Curve: Persistence of High Inflation and
High Unemployment, Boston, Massachusetts,
Federal Reserve Bank of Boston, 1978, pp. 49–
72, with Thomas J.Sargent
“Rules, Discretion and the Role of the Economic
Advisor,” in Rational Expectations and
Economic Policy, ed. Stanley Fischer, Chicago,
Illinois, University of Chicago Press, 1980, pp.
199–210
Studies in Business Cycle Theory, Cambridge,
Massachusetts, MIT Press, 1981
Models of Business Cycles, Oxford, Basil Blackwell,
1987
“Nobel Lecture: Money Neutrality,” Journal of
Political Economy, 104, 4 (August 1996), pp.
661–82
Works about Lucas
Chari, V.V., “Nobel Laureate Robert E.Lucas, Jr.:
Architect of Modern Macroeconomics,”
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ROBERT E.LUCAS, JR.
Journal of Economic Perspectives, 12, 1
(Winter 1998), pp. 171–86
Fisher, Stanley, “Robert Lucas’s Nobel Memorial
Prize,” Scandanavian Journal of Economics,
98, 1 (March 1996), pp. 11–31
Klamer, Arjo, Conversations with Economists:
New Classical Economics and Opponents
Speak Out on The Current Controversy in
Muth, John F, “Rational Expectations and the
Theory of Price Movements,” Econometrica,
29, 3 (1961), pp. 315–35
Macroeconomics, Totowa, New Jersey,
Rowman & Allenheld, 1984
Other references
Barro, Robert, “Are Government Bonds Net
Worth?,” Journal of Political Economy, 82
(1974), pp. 1,095–117
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GLOSSARY
Absolute advantage A theory holding that whichever country can produce a good more efficiently
will export that good (also see comparative advantage).
Accelerator A theory of investment which holds that investment increases whenever the
economy expands.
Adding up problem Concerns whether summing the marginal productivity of all inputs used by
the firm will equal the value of output, and thus whether sales proceeds can pay factors of production.
Adverse selection A problem in the insurance industry, whereby people take out insurance
who are more likely to file claims than the population in general.
Arbitrage The simultaneous purchase and sale of some asset in two different markets in
order to make money from the price differential.
Asymmetric information Differences in knowledge by two parties to some trade or
transaction.
Cambridge Controversy A dispute between Cambridge, England and Cambridge,
Massachusetts in the mid-twentieth century concerning how to measure capital.
Cantillon Effect The differential impact of money on the economy depending upon how
money enters the economy and who gets the money.
Cardinal utility The belief that consumers can distinguish how much more they prefer one
bundle of goods to another bundle of goods (see ordinal utility).
Class struggle A conflict between capitalists and workers.
Cliometrics The new economic history, which uses advanced statistical techniques to test
hypotheses about economic history.
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GLOSSARY
Comparative advantage The doctrine that it is relative efficiencies (or relative inefficiencies)
that determine the goods a country will export (see absolute advantage).
Complimentary goods Two or more goods usually consumed together, like gasoline and
automobiles.
Conspicuous consumption Expenditures made to impress others rather than improve one’s
well-being.
Constant returns to scale Occurs when an increase in inputs leads to a proportional increase
in output.
Consumer sovereignty The belief that each consumer is the best judge of their own well-
being and should be allowed complete freedom in purchasing goods.
Consumption function The relationship between consumer spending and income.
Contract curve A curve within the Edgeworth Box connecting the points at which two
individual’s or two countries’ indifference curves are tangent.
Correlation coefficient A measure of the relationship between two economic variables, or
the extent that they move together.
Cost-benefit analysis A tool for evaluating investment projects and government spending
programs by comparing all the benefits that will result from the project and all the costs of
the project.
Creative destruction The process by which new innovations and technological
breakthroughs come to destroy old products and production processes.
Cumulative causation A positive or negative feedback mechanism involving two or more
variables, so that increases in one variable lead to increases in the second variable, which
increases the first variable again, etc.
Differential theory of rent Belief that the rent on any plot of land is determined by the
difference between the productivity of that plot and the productivity of the least fertile land.
Diminishing marginal utility The satisfaction received from consuming a good will decline
with each additional unit of the good that is consumed.
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GLOSSARY
Diminishing returns When additional workers (or other factors of production) produce less
than the previous worker (or factor) hired.
Division of labor Specialization in the production process whereby tasks are divided into small
operations and individual workers are assigned to do just one task.
Dual labor market hypothesis The theory that there are two different labor markets in developed
countries—one for skilled workers and one for unskilled workers.
Dumping The practice of charging less for some good abroad than the firm charges in its domestic
market.
Econometrics The part of economics that measures economic relationships using statistical
techniques.
Economies of scale Reductions in the cost of producing goods as a result of producing larger
quantities of the good.
Edgeworth Box A diagram which combines the indifference curves of two individuals or two
countries in order to determine the outcome of their attempts to trade with each other.
Effective demand The demand for goods and services which is backed up with the ability to
purchase those goods and services.
Elasticity of demand The percentage change in consumer purchases divided by the percentage
change in price of a good. This shows how much sales change given a price change.
Elasticity of substitution A measure of how much business will change their use of inputs into
the production process as a result of changes in the cost of buying that input. If the elasticity of
substitution is zero, factors of production are always used in fixed proportions no matter how
expensive the cost of some input becomes. If it is greater than zero, then higher wages will lead
business to use more machinery and less labor.
Equation of exchange MV=PQ, or the money supply (M) times the number of times each
dollar gets spent (V) equals the output of the economy (prices times quantities).
Ex ante-ex post Distinguishes that which is planned (ex ante) from what actually occurs (ex
post).
Expenditure tax An income tax that exempts all savings from taxation.
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Exploitation The appropriation of surplus value by owners of capital.
GLOSSARY
Externalities The costs (or benefits) of producing a good for consumption that are not paid for
(or are not received) by the ultimate consumer. For example, pollution imposes a cost on all
society, but these costs are not part of the price of a polluting good.
Factor price equalization theorem Free trade in goods leads to equal wages among trading
partners and equal profit rates.
Feminist economics A branch of economics that employs feminist theory in order to uncover
the causes and consequences of women’s economic oppression. Fiscal policy The use of
government spending and government tax policy to direct the economy.
Free rider problem Because some goods or benefits (for example, the benefits of defense
spending and higher wages due to unionization) are available to everyone, people will not
voluntarily pay for them; therefore unless people are forced to pay for these goods they will not
get produced.
Game theory The study of interdependent decision-making.
General equilibrium A situation where all markets in an economy are simultaneously in
equilibrium.
Gresham’s Law “Bad money drives out good money”. This law stems from the fact that people
will hold on to money that is more valuable (has more precious metals in it) and pass on to
others money that is less valuable.
Income effect The increased quantity of some good demanded by consumers as a result of
higher consumer incomes.
Incomes policy Government attempts to control wage and price increases, and thus inflation.
Increasing returns Occurs when additional workers produce more output (on average) than
previously hired workers.
Indifference curve A set of points, representing different combinations of two goods that yield
the same level of satisfaction to the consumer.
Infant industry argument The claim that protection from foreign competition is justified for
firms that are just starting up in an industry.
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GLOSSARY
Input-output analysis A mathematical representation of the economy that shows how much
of various different inputs are needed to produce one more unit of every good.
IS-LM model A macroeconomic model showing how the goods market (IS) and the money
market (LM) reach equilibrium together.
Kondratieff waves Long run (45 to 60 years) cycles in economic activity.
Labor theory of value A theory holding that relative prices of goods depends on the relative
amounts of work required to produce that good.
Law of demand The view that (other things being equal) the lower the price for some good,
the more of that good consumers will buy.
Law of supply The view that as prices rise for some good, business firms will produce and
sell more of that good.
Leontief Paradox The surprising finding that the US, rich in capital, was exporting goods
that used relatively large amounts of labor and relatively small amounts of capital.
Life cycle hypothesis The belief that individuals gear their annual consumption to their
expected average lifetime income rather than to their current income.
Loanable funds theory of interest Holds that interest rates are determined by the supply of
savings and the demand for loans.
Lucas Critique The argument that large-scale macroeconomic models cannot help make
macroeconomic policy because making any policy changes will alter the macroeconomic
model.
Macroeconomics A study of the performance of the entire economy.
Marginal cost The extra cost of producing one more unit of output.
Marginal productivity Additional output that results from hiring one more worker (or using
one more input).
Marginal productivity theory of distribution The view that the incomes received by each
input in the production process is equal to its marginal productivity.
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GLOSSARY
Marginal propensity to consume The proportion of any additional income that is spent by
consumers.
Marginal revenue The additional revenue received by a firm when it produces and sells one
more good.
Marginal utility The utility consumers get from the last unit of some good that they consume.
Market socialism An attempt to combine the characteristics of capitalist and socialist economies
by using the market to set prices and allocate resources but having the government own most
large enterprises.
Mark-up pricing The view that firms set prices by adding a (percentage) increase to their costs.
Mercantilism An early economic doctrine stressing that nations must run trade surpluses and
accumulate money if they are to grow and develop.
Methodological individualism The belief that economic phenomena should be explained only
as a result of individual choices.
Methodology A study of the methods used in trying to understand how economies work and
how economic laws operate.
Monetarism A doctrine holding that inflation stems from too much money in the economy.
Monetary policy The attempt by a central bank to influence economic outcomes through its
ability to control interest rates and/or the domestic money supply.
Money illusion When individuals react to changes in monetary terms (they are happy because
they got a pay raise) rather than to changes in real terms (the greater pay can buy no more than
the previous paycheck because prices have gone up also).
Monopsony A market in which there is only one buyer of some factor of production.
Moral hazard A problem arising from insurance systems; insurance causes people to behave in
more risky ways, thus increasing the chance they will need to collect from the insurance pool.
Multiplier The relationship between a change in spending and the impact of that change on the
entire economy.
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GLOSSARY
Natural rate of unemployment The lowest rate that unemployment can go before it results in
accelerating inflation.
New classical macroeconomics A twentieth-century school of macroeconomics that
combines rational expectations and a belief that there exists a natural rate of unemployment
for all economies.
New institutional economics A study of how and why economic institutions (such as
property rights, markets, and the state) come into existence.
Nominal interest rate The rate of interest in today’s prices or ignoring the impact of inflation
(see real interest rate).
Occupational segregation The practice of hiring primarily women or minorities for certain
types of jobs and hiring white males for an entirely different set of jobs.
Opportunity cost The cost of some foregone alternative.
Ordinal utility The belief that consumers can only distinguish that they prefer one bundle
of goods to another bundle (see cardinal utility).
Pareto Optimality When an economy’s resources are distributed in such a manner that
no one can be made better off without making someone else worse off.
Partial equilibrium Economic analysis that looks at just one market in isolation from all
the other markets in the economy.
Permanent income hypothesis A theory of consumption holding that consumer spending
depends on average expected income over several years rather than on current income.
Phillips Curve A trade-off between inflation and unemployment. The curve shows that
when inflation rises unemployment falls and vice versa.
Physiocracy The first school of economics, headed up by François Quesnay. The Physiocrats
held that only agriculture was productive.
Physiocratic theory of rent The view that rents are determined by the surplus produced on
a plot of land.
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GLOSSARY
Pigou Effect (real balance effect) The argument that during a recession declines in prices
will increase the real wealth of consumers and thereby increase spending.
Poll taxes Taxes of some fixed amount that everyone has to pay regardless of their income
or their spending habits.
Population principle A belief (due to Malthus) that population growth would exceed the
growth of the food supply.
Predatory pricing The practice of lowering prices to unprofitable levels in order to drive
your competitors out of business.
Price discrimination The practice of charging different prices for some good to different
consumers.
Prisoner’s dilemma A famous result in game theory which shows that individual self-
interest may not lead to an optimal outcome.
Progressive tax A tax that falls more heavily on wealthy households than on low and
middle-income households. The income tax is an example of a progressive tax.
Proportional tax A tax which has all households pay the same fraction of their income to
the government.
Public choice The economic study of politics.
Public finance A study of government spending and tax policy.
Purchasing power parity A view that exchange rates will tend towards levels so that two
currencies will be able to buy the same set of goods in their respective country.
Quantity theory of money Belief that changes in the quantity of money lead directly to
changes in the price level.
Radical subjectivism The belief that only individuals themselves are capable of knowing
what is best for themselves.
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GLOSSARY
Rational expectations The belief that businesses and individuals will learn about the effects of
government policy and change their behavior in a way that will counteract any government
policies.
Real balance effect See Pigou Effect.
Real interest rates Nominal interest rate minus the rate of inflation. The real interest rate
represents the gain in purchasing power for a lender and the loss of purchasing power for a
borrower.
Regressive tax A tax whereby the poor pay larger fractions of their income for the tax than
middle-class and wealthy households. Sales taxes are a good example of a regressive tax.
Roundabout production Production methods using more machinery and capital, and requiring
a longer period of time between when production decisions are made and when goods are
produced and ready for sale.
Samuelson-Stolper Theorem Shows that tariffs on imports increase the returns to those inputs
that are heavily used in producing domestic goods which compete with the taxed good.
Social Darwinism The belief that in all social and economic interactions “the fittest”, or the
best competitors, will win out.
Specie flow mechanism A process whereby trade imbalances automatically correct themselves
because they lead to changes in the domestic money supply and price level.
Stagflation The simultaneous occurrence of high unemployment (stagnation) and inflation.
Subsistence theory of wages The view that wages will tend to fall to a level that is just sufficient
to let workers survive.
Substitution effect The effect on sales for some good due to a change in price. Higher prices
cause people to purchase (substitute) other goods.
Surplus The difference between the output of some economy and the inputs required to produce
that output.
Surplus value The value of a product over and above the wage and depreciation costs of producing
that good.
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GLOSSARY
Tâtonnement A “groping” process by which equilibrium can be reached in all markets at once.
Total utility The total amount of satisfaction that one gets from consuming a certain quantity of
goods.
Usury (laws) Laws that regulate or prohibit charging (high rates of) interest.
Utilitarianism The philosophical doctrine that people should seek to promote the greatest possible
happiness in society.
Utopian socialism A belief that the problems of capitalism could be solved by establishing co-
operative communities not dominated by the profit motive.
Wage fund doctrine A theory of the demand for labor which holds that employers must have a
fund of capital available to pay workers during the production of goods.
Welfare economics The part of economics which studies how to maximize the well-being of
the nation by both increasing output and changing its distribution.
Yield curve A diagram showing how interest rates change as the time to maturity on some asset
increases.
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